Across - The - Curve - in - Rates - and - Structured - Products - and - Across - The - Grade - in - Credit - Products - December 19, 2006 - (Bear, - Stearns - & - Co. - Inc.) PDF

December 19, 2006
Bear, Stearns & Co. Inc. 383 Madison Avenue New York, New York 10179 (212) 272-2000 www.bearstearns.com
Coordinators:
Steven Abrahams, Rates Markets Gyan Sinha, Credit Markets Victor Consoli, Corporate Credit Markets
A CROSS THE C URVE

in Rates and Structured Products
AND
A CROSS THE G RADE

in Credit Products
Outlook 2007
Rates: The Resilient Rates Market...................................................................... 3
The Fed and foreign investors continue to have a firm grip on the U.S. rates markets, although the road ahead looks rougher than last years stretch.
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Economics
John Ryding Conrad DeQuadros Elena Volovelsky Meghna Mittal David Boberski David Boberski Jon Blumenfeld (212) 272-4221 (212) 272-4026 (212) 272-4447 (212) 272-1961 (212) 272-1507 (212) 272-1507 (212) 272-2993 (212) 272-2206 (212) 272-3082 (212) 272-9858 (212) 272-1490 (212) 272-9858 (212) 272-1978 (212) 272-7431 (212) 272-1490 (212) 272-2152
Treasuries/Futures/Agencies Interest Rate Swaps/Options
Corporate Credit Strategy: Good, But Not Great, Outlook for Corporate Credit in 2007 .................................................................................................... 8
Another year of solid credit fundamentals and technicals holding spreads in a tight range. Active credit selection in our recommended sectors could provide further upside from our expected return ranges of 4% in high grade and 6.5% in high yield.
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Agency MBS
Steven Abrahams Victor Gao
Emerging Market Sovereigns: Emerging Market Debt: 2007 Outlook ........... 13

For 2007, we believe spreads in emerging markets can continue to grind tighter, though at a reduced pace. Our base-case scenario calls for a total return of 8%-10% on the index in 2007.
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Adjustable Rate MBS

Gyan Sinha Aditya Bhandari Gyan Sinha Karan PS Chabba Mary Ann Thomas Aditya Bhandari Jesse Singh, CFA Beau Paulk Kunal Shah
ABS and Non-Agency MBS
Rate Sectors
Economics ......................................................................................................... 17 Growth, Inflation and Monetary Policy Outlook for 2007 Treasuries/Agencies ......................................................................................... 21 Repo Scrutiny, Steeper Curve and a New GSE Regulation Interest Rate Swaps/Options ........................................................................... 25 Swap Spreads in 2007: Grinding Tighter Volatility in 2007: Watching the Fed Agency MBS...................................................................................................... 31 MBS in 2007: The Case for Tighter Spreads Adjustable Rate Mortgages ............................................................................. 36 Agency Hybrid Outlook 2007
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CDOs
Gyan Sinha Karan PS Chabba Andrew Bierbryer Kunal Shah (212) 272-9858 (212) 272-1978 (212) 272-7331
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CMBS
Marielle Jan de Beur Naynika Chaubey (212) 272-1679 (212) 272-0894 (212) 272-2662 (212) 272-8054 (212) 272-8234 (212) 272-5944 (212) 272-5349 (212) 272-9040
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Prepayments
Dale Westhoff V.S. Srinivasan Steven Bergantino Victor Consoli Michael Mutti Carl Ross
Credit Sectors
Structured Credit ............................................................................................. 38 The Structured Credit Markets in 2007: Opportunities and Challenges CMBS ................................................................................................................ 50 CMBS: A Year of Firsts
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Corporate Credit Strategy
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Emerging Market Sovereigns
Portfolio Strategies
Challenges and Opportunities in 2007 .................................................. 55
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Please see Regulation AC certification and other disclaimers on the last page of this document.
Across the Curve and Across the Grade: Outlook 2007 View Across the Curve
December 19, 2006
The Spread Surface (as of 12/15/06)

Average Life Bucket 2Y MBS PassThroughs Par Coupon Agency1 Average Life Spread to LIBOR Cashflow / ZV Spread to LIBOR OAS to LIBOR Pricing Spread to Tsy Nominal Spread to Tsy Cashflow / ZV Spread to LIBOR OAS to LIBOR Pricing Spread to Tsy Nominal Spread to Tsy Cashflow / ZV Spread to LIBOR OAS to LIBOR Average Life Spread to Tsy ZV Spread to Swap OAS to Swap OAS Spread to Collateral Z Spread to Tsy (15 CPB) Z Spread to Tsy (EPM)8 Cashflow / ZV Spread to LIBOR OAS to LIBOR Swap Spread (25 CPB) Swap Spread (EPM)8 Cashflow / ZV Spread to LIBOR OAS to LIBOR Spread to Swap E-Spread Spread to LIBOR Spread to Swap (23 HEP) Nominal Spread (EPM)8 Cashflow / ZV Spread to LIBOR OAS to LIBOR Spread to LIBOR (23 HEP) Nominal Spread to LIBOR (EPM)8 Cashflow / ZV Spread to LIBOR OAS to LIBOR Spread to Swap E-Spread Spread to 3 mo LIBOR Yield Yield Yield OAS to Treasury Yield to Worst Spread 4.725 5.068 4.984 47 4.567 4.980 4.826 85 3Y 4Y 5Y 42 33 -15 136 135 84 20 140 145 92 46 118 75 0 14 7Y 68 56 -10 10 Y
Non-Agency Jumbo2
100 99 52 16
Non-Agency Alt-A2
Structured MBS
Current Coupon PAC9
ARMs
Agency Hybrid3
Non-Agency Hybrid4
ABS
Autos - Prime Credit Cards - Floating Home Equity - Fixed
HEL / HELOC Floating
87 44 -12 2 46 77 37 26 20 47 50 39 2 1 -1 35 18 21 16 11
125 77 -2 14
131 77 0 16
CMBS CDOs
New Issue5 CLO ABS CDO Trust Preferred Government Swap Agency Debt6 Corporate - High Grade7 Corporate - High Yield7
62 83 41 19 45 54 59 38 4 3 0 45 32 32 23 16 16 16 16 17 17
77 95 45 19 60 79 69 35
80 94 86 42
2 55
19
3 75 69 67 51 23 30 31 31 21 21
3 90
5 100 96 95 73
24
30 30 24 31 32
24 24
69 287
93 351
4.595 5.068 4.899 125 334
(1) FNMA 15 yr (5.41 cpn) AL spread to LIBOR @ 5 yr; FNMA 30 yr (5.38 cpn) AL spread to LIBOR @ 7.5 yr (2) 'AAA' shown for (from left to right) 15 yr (5.5 cpn) and 30 yr Jumbo (6.0 cpn) and (next row) 30 yr Alt-A (6.25 cpn) (3) Bonds shown from left to right are 3/1 (5.25 cpn), 5/1 (5.25 cpn), and 7/1 (5.5 cpn) (4) Run to Maturity; bonds shown from left to right are 3/1 (5.5 cpn), 5/1 (5.5 cpn), 7/1 (5.75 cpn), and 10/1 (6.0 cpn) (5) 5 yr bond is tight window; 10 yr bond is 30 % super senior (6) Agency spreads are FNMA debt (7) Corporate Index spreads for the following maturities: HG: 1-3 yr, 3-5 yr, 5-7 yr, 7-10 yr, 10-50 yr; HY: 1-5 yr, 5-10 yr, 10+ yr; HY bonds are callable (8) EPM is Econometric Prepayment Model (9) Spread of 6.0% PAC structured off of 30-year Freddie Mac TBA collateral. For historical spreads, go to Relative Value Studio: https://aloha.bearstearns.com/rvs/rvMain.jsp. Contact your sales representative if you do not have access.
Bear, Stearns & Co. Inc.
December 19, 2006 View Across the Curve: Rates
Across the Curve and Across the Grade: Outlook 2007
The Resilient Rates Market

Steven Abrahams (212) 272-2206 / sabrahams@bear.com The Fed and foreign investors continue to have a firm grip on the U.S. rates markets, although the road ahead looks rougher than last years stretch. The Fed faces a contentious battle with market expectations over the path of policy, with widespread doubt about the Feds willingness and ability to avoid a rate cut. A steady Fed should prevail. Foreign investment in U.S. debt should again keep long-term rates well below levels indicated by economics alone, but flows should lighten as the cost of servicing U.S. foreign debt continues to rise. The yield curve looks likely to rise modestly from current levels and remain inverted with volatility generally lower and spreads tighter at least through the first half of the year. For investors, the payoffs should come in a few ways: By remaining either barbelled around target durations or overweighted in cash latelythat foreseeable economic conditions justify steady policy, that view deserves significant weight. Its economic call through 2006, after all, has been excellent. The market does have grounds for believing that the Fed could be wrong and that the economy could force the Fed to ease. In 1989, 1994, 1998 and most recently in 2000 the market drove 2-year Treasury yields well below fed funds in expectation of an eventual ease. In each case, the Fed did eventually ease. The Fed is fallible. Nevertheless, John Ryding and his team make an excellent case that the Fed will not see its hand forced in 2007 (see Parallels with 2000, Across the Curve, December 5, 2006). Consumer balance sheets remain strong, with gains in housing over recent years leaving net worth near record levels despite softening home prices. Corporate balance sheets remain strong, too, with near record levels of cash. These signal a much stronger economy than the one faced by the Fed in 2000, for instance, after the bursting internet bubble drew down consumer wealth and eventually trimmed capital investment. In fact, Ryding thinks the strong economy will force two hikes in 2007, with funds ending at 5.75%. Market expectations for inflation also point to a Fed at least on hold. The single most effective variable for gauging Fed policy has been the spread between 10-year Treasury notes and TIPS.* When that spread falls materially below 200 bp, the Fed tends to ease. When it rises materially above, the Fed tends to tighten. Today that spread stands near 230 bpnot enough to spur the Fed higher, but far from enough to signal an ease (Figure 1). Only if the spread dipped toward 150 bp and stayed there long enough to constitute a reliable signal might the Fed lower rates. Unlikely.
By taking spread risk in the first half of the year, and By selling options in the first half as well
Despite prospects for a bumpier road, the rates markets still can rely on persistent global liquidity to help absorb most shocks. The road may get a little rougher, but the market looks resilient. Rates and the Fed The Fed in 2007 is likely Strategy Outlook for the to find itself in a End of 2007 continuing fight with the market over expectations Fed funds: 5.25% 25 bp about policy, with most of the impact coming on the 2-Yr Treasury: 5.00% 25 bp short end of the Treasury curve. Taken at face value, everything the Fed says suggests that through most of next year it expects to keep fed funds at least at 5.25%. The market, however, doubts that. Thats the message implied by 2-year Treasury yields that have traded as low as 4.50% in recent weeks and now stand near 4.70%. The Fed and the markets are at loggerheads. For 2007, my money is on the Fed. The Fed has a clear comparative advantage in this forecasting game. It certainly has as much economic information as anyone. It has as large and as competent a staff of analysts. But unlike most other players, it has incentives to get the path of inflation and growth right and no way to diversify away its risk of being wrong. Fed transparency has upped the ante, with the institutions credibility riding partly on its forecasts of the economy. Information, expertise and incentives are a powerful combination. If the Fed saysas it has repeatedly
Sack, Brian (2003). A Monetary Policy Rule Based on Nominal and Inflation-Indexed Treasury Yields, Finance and Economics Discussion Series Working Paper No. 2003-7, Board of Governors of the Federal Reserve System.

Figure 1. Inflation Expectations: Unlikely to Signal a Fed Ease in 2007
Imp'd Infla: 10Y Notes - 10Y TIPS (%) 3.00 2.80 2.60 2.40 2.20 2.00 1.80 1.60 1.40 1.20 1.00 Biased to Ease Biased to Tighten
December 19, 2006

simply buys more than it produces, and it borrows the difference by selling bonds. The persistence of the deficit stands on several grounds.
/20 3 /9 03 /2 5 /2 0 04 8/2 8 /1 00 4 8/2 1 1 00 4 /8/ 2 1 /2 00 4 7/2 4 /1 00 5 9/2 0 7 /8 0 5 /20 9 /2 05 8 1 2 /2 00 /19 5 /2 3 /1 0 05 0/2 5 /3 00 6 1/2 8 /2 00 6 1/2 1 1 00 6 /9/ 20 06
Currency policy. China and other Asian exporters link their currencies to the dollar in order to remain the lowcost providers to the U.S. and other dollar-bloc markets. That forces these exporters to buy dollars in order to prevent appreciation of their local currencysomething that would push up the price of their exports in dollar terms. These countries have taken their resulting immense foreign reserves and plowed two-thirds of them right back into U.S. debt. The arrangement has helped both sides: the exporters effectively buy access to the U.S. markets, and the U.S. gets inexpensive money. The international role of the dollar. The dollars role in international trade has created powerful constituencies for keeping other currencies pegged to the greenback. Among central banks, an estimated 66% of the worlds $4.8 trillion in reserves sit in dollar assets, a powerful incentive to preserve the dollars value. In addition, a significant percent of international trade outside of Europe gets priced and settled in dollars even in the absence of a U.S. counterparty, an incentive to avoid the friction of currency volatility. The relative quality of U.S. debt markets. In size, liquidity and diversity, the U.S. debt markets have sizable advantages over other places where global investors might put their funds. At the end of 2005, for instance, the U.S. had $22 trillion in non-government debt outstanding compared to $10 trillion in euro, $2.5 trillion in yen and $1.5 trillion in sterling. U.S. debt also spanned a wider range of rating categories and included significantly more securitized assets than the other markets. Apart from individual credit concerns, the ability to diversify constitutes another source of safety in U.S. debt.
12 /18
Source: Bear Stearns
Investors in the short end of the U.S. curve should also worry about the path of the European Central Bank. Many analysts see the ECB pushing up euro policy by the end of 2007. Given the good odds of depreciation in the dollar against the euro, any narrowing of the interest rate difference between U.S. and euro rates should encourage flows out of the U.S and into euro, especially for foreign private portfolios not wedded to managing exchange rates. Central banks are another story. The likely tension between the Fed path and a market anticipating an ease should drag yields along the short end of the Treasury curve higherwith a little kicking and screaming along the way. Yields on 2-year Treasuries should end up closer to 5.00% than where they stand today. And the realized volatility of short rates should rise from levels seen in 2006. Rates and Global Flows In 2007, the global Strategy Outlook for the stampede of dollars into End of 2007 U.S. debt may slow, paving the way for a 10-Year Treasury: 4.85% modest and sustained rise 25 bp in 10-year yields into the neighborhood of 4.85% or higher. Foreign investment should still keep yields on the long rates well below levels dictated by economics alone. At times, foreign flows in recent years equivalent to more than 7% of GDP have dragged 10-year yields as much as 95 bp below the levels that economics alone might anticipate.+ Those flows will not turn on a dime, but they may have good reason to throttle back. Foreign inflows have dominated the long end of the curve as the U.S. current account deficit has exploded. The U.S.
None of these factors change quickly, but on the last count the relative quality of U.S. debtthe tide may turn a little in 2007, and not so much in the eyes of central bankers as in the view of foreign private investors. Those investors might start to worry that the U.S. is approaching practical limits to expanding its foreign liabilities. Until just this year, the U.S. was able to cover the costs of its ballooning foreign liabilities simply out of the cash flow from its own foreign investments (Figure 2). In 2005, for example, the U.S. received from foreign assets $17.5 billion more than it paid out for foreign liabilities. Considering the nearly $6 trillion in current account deficits piled up over the last quarter
Warnock, F.E. and V.C. Warnock (2005) International Capital Flows and U.S. Interest Rates, International Finance Discussion Series Working Paper No. 2005-840, Board of Governors of the Federal Reserve System.
Galati, G. and P. Wooldridge (2006) The Euro as a Reserve Currency: A Challenge to the Preeminence of the U.S. Dollar? Bank for International Settlements Working Paper No. 218.
December 19, 2006

century, the surplus is remarkable. Some analysts have argued that this persistent surplus signals that the current account deficit is easily sustainable. Through the first half of 2006, however, revenues from foreign assets fell short by an annualized $7 billionthe first shortfall in at least 46 years. With the maturing of U.S. debt issued in 2002-2004 and its likely reinstatement at todays higher rates, the U.S. shortfall looks bound to grow.
Figure 2. Covering the Cost of U.S. Foreign Liabilities Gets Harder
$50 US Net Int'l Invest Inc ($B) $40 $30 $20 $10 $0 -$10 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004

Foreign investors look likely to cut back their appetite for Treasury debt and raise it for spread product as a way to diversify risk. Before leaving a discussion of the curve, its worth noting that students of U.S. business cycles see good reasons to believe that the yield curve could steepen next year instead of remaining inverted. An important part of this case rests on expectations for weaker credit. David Boberski lays out a case for a steeper curve in Repo Scrutiny, Steeper Curve and a New GSE Regulation in these pages. Im still staked to the bet that this cycle will continue to be a little different. The Volatility Markets The Fed, issuance of bank Strategy Outlook for the debt and possibly the End of 2007 mortgage market should shape the path of implied 1Y10Y Swaption volatility in the year ahead Volatility: 80 bp 5 bp with volatility rising over 2006 levels in shorter 5Y5Y Swaption options while falling in Volatility: 80 bp 5 bp longer ones. The shape of the volatility surface may change, but the general level still shouldnt stray too far from the levels of this year, which were some of the lowest since the 1960s. The main source of volatility in short-dated options should come from the likely tension between the Feds actual path and the markets eagerness to anticipate an ease. The pricing of the 2- to 5-year part of the curve today embeds a bet that the Fed will ease. If they do, these notes will have enough duration to profit from the likely ensuing rally. If the economy instead produces acceptable inflation and growth, as the Fed anticipates, then front of the yield curve will need to re-price. Look for the re-pricing. And look for volatility in the short part of the curve to rise. The volatility implied by long-dated options should drift lower through the first quarter as the refinancing of callable bank trust preferred debt continues. Nearly $25 billion of the debt issued in 1996-1997 and in 2001-2002 becomes callable in a window running from December through March. Much of this is likely to get refinanced into new callable debt and then swapped, leaving the Street heavy with supply of long-dated options. Mortgage investors should absorb some of the supply, but slowly. Look for volatility in long-dated options to bottom in the second quarter as the trust preferred pipeline empties. The joint effect of rising volatility in short-dated options and falling volatility in long-dated should reshape the volatility surface; short-dated vol should rise relative to long-dated. Thats most likely to happen in the first half of the coming year. By the second half, demand for long-dated options from the mortgage market should put a floor on the trend.
Source: Bureau of Economic Analysis
The U.S. and its lenders consequently find themselves like a homeowner and banker watching the borrowers thinning ability to cover mortgage costs. The investment account used to do it. Now the homeowner has to reach into other pockets. And the payment is going up. That could take a little of the fizz out of the economic party. No lender likes that. Any nervousness about the increasing burden of servicing U.S. foreign liabilities is likely to show up first in the flows of foreign private investors. Without a currency to protect, private investors have more leeway than central banks do to sell. Private investors also face improving conditions in other global markets. The pool of foreign currency reserves has made a number of emerging markets countries much safer today than they were five years ago, something reflected in this years generally tighter spreads. The prospects for appreciation in the euro against the dollar could also draw funds into Europe. Nervousness among foreign investors would show up in higher U.S. rates. From January through March 2006, we saw the impact of a drop in foreign inflows into U.S. debt. Foreign investors bought $82 billion fewer Treasuries than they did the year beforealthough foreign portfolios instead invested heavily in spread productsand real yields in the U.S. rose by 35 bp. The year ahead is likely to see more episodes like this.
See Ricardo, R. and F. Sturzenegger (2006). Why the U.S. Current Account Deficit is Sustainable, International Finance, 9 (2), 223-240. For a contrasting view, see Gros, Daniel (2006). Why the U.S. Current Account Deficit is Not Sustainable, International Finance, 9 (2), 241-260.

As for the mortgage market, it should add to net demand for options by continuing to add to the stock of 30-year loans outstanding near par. In the first half of 2006, the general rise in rates left most mortgages below par, reducing the need for servicers and others to manage negative convexity. Nevertheless, more than $950 billion in new fixed-rate loans were produced around par last year, and in the year ahead another $830 billion should roll out of the pipeline. Prudent servicers will buy some option protection on all of that production. Of course, if 10-year Treasury yields take a surprising sustained dip below 4.35%, then the rising negative convexity of the mortgage market should drive up demand for options sharply. Jon Blumenfeld and David Boberskis detailed outlook for the volatility markets appears elsewhere in these pages in Volatility in 2007: Watching the Fed. The Spread Markets Opinions on spreads Strategy Outlook for the around here vary from End of 2007 slightly wider to slightly tighterusually with the 2-Year Swap Spread: outlook for creditbut 30 bp 2.5 bp Im in the tighter camp. Spreads in swaps, agency 10-Year Swap Spread: MBS and agency debt 40 bp 2.5 bp look likely to end the coming year tighter than where they began. The key assumptions Im making: that credit spreads will generally tighten and that MBS will avoid a refinancing wave. Swap spreads in the last year moved largely in sync with spreads in credit while other potentially important drivers of swap spreadsmortgage hedging, Treasury repo, debt issuance and Treasury supplylargely sat on the sidelines. In fact, tightening credit spreads and an inverted Treasury curve helped invert the 2- to 10-year swap curve in February and then again in November and December. As long as MBS avoids a refinancing wave, credit should still call the tune for swaps. While credit always has a few surprises in storeemerging markets, leveraged buy-outs and subprime housing provided some in 2006a generally healthy global economy and continuing diversification of global dollar portfolios away from basic Treasury and agency debt should help spreads. The World Bank sees global GDP rising by 4.9% next year, which would cap the strongest 4-year stretch of growth since the early 1970s.
December 19, 2006

The U.S. Treasurys TICS data continue to signal sizable diversification of global dollar portfolios into spread products, as does the World Banks latest Global Financial Stability Report. The diversification makes sense for global investors trying to protect against the rising cost of U.S. debt service or depreciation in the dollar. Global growth and dollar portfolio diversification should keep the appetite for spread product very healthy. With swap spreads likely to tighten and key parts of the volatility surface likely to fall, mortgage spreads should tighten too, especially in the first half of next year. Good foreign demand for MBS should continue, with most of that coming from foreign central banks. MBS should also see reasonable demand from U.S. banks as well since it is one of the few remaining rates products with positive carry to shortterm funding; U.S. banks also should reach for MBS next year as a slowing economy trims demand for business and consumer loans. Demand from GSEs is likely to fall below the expected 7% growth rate in outstanding 1-4 family mortgage debt, but the GSEs have not been key marginal buyers of MBS since 2001. Nominal spreads of MBS to Treasuries and swaps should slowly tighten as long-dated volatility drops in the first half of next year; nominal spreads in the second half should soften. Good demand should keep OAS tightening all year long. Finally, spreads in agency debt stand to end the year tighter to the Treasury curve. The stock of outstanding agency debt should follow the slight growth in portfolio balances, but demand from foreign portfolios remains robust. With many investors expecting few opportunities for trading profits, the spread in agency debt should prove attractive. Views on the swap and agency MBS markets are detailed elsewhere in these pages in Swap Spreads in 2007: Grinding Tighter and in MBS in 2007: The Case for Tighter Spreads. Still Riding Down Liquidity Lane Despite concerns about a modest rise in Treasury rates, a persistent inversion in the curve, some twists in volatility and expectations for tighter spreads in most markets, U.S. rates still can rely on a historically deep supply of liquidity. Most of the changes anticipated in 2007 reflect subtle shifts in that liquidity. The higher rates could come with rising concerns about the cost of U.S. foreign liabilities, the tighter spreads with continuing diversification. But the liquidity should still allow the market to absorb change easily. The ongoing proliferation of hedge funds and growth of assets under management helps, too, bringing investors willing to be either long or short into an increasing number of markets. Liquidity and its managers should continue to be forces in 2007 for well functioning markets.
For a detailed discussion of these factors, see Kobor, A., L. Shi and I. Zelenko (2005). What Determines U.S. Swap Spreads, World Bank Working Paper No. 62.
December 19, 2006

If this outlook gets derailed, its likely to be at the instigation of only a few things:

Politics in China or the U.S. The benefits of the current arrangement between Chinas exporters and U.S. borrowers dont extend to everyone in those countries, and politics could reflect any discontent. The tension in China is between the wealthy coastal areas that are home to most exporters and the poorer interior regions. In the U.S., it is between service industries that benefit from globalization and manufacturers that dont. Chinas interior could demand an end to purchases of dollars something that effectively subsidizes the export sector and a beginning to investment in interior infrastructure such as health care, social security and pensions. In the U.S., theres already pressure to break Chinas link to the dollar through tariffs or other means. These kinds of politics in China or the U.S. would send long-term rates much higher.
Recession in the U.S. A U.S. recession would have dramatic implications for both rates and spreads. In rates, recession could spur a sharp steepening of the yield curve with a both a quick drop in short-term rates and a modest rise in long-term rates. The drop in short-term rates would reflect broad expectations of a series of cuts by the Fed. The rise in long-term rates would reflect expectations of a shrinking U.S. current account deficit and less foreign reinvestmentas consumer spending slowed. Recession would normally dictate a drop in longterm rates, but shifting foreign demand would likely make this yet another exception to long-standing rate market rules. In spreads, the prospects of recession would raise concerns about credit and send spreads in swaps and MBS wider.
Beyond these or other unforeseen risks, a flat or inverted yield curve with modest moves in rates and tighter spreads seem in the cards for 2007 and possibly beyond.
Across the Curve and Across the Grade: Outlook 2007 View Across the Grade: Corporate Credit Strategy
December 19, 2006
Good, But Not Great, Outlook for Corporate Credit in 2007

Victor Consoli (212) 272-5944 / vconsoli@bear.com We expect the continued strong technicals from synthetic instruments and investor liquidity to remain, holding spreads in tight range, and we view the economy as very supportive for another year of solid credit fundamentals, with Treasury rates being the major swing factor to our outlook. Most of the elements of a good corporate credit environment should remain in place throughout 2007, allowing for high grade returns in the 4% range and high yield returns in the 6.5% range, falling behind the respective 4.7% and 11% high grade and high yield returns for 2006. The outlook for the Treasury market is perhaps the most significant swing factor, with the Street consensus on rates ranging more than 100 bps, implying a 56 percentage point variance of potential returns. We have at least contained our scenarios to the camp of gradually rising rates, somewhat narrowing the potential impact on our forecasts to 12 percentage points of variance. We recommend a marketweight in corporate credit overall for 2007, with the direction of rates being the key to further upside. Marketweight high grade. High grade can expect to be subjected to the see-saw of LBO speculation pushing spreads wider, particularly in CDS, and then having the spreads quickly tighten as CDOs/CPDOs find high-nails to sell down. In cash, we expect growing demand from U.S. pensions and foreign buyers, particularly at the long end. The demand for new issuance should remain strong, with more deals having some covenant protections. The threat to high grade spreads and total returns is that Treasury yields could gradually widen and LBOs or that other credit-dilutive shareholder-friendly events could collectively chip away 1.5 points of return from an average index coupon rate of 5.9%, leaving 4%4.5% of net return and spreads perhaps 5 bps wider by year-end. We believe that returns could be improved beyond our baseline index estimate by increasing exposure to autos, energy, homebuilders, media/cable, supermarkets and telecom. Marketweight high yield. In high yield, we expect the demand for new issuance, particularly for well-sponsored LBO financings, to remain very strong. We think that the 11% returns in 2006 (9.5% excluding autos) will entice more retail inflows into high yield mutual funds, and we expect the hedge fund strategy of leveraging leveraged loans and buying high yield bonds to remain attractive; spreads could tighten marginally, into the range of 300330, through the second quarter. In our view, the 8% average high yield coupon would be the upper end of expected returns in 2007, partly because the contribution from autos, cable and telecom will be hard to replicate. We see little risk of default rates increasing significantly and expect only a slight increase in defaults, to the 2.3% range, largely on the seasoning of the substantial triple-C issuance from 2004. Were mildly concerned that corporate profits could begin slowing later in 2007 and that the expected supply of new issuance, particularly LBO financings, could come at an attractive price, which could cause a bit of relative value pressure. While we think that the high yield market will have a strong start to the year and could possibly tighten through 300 for a test, we ultimately foresee high yield spreads backing out towards their 2006 mean of 357 by year-end, leaving us with an expected high yield return of about 6.5% for 2007. Lower Treasury rates or lower defaults can of course also improve returns, but more actively, we believe higher returns could potentially be achieved by increasing holdings in the autos, cable, energy, homebuilders, retailers and wireless sectors.
2007 Potential Return Outlook
High Grade Scenarios Spread UST 10-year Annual change (bps) Spread UST 10-year Returns attributable to: Coupon Spread UST 10-year LBOs Expected Return (%) 4Q06 102 4.6 102 4.6 0 0 5.9 0.0 0.0 -0.3 5.6 4Q06 330 4.6 1.8 105 4.7 3 10 107 4.8 5 20 107 5.1 5 50 5.9 -0.3 -3.0 -0.3 2.3
5.9 5.9 -0.2 -0.3 -0.6 -1.2 -0.3 -0.3 4.8 4.1 High Yield Scenarios 330 4.7 2.3 0 10 8.0 0.0 -0.5 -0.9 6.6 350 4.8 2.3 20 20 8.0 -1.0 -1.0 -0.9 5.0
Spread UST 10-year Defaults Annual change (bps) Spread UST 10-year Returns attributable to: Coupon Spread UST 10-year Defaults Expected Return (%)
315 4.6 2.3 -15 0 8.0 0.8 0.0 -0.9 7.8
360 5.1 2.3 30 50 8.0 -1.5 -2.6 -0.9 3.0
Source: Bear Stearns Credit Research.
Looking back. In our initial outlook last year, we were far too concerned about the consumer slowing down, the fate of the auto sector, the Fed tightening, and wage and cost inflation putting pressure on corporate profits. We expected a mid-3% high grade return and eventually arrived at a 6% estimate for high yield. We became much more bullish on the credit markets and homebuilders in later July, and for high yield proposed barbelling double-Bs and triple-Cs and fading single-Bs.
December 19, 2006

Four legs support the credit platform. Overall, the economy, credit fundamentals, market technicals and investors views are now and should remain in a very beneficial position, permitting fairly good corporate credit returns. Starting with the economy, we expect unemployment to hold at 4.5%, with wage growth over 4%, inflation remaining in the mid-2% range, and real GDP growth in the area of 2.7%3%. In our view this would be a fine environment to keep the consumer spending, ensure a soft landing in housing and maintain solid corporate profit growth. Should the Fed hike rates one more time, we think that foreign investors would likely be pleased by this inflation-fighting diligence, as well as by the strength of the U.S. economy, and would increase their dollar investments. Should the Fed stay on hold or even cut rates, it should also be well received, as it is the path the market anticipates. Second, credit fundamentals are still strong, with record-high corporate cash balances1 and corporate leverage increasing slightly, to 2.8x from 2.6x. We expect defaults to increase only slightly from record lows. We also expect an increasing portion of high grade new issuance to have protective covenants like change-of-control puts, limitations on liens or coupon step-ups. Third, we think that technicals will be driven by synthetic structures like CDOs and CPDOs as sellers of protection, while natural buyers of such protection, such as banks, are moving on to LCDS, all of which may be creating an effective ceiling on spreads. Should IG7 back up to 3637 from 34.5 today, CPDOs could become sideline index sellers of 15 times their notional amount. We think that hedge funds and prop desks will remain firmly focused on technicals, trading credit around LBO speculation. Liquidity is still plentiful, coming from banks, hedge funds, the emerging markets and from recycled trade surpluses in Asia. The M&A cycle should continue as long as the stock market stays fairly valued and rates stay range-bound. Banks are eager to lend, having few alternatives due to the inverted yield curve. We also see a potential $250300 billion of increased demand for longerdated bonds from pensions as a result of new legislation.2 Fourth, investors have not been rewarded for being short or bearish, nor have they been punished for accepting more credit risk. Volatility generally has been very low for most of the year, with only a third of the trading weeks having seen the VIX above 13 (roughly the 200-day moving average), giving investors the confidence to stay invested. There could still be investors on the sidelines waiting for the Feds next move, or for a widening in spreads, before taking on more credit risk.

Four Legs Support the Credit Platform
Economy / Macro Employment is strong (4.5% UE, 4% wages) Inflation reasonable (TIPs 2.3%, PCE 2.4%) Fed is win-win-win (last hike, pause, cut) Lot of dollar-vested trade partners Housing/consumer = Fed/ low UE Technicals / Liquidity CDOs/CPDOs driving spreads tighter Pension rules and Asia demand for long end Less natural demand for protection Continued lending to fund M&A and LBOs Credit Fundamentals Corporate profit growth slowing but stable Defaults are below 2% Covenants and step-up protections Lot of balance sheet cash ($750 billion SPX) LBOs and leveraging will continue Investors' View Volatility is extremely low No punishment for risk taking Opportunity cost of being under-invested Competing asset choices vs. 5% CD rates
Strategies to watch. In a tight-spread, low-volatility, lowdefault-risk credit environment with an inverted/flat yield curve, we expect more leverage to be employed by hedge funds to generate double-digit net portfolio returns out of 6% 8% corporate credit yields. The leverage could be in the form of margin loans, aggressive CDX index selling, structured products or even permanent debt financing, such as hedge funds issuing bonds. The uses of these leverage sources are typically to buy LIBOR+275 leveraged loans or to new issue high yield bonds, or perhaps for CDS protection on an LBO candidate. We anticipate that trading LBO speculation will remain the dominant credit theme until there is some episode of volatility. We like purchasing volatility cheaplysetting up steepener trades on LBO candidates, for example, or buying HiVol protection where we see more LBO risk and funding it by selling the XO crossover index where we think more event risk has been priced in. In general, when carrying out duration-neutral (DVO1-neutral) steepeners we are willing to accept default risk and sell LBO risk, so, for example, we would sell more 3-year CDS to fund buying 5-year CDS (or 5s/7s, 5s/10s). This is consistent with our view that credit curves are biased to steepening. We think that there are fewer natural buyers of short-dated default protection in CDS, and in a low-default environment traders are more comfortable accepting default risk (selling 35-year CDS) to fund the payment of LBO speculation (buying CDS). We would also seek out high grade bond issues with changeof-control or step-up covenants. Such issues often trade at only a 1525-bp premium to similar bonds without covenants, and such premiums can become considerably more valuable in the event of an LBO speculation.
1 2
Cash held by S&P 500 (non-financials) is approximately $750 billion. See Across the Grade, November 7, 2006, The Pension Law Changes and a Few More Thoughts on CPDOs.

Sectors in Focus
High Grade Relative Value Opportunities Autos Media/Cable Energy Supermarkets Homebuilders Telecom LBO-Resistant E&P Financials Utilities Railroads LBO / Event Risk Potential Consumer Products Industrials Retailers Media/Newspapers High Yield Relative Value Opportunities Autos Homebuilders Energy Retailers Cable Wireless Defensive Gaming Satellites Healthcare Media/Directories Cable Wireless
December 19, 2006

sector is 2.5x3x leveraged, the ratings agencies have already made their downgrades, and the homebuilders have few shortdated maturities which reduce potential default triggers if the economy really slows. We also consider media (particularly cable) at 145 bps and telecom at 135 bps (as measured by our high grade index) to be among the most attractive sectors, with their strong fundamentals likely to persist. We are more cautious on high grade retailers because of LBO risk and potentially higher minimum wages. Along with retailers, we also see more LBO risk in industrials, consumer non-durables and newspapers and could see a slightly higher risk premium being demanded. Should the economy slow, we also think these sectors would be more challenged. In high yield, we think that the recent LBO issues will remain favored, particularly retailers. These credits have among the best spreads, as well as larger issue sizes and good trading liquidity. We believe that the market likes fresh deals, concerned that default risk starts to increase significantly after three years. We think that high yield buyers will look to autos as a sector with the worst behind it, with attractive spreads and with significant upside potential remaining. We also favor cable, satellite and wireless, which generally have improving fundamentals and the potential to issue equity over the next 18 months. As in high grade, we also like the high yield homebuilders. The health care sectordominated by HCA, where our high yield health care index is trading at 380 bps also has a lot of headlines behind it, and results are stabilizing; it is one of the least economically sensitive sectors. Media, particularly the directories, remains an attractive free cash flow story, and in general, media credits with divestible assets could benefit from the strong M&A cycle.
Sectors in focus. We suspect that there will be plenty of press advising credit selection (and adverse selection of LBO risk) as the roadmap to Alpha-cityno surprise there. We do think that the credit market has good technical momentum behind it and that fundamentals are good, and we expect investors to be on the hunt for excess spread. We believe that autos, energy, homebuilders, cable, media and telecom offer some of the best relative spreads for their ratings and have a lot of headline risk behind them. With Ford and GM having addressed their liquidity needs, their 200708 default risk is essentially a nonconcern, in our view, making these credits core-holding candidates, if theyre not already. We think that energy is a good defensive sector, with low LBO risk; its downside scenariotrading even with industrialshas already happened. Our high grade energy index now trades even with our industrial index at 117 bps, having been 14 bps inside at the end of 2005. We like the risk-reward in homebuilders, figuring that the sector most likely holds its 2030-bp relative discount to triple- and double-Bs and should gradually tighten as the sector stabilizes. On the downside, the homebuilding
Bear, Stearns High Grade Corporate Index 2006 Sector Trading Ranges as of 12/08/06
180 Current 160 12/31/2005
140 OAS
120
100
80
60
y Te lec om Tr an sp or tat ion Ut ilit ies Liq uid Ind ex gy Fin an cia ls Fin an ce Co ex te us tria ls Ins ur an ce Me dia nCy c riti es ria ls ing fg Cy c Ba nk Ma te En er Es ta -M Ind um er oo ds Se cu ch no log
No
Re al
Ind
Ca pG
Ba sic
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um
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10
December 19, 2006
Bear, Stearns High Yield Index (BSIX) 2006 Sector Trading Ranges as of 12/08/06
675 625 575 525 475 OAS 425 375 325 275 225 175
Me dia No nCy c Te lec om Fin an ce En er Mf gR ela Ma te Co mp um er oo ds hn o or tat ns p hc Ut ilit y BB ted gy B e ria ls -M fg Cy c ar e os it log ion y
Current 12/31/2005
He alt
Ca pG
Ba sic
Co ns
Te c
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Au to
Where could market stress come from? Tight spreads lead many of us to think that we are not being fairly compensated for risk, but the market establishes a price for everything, and when defaults are low, fundamentals are solid and the VIX is under 13 more than two-thirds of the time, you could wait quite a while for the market to offer you better spreads. In the high grade index, spreads have actually widened to 102 from 99, in part corresponding to the 10-year Treasury yield rising to 4.6% from 4.39% a year ago but maintaining the same 1.22 corporate yield to Treasury yield risk premium (e.g., 4.6 + 102 / 4.6). Assuming that the UST 10-year yield moves up to the 4.8%5.1% range from 4.6% today, if high grade creditors remain content with a 22% spread premium, we could see high grade spreads widen by 57 bps. The market could, of course, demand a greater spread premium to hold corporate risk if inflation surges or if confidence corporate profits growth diminishes. We view any potential market stress as likely be episodic, coming from LBO speculation or from the inevitable string of down days in the stock market driven by earnings disappointments or economic data. Recent episodic disruptions have also been caused by unfortunate headlines related to terrorism, hedge fund blow-ups and proposed regulatory changes. But these have all been short-lived distractions, spiking volatility and widening spreads for days to weeks only, and they are a reality of the markets. The larger riskslow probability, in our viewconcern the economy stumbling or the market facing systemic problems like a drop in corporate profit growth, a cluster of defaults, or hedge funds crowding into a mistaken theme.
Co ns
um
Where Could Potential Market Stress Come From?

Economy / Macro Housing hard landing (low probability) Inflation hits 3% (moderate probability) GDP below 2%, recession fears (low prob.) Severe dollar weakness (low prob.) Episodic Stresses LBOs and rumors widen spreads Stock market corrections / VIX spikes Subprime mortgage contagion Systemic Concerns Corporate profit growth drops sharply Multiple credit defaults (weak LBOs) Hedge fund leverage problems Global liquidity stalls Exogenous / Unpredictable Terrorism Bird Flu Oil shock Tax hike rhetoric Corporate fraud New war or confrontation
Defensive positioning. Insurance comes at a cost, whether from paying default protection premium or from forsaken opportunity. The least expensive defense, in our view, is to increase a portfolios allocation to cash, shorten duration, select bonds with covenants, and overweight lower-viability LBO sectors like financials, railroads, utilities, deep-cyclicals, capital-intensive industries like E&P, and super-cap companies (over $50 billion TEV). A more selective approach could be to define a basket of LBO candidates and set up CDS steepeners in each, funding these steepeners by selling the 5year XO7 CDX index (which, in our view, should demonstrate less correlation to the VIX widening) or selling 3-year IG7 (or 5-year IG4 with 3.5 years remaining), which can generate returns just by rolling down the credit curve. Diversification is another reasonable strategy: consider that there were only seven actual high grade LBOs in 2006, out of 700 issuers across A3- through Baa3-rated high grade index credits (excluding financials and utilities). Albertsons, Kerr-McGee and Knight-Ridder were close to being LBOs and ended up with strategic acquirers. Overall, perhaps the best defensive strategy is diversity and doing your credit homework, applied
Tr a
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by swapping out of fully-priced high-LBO viability credits. Consider a diversified high grade credit portfolio of, say, 200 names (0.5% positions): with six credits experiencing LBO widening of 300 bps (15 bond points) and another ten LBO rumors leading to an average of 100 bps of widening (57 bond points), the impact on the portfolio would be a loss of 0.75%. Even doubling positions to 1% each would lead to a 1.5% drop in returns. In practice, an index-matched portfolio, excluding financials and utilities, would only have roughly 45% of its holdings exposed to LBO rumors.
2006 Credit Events & Market Movers
High Grade LBOs (7) CCU Clear Channel FSL Freescale Semiconductor HET Harrah's Entertainment KMI Kinder Morgan Inc. H Realogy Corp. TSG Sabre Holdings UVN Univision High Grade M&A ABS Albertsons CD Cendant Corp KMG Kerr-McGee KRI Knight-Ridder MYG Maytag (WHR) SVU SUPERVALU (ABS) CDS Succession Events AT Alltel Corp. VZ Verizon
December 19, 2006
Active LBO Speculation CAR Avis CBS CBS FD Federated GPS Gap JNY Jones Apparel RSH RadioShack RRD RR Donnelley RRD SLE LUV Southwest Airlines TRB Tribune Co. Major High Yield LBOs CVC CSC Holdings Inc. GP Georgia-Pacific Corp. HCA HCA Inc. STN Station Casinos
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December 19, 2006
View Across the Grade: Emerging Market Sovereigns
Emerging Market Debt: 2007 Outlook

Carl Ross (212) 272-9040 / cwross@bear.com We are constructive on emerging market debt in 2007, due to our expectation of favorable global economic conditions (robust growth and ample liquidity) and reasonably strong fundamentals in developing countries generally. Before we delve into more detail on the 2007 outlook, it is worthwhile to briefly consider the 2006 experience. Salient Points on the 2006 Performance of EM Debt Returns in 2006 were better than expected. The total return of our BSEMIX index of emerging markets sovereign debt was 8.74% as of mid-December, with positive momentum in the market likely to carry the return to above 9% for the year. Our base-case scenario, which we laid out in January of 2006, was that the BSEMIX would return 3.75%, based on 30 bps of spread contraction and a 100-bp increase in the U.S. Treasury 10-year yield, consistent with the firms forecast. In the end, the spread tightening looks to be more than expected (4050 bps) and there has been surprisingly little (point-to-point) increase in U.S. Treasury rates at the 10-year sector. In short, 2006 turned out to be very close to the bullish alternative scenario we outlined at the beginning of the year. Most of the returns came in the second half of the year. The weakness in the Treasury markets in the second quarter led to a decline in the EM debt market, and the total return for the first half of the year was a mere 0.30%. In the second half, it would appear that the market (rightly or wrongly) has taken the Feds pause in rate hikes as a sign that the U.S. economy is heading into a soft landing. Long term interest rates have fallen, and EM bonds have performed well, returning 8.42% thus far in the second half. Latin America and high-yielding credits were the outperformers. As a region, Latin America, with the highest concentration of high yield sovereigns, has led the gains for the year. The Latin America component of our BSEMIX index, has returned 11.11% year-to-date, compared with 8.67% for Asia, 3.56% for Middle East/Africa, and 4.17% for Eastern Europe.
BSEMIX Ranked Returns YTD as of December 15, 2006
Argentina Peru Uruguay Jamaica Dom. Rep. Philippines Brazil El Salv ador Latin America Kazakhstan Indonesia Ecuador Panama Pakistan Venezuela Guatemala Sov ereign Asia Colombia Vietnam Egy pt Serbia Ukraine Nigeria Costa Rica Mex ico Thailand Qatar Russia Eastern Europe Hong Kong Chile Middle East/Africa South Africa Turkey Lebanon China Malay sia Korea Hungary Poland T&T Iraq -5.00% 0.00% 5.00% 10.00% 15.00% 20.00% 25.00%
Source: F.A.S.T., Bear Stearns Emerging Markets Research.
The 2007 Outlook We believe that 2007 will be another good year for the emerging market debt asset class, with a lot depending on the path of the U.S. economy. The path of the U.S. economy has obvious implications for U.S. interest rates, which affect not only the prices of emerging market bonds (denominated in dollars) but also the global flow of funds toward risk assets. It also has an effect on emerging country fundamentals. By now the increase in reserve assets in emerging country central banks is well known. The chart below shows the historical perspective on external debt and foreign exchange reserves in emerging market countriesin effect, a very simplified balance sheet. The chart clearly shows that foreign reserve asset accumulation in emerging market central banks has massively outpaced the rise in external debt. In 1998, reserves as a percentage of external debt stood at roughly 27%, whereas the same ratio in 2007 is expected to approach 100%. Clearly, this is a favorable balance sheet position for emerging countries. 13

Global Emerging Markets: The Balance Sheet Has Improved Dramatically
3800 3600 3400 3200 3000 2800 2600 2400 2200 2000 1800 1600 1400 1200 1000 800 600 1998 Total External Debt Emerging Region (Public & Private, US$ in Bns) FX Reserves Emerging Region (US $Bns)
December 19, 2006

Base case scenario. The BSEMIX index spread will tighten by 10-20 bps over the course of the year, to +140 to +150 bps over U.S. Treasuries. This scenario assumes that the U.S. economy stays out of a recession and that the Fed, if it moves rates in 2007, will move glacially (meaning +/- 50 bps from current levels and no more in either direction). Under this scenario, China is likely to keep growing at roughly 10% in real terms, commodity prices are likely to remain high and emerging market fundamentals are likely to continue to improve. We believe that spreads can continue to tighten under this scenario, though the pace of tightening is likely to slow (from 4050 bps of tightening in 2006). The table below shows simulations of our BSEMIX index under various combinations of spread changes in the BSEMIX index and the U.S. Treasury curve (which we model as simply the 10-year UST yield). As the chart shows, with a spread of 140150 bps on the BSEMIX, we need stable U.S. Treasury rates for this asset class to be interesting. A 5.00% 10-year yield in 2007 would generate EM index returns of only around 5%, while a 6.00% 10-year would wipe out returns. Upside scenario. The BSEMIX index spread tightens by 30 bps to +130 over U.S. Treasuries due to favorable fundamentals, and the inflation outlook in the U.S., contrary to our economists expectation, remains well-behaved. Foreign central banks continue to purchase dollar assets, keeping U.S. Treasury yields low. Under this scenario, the BSEMIX would return 8%10% (see table below). This scenario would continue to call into serious question the relative value of emerging market assets, since the current spread over U.S. Treasuries of the investment grade U.S. corporate index is about +130 over. Downside scenario. Downside scenarios could result from either a series of negative credit shocks in emerging countries or a significant deviation from the base case scenario for the U.S. economy. Our U.S. economics team would give a higher probability to the U.S. economy being stronger than expected, inflation pressures being higher than expected and the Fed being more aggressive in tightening in 2007 than the market expects. The alternative to this would be a scenario in which the U.S. economy goes into a recession or near-recession as a result of weakness in housing and the U.S. consumer. Either of these scenarios would be negative for EM debt, but we believe that EM debt is somewhat cushioned from both. If the economy is stronger than expected, this will keep upward pressure on commodity prices, which is beneficial to emerging countries in general. If the economy is weaker than expected, Fed cuts could keep the liquidity machine pumping.
1999
2000
2001
2002
2003
2004
2005
2006(e)
2007(f)
Sources: IMF World Economic Outlook.
We admit that there is a lot of good news priced into the emerging market debt market. But looking simply at likely rating actions, there is the strong possibility of continued good news. The table below lists sovereign credit ratings for the countries in our BSEMIX index, along with rating outlooks. Of the 37 sovereigns in our index, sixteen have a positive rating outlook from at least one of the major rating agencies, and only two have negative outlooks.
BSEMIX Countries: Ratings & Outlook, December 2006
Countries Latin America Argentina Brazil Chile Colombia Costa Rica Dominican Republic /1 Ecuador El Salvador Guatemala Jamaica Mexico Panama Peru Trinidad and Tobago Uruguay /1 Venezuela Asia China Hong Kong Indonesia Korea Malaysia Pakistan Philippines Thailand Vietnam Eastern Europe Hungary /1 Kazakhstan Poland Russia Serbia Ukraine Middle East/Africa Egypt Iraq Lebanon Qatar South Africa Turkey Moody's Rating Outlook B3 Ba2 A2 Ba2 Ba1 B3 Caa1 Baa3 Ba2 B1 Baa1 Ba1 Ba3 Baa1 B3 B2 A2 Aa3 B1 A3 A3 B1 B1 Baa1 Ba3 A1 Baa2 A2 Baa2 NR B1 Ba1 NR B3 Aa3 Baa1 Ba3 STA STA STA STA STA NA POS STA POS STA STA STA POS STA NA STA POS POS STA POS STA STA STA STA STA NA STA STA STA NA POS STA NA NEG STA STA STA Rating B+ BB A BB BB B CCC+ BB+ BB B BBB BB BB+ AB BBA AA BBA AB+ BBBBB+ BB BBB+ BBB BBB+ BBB+ BBBBBB+ NR BA+ BBB+ BBS&P Outlook STA POS STA POS STA POS STA STA STA STA STA STA STA STA STA POS STA STA STA STA STA POS STA STA STA NEG STA STA STA POS STA STA NA NEG STA STA STA Rating B BB A BB BB B BBB+ BB+ NR BBB BB+ BB+ NR B+ BBA AABBA+ ANR BB BBB+ BBBBB+ BBB BBB+ BBB+ BBBBBB+ NR BNR BBB+ BBFitch Outlook STA STA STA POS STA POS STA STA STA STA STA STA STA NA POS STA POS POS STA STA STA NA STA STA STA NEG STA POS STA STA POS STA NA STA NA STA POS
Source: Bloomberg. Legend Key: POS = positive outlook; STA = stable outlook; NEG = negative outlook; NR = not rated; NA = not available; /1 = ratings under review.
14
December 19, 2006
BSEMIX Expected 12-Month Returns Under Different 10-Year UST Yields and BSEMIX Spread Scenarios
BSEMIX Index Spread Over 10-Year UST (bps) UST 10-Year Yield 4.00% 4.25% 4.50% 4.75% 5.00% 5.25% 5.50% 5.75% 6.00% +130 11.98 10.41 8.87 7.36 5.89 4.46 3.06 1.70 0.36 +140 11.33 9.76 8.23 6.74 5.29 3.87 2.48 1.13 -0.20 +150 10.67 9.12 7.60 6.13 4.68 3.28 1.90 0.56 -0.75 +160 10.01 8.48 6.98 5.51 4.09 2.69 1.33 0.00 -1.29 +170 9.37 7.84 6.36 4.91 3.50 2.11 0.77 -0.55 -1.84 +180 8.73 7.22 5.75 4.31 2.91 1.54 0.21 -1.10 -2.37 +190 8.09 6.60 5.14 3.72 2.33 0.97 -0.35 -1.64 -2.91 +200 7.46 5.98 4.14 3.13 1.75 0.41 -0.90 -2.18 -3.44 +210 6.84 5.37 3.94 2.54 1.18 -0.15 -1.45 -2.72 -3.96
Source; F.A.S.T., EM Fixed Income Research. Note: The current spread of the BSEMIX at the time of writing is +163 bps to U.S. Treasuries. Our base case scenario for 2007 calls for a tightening in spread on the index to +140150 bps.
Regional Outlooks for 2007 In this publication, we stop short of focusing on particular countries, but we would like to provide the reader with some guidance on our views for the major regions in emerging markets. For Latin America, my colleagues Alberto Bernal and Franco Uccelli believe that the main credit driver will be economic growth, since many of the key elections in Latin America are over (Brazil, Chile, Colombia, Ecuador, Mexico, Peru, and Venezuela). Economic growth will reduce the likelihood of anti-market economic policies. By contrast, my colleagues who cover Eastern Europe, Middle East and Africa (Tim Ash) and Asia (John Stuermer) believe that politics may be the key credit drivers in those regions in 2007. Latin America. We expect 2007 to be yet another good year for the Latin American region, the fifth consecutive one of positive growth, and the fourth consecutive one showing growth of more than 4% year over year, significantly higher than the long-term average growth rate for the region of around 3%. We believe that a combination of high commodity prices, higher investment rates and lower interest rates (that spurs investment and consumption) should allow Latin America to achieve the 4% number. Argentina and Venezuela might decelerate in 2006 due to low investment rates in recent years, but commodity prices are still likely to keep growth rates above trend. Lingering good growth is consistent with stable fiscal stances and continued improvement in debt ratios. We do not think that 2007 will be a year in which we see the same amount of erosion in the supply of bonds (i.e. buybacks) from the Latin America region. We believe that 2007 will be a year in which the demand/supply schedule will be more aligned. Why is that? First, from the perspective of governments, the carry of local bonds tends is higher than the carry on foreign debt, especially under a scenario of real exchange rates appreciating further. Second, we believe that diminishing returns may be entering the equation at this time. Specifically, we believe that the willingness/logic of further reducing external debt may not be that clear any more, at least judging from a social welfare point of view. For example, Brazils net public external debt already stands at 0% of GDP. The logic of further depressing that number may not longer be
fully evident. That said, with fiscal accounts in good order in the region, the likelihood of significant net new issuance from the sovereigns is also unlikely. Asia. There seem to be identifiable potential flashpoints in almost all political systems in Asia over the next year, taking the form of elections to be held in 2007, coup attempts or broadly based efforts to force elected leaders out of power using extra-constitutional means, fracturing of political coalitions or other groupings that have provided a basis for political and policy continuity in past years, and finally, the North Korean bomb. North Korea has proceeded with testing a nuclear bomb, with little immediately observable effect on regional political stability. The 2007 elections in the region will take the form of regularly scheduled elections (presidential and parliamentary elections in Pakistan, parliamentary and local government elections in the Philippines, a presidential election in South Korea, parliamentary elections in Taiwan, crucial state elections in India) or potential snap elections (Malaysia, India). We note that presidential and parliamentary elections are not due in Indonesia until 2009, but many observers believe that political maneuvering by parliamentarians seeking re-election and political positioning by potential presidential candidates will begin in 2007, making any further effort at meaningful economic policy reforms impossible until after 2009. The decision of the Yudhoyono government in September to back off from submitting a bill to parliament that would reform Indonesias controversial labor law might suggest that the 2009 political season has already begun. The most interesting election in 2007 may turn out to be the effort of President Pervez Musharraf to get himself re-elected by Pakistans electoral college. There is a small but real threat that dissatisfaction with economic performance in Asia could spill over into the politics. Although real GDP growth rates have ranged between 5% and 6% or higher in good years, this outcome has been driven more by consumption and exports than by investment, and seems not to be creating employment or driving up living standards as much as the investment-driven growth prior to 1997. Furthermore, Asias export-based economic growth model seems to have created sharp regional or urban/rural
15

differences in the distribution of the benefits of economic growth throughout the region. This discrepancy, interestingly enough, has become most pronounced in countries that have been some of the better-performing countries in the region, such as China, India and Thailand. Eastern Europe, Middle East, and Africa. Elections are set to dominate the agenda in Eastern Europe, the Middle East and Africa region in 2007. First off is Serbia which elects a new parliament under the newly approved constitution on January 21, 2007. The elections are important, as the next government will be expected to grapple with the difficult issue of the future of Kosovo. The UN-sponsored Kosovo status talks are expected to rule in favor of independence in 1Q07, which is unlikely to go down well in Serbia proper. The hope will be that a reformminded government will be elected in Belgrade, which will see the bigger picture: that a moderate response over Kosovo will reap rewards in terms of Serbias own EU accession bid. April then sees presidential/parliamentary elections in Nigeria and presidential elections in Turkey. Nigeria is important from a broader market perspective given its status as a significant oil producer. We expect some political/social unrest around the elections, but it seems likely that the security forces will ensure the smooth transfer of power to the successor to the incumbent Obansanjo. The presidential elections in Turkey, though, look set to produce more volatility and hence opportunities for investors. The market consensus seems to be that the ruling AKP will nominate a compromise candidate to run for the presidency; the president is elected by parliament, thereby offsetting the chances of a clash with the secular establishment. We believe that the market could well prove to be disappointed as we believe that the AKP leader and prime minister, Recep Tayyip Erdogan, is priming himself for a move to the presidential palace. This would likely incense the secular establishment in Turkey, which would be fearful that by controlling the presidency and the government the AKP would be able to swap Turkeys secular traditions for Shariah law. Given the AKPs majority in parliament, it is difficult for the secularists to block Erdogans appointment as president, but the secularists will likely fight tooth and nail in the run up to parliamentary elections due in November 2007. The risk of major political unrest and security crises is not insignificant, although we believe that the end result may be a relatively market-friendly outcome to the parliamentary elections, with the AKP joining the secular DYP party in a coalition government at year-end. This suggests considerable market volatility in the period AprilNovember. And, last but not least, Russians elect a new parliament in December 2006, and then a new president in March 2008. We do not expect any surprises on either, with the party of power, United Russia, expected to produce a landslide victory in the parliamentary elections, followed by a similarly convincing
December 19, 2006

victory by the anointed Putin successor in March 2008; thus far it seems set to be the deputy prime minister and chairman of Russias largest company, Gazprom, Dmitri Medvedev. Herein the main factor driving the elections will be the complete lack of any substantive opposition force in Russia. Over the longer term, this does raise concerns over accountability, but in the short term it suggests a stable succession to a Putin loyalist, which will no doubt be appreciated by investors. In the short term, we believe that investors value stability rather than accountability, and Russia will continue to offer solid investment opportunities. Emerging Market Corporate Debt Outlook Our relatively constructive outlook for sovereigns in 2007 also spills over into corporatesand thus my colleagues who cover EM corporate debt (Alex Monroy, Robert Schmieder, Okan Akin and Daniel Fan) expect another year of healthy emerging markets issuance levels. Assuming continued spread tightening, we believe that corporates, given that they typically trade at a spread to sovereign benchmarks, will continue becoming more of an outright focus for yield-hungry emerging markets investors, rather than one-off bets. We believe this to be particularly the case for countries such as Mexico and Brazil, which have shown significant institutional maturity that has allowed them to weather challenging political situations (such as the recent Mexican elections), which historically might have caused significant sell-offs. The increase in institutional stability has also led to the growth of local currency debt markets, particularly in Mexico and Brazilbut also in countries such as Argentina, which is still sorting through the after-effects of the 20012002 peso devaluation. We expect this trend to continue into other countries, as political stability takes effect, allowing emerging market companies more diversification in their financing sources. We would expect that this trend, over time, could lead to a lower default rate, particularly for companies with primarily local currency revenues. The growth of the local currency markets has also led to interesting investment opportunities for investors not able to directly invest in local currency assets, such as bond issues by Tarjeta Naranja in Argentina and Eletropaulo in Brazil, where the borrowed amounts are in local currency and thus carry a significantly higher coupon (reflecting the higher local interest rates than those in the U.S.), but where payments are made in dollars and familiar RegS and 144A structures are in place. Given the success of these deals, we wouldnt be surprised if we continued seeing similar structures in 2007. In addition, during 2006, given the ever-tightening yield scenario in the United States, we have seen significant crossover interest from traditionally First-World-centric high yield and high grade investors looking for additional yield. We would expect that trend to continue into 2007 as general comfort levels with the asset class, in general, and certain regions or countries, in particular, continue increasing and as cross-border consolidations continue blurring country lines.
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December 19, 2006 Economics
Growth, Inflation and Monetary Policy Outlook for 2007

John Ryding (212) 272-4221 / jryding@bear.com Elena Volovelsky (212) 272-4447 / evolovelsky@bear.com Summary We project that 2007 will be a year of modestly above-trend economic growth accompanied by continued elevated rates of core inflation. Although the slowdown in growth after the first quarter of 2006 was more pronounced than we anticipated, we attribute the bulk of the deceleration in economic activity to a steeper decline in residential investment than we thought likely and to cutbacks in motor vehicle production. Importantly, we have seen little evidence of spillover effects beyond these two industries and we may have begun to see tentative signs of stabilization in both of these sectors. If, as we believe is the case, housing starts and new home sales have begun to stabilize, then the drag on growth from residential construction should begin to dissipate in the first quarter of 2007 and be largely behind the economy by the second quarter. As the forces restraining growth diminish, we expect real GDP growth to pick up to 3.1% for 2007. We still judge that monetary policy is accommodative and providing considerable support to economic activity. We also see easy money as the source of continued elevated inflation pressure and we expect core PCE inflation to drift higher in 2007 to 2.7%, which is well above the Feds comfort zone of 1% to 2%. We expect that once it is clear that economic growth is picking up and that core inflation is not easing back towards its comfort zone, the FOMC will take steps to modestly tighten monetary conditions. We project that the Fed will hike rates twice in 2007, which would take the funds rate up to 5% by year end, although we do not expect the first move to occur until May 2007 at the earliest. With interest rate futures pricing in two rate cuts in 2007, we expect the realization of our forecast will put renewed upward pressure on yields and keep the yield curve inverted throughout 2007.
Figure 1. Real GDP
8 quarterly a.r. change; % 6 4 2 0 -2 2000 2001 2002 2003 2004 2005 2006
Conrad DeQuadros (212) 272-4026 / cdequadros@bear.com Meghna Mittal (212) 272-1961 / mamittal@bear.com Postmortem of 2006 Nominal GDP growth thus far in 2006 has run half a percentage point slower than we projected a year ago. Over the first three quarters of 2006, nominal GDP growth has averaged 6.3% versus our projection of 6.8%. This shortfall relative to our forecast has primarily shown up in slower real growth as real GDP growth has averaged 3.4% thus far in 2006 versus our forecast of 3.8% for the year as a whole. After factoring in our estimate of 2%2% for fourth quarter real GDP growth, we expect growth for 2006 to be about 3.2%. This rate of growth, however, appears to be above the economys current potential growth rate as judged by the unemployment rate. In November 2006, the unemployment rate stood at 4.5% versus 5.0% in November 2005. It appears that the potential growth rate for the U.S. has declined significantly. A year ago, our forecast for the unemployment rate for the fourth quarter of 2006 based off a projection of 3.8% growth was 4.7%, which is above the current unemployment rate. The distribution of growth through 2006, however, was more uneven than we anticipated as the drag from residential investment hit strongly after the first quarter. Real GDP growth was 5.6% in the first quarter but has slowed to an estimated average pace of about 2.4% since then, as a decline in residential investment subtracted what appears to be slightly more than one percentage point from real GDP growth. The other sector that has weighed more heavily on growth than we anticipated has been motor vehicle production, as the production of motor vehicles and parts declined at an annualized rate of 8.5% since June. In our judgment, there is no evidence that the weakness in housing and autos has spilled over into the rest of the economy. In the first 10 months of 2006, real consumer spending growth has averaged 3.1% at an annual rate, which has largely matched the 3.0% growth rate in real disposable income. This growth occurred despite a flattening out in wealth creation as household real net worth rose by only $1.4 trillion at an annual rate over the first three quarters of the year versus an average annual increase of $2.9 trillion over the previous three years. At the end of the third quarter, household net worth totaled $54.1 billion, or 5.6 times annual disposable income, suggesting that in aggregate the household sector is in sound financial shape. In short, growth has slowed because of the traditional multiplier impact of reduced residential investment. There is nothing in consumer behavior in 2006 to suggest that a pullback in mortgage equity withdrawal has held back consumer spending and growth.
Source: Commerce Department
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On the inflation and monetary policy fronts, our projections have been closer to the mark. We projected that core PCE price inflation would average 2.4% in 2006 and, through the first 10 months of the year, the average rate has been 2.5% which is at the top of the Feds forecast range for 2006. We argued that the most likely path for Fed policy was that the funds rate would plateau at 5% in 2006, but added that a 4.7% unemployment rate, and2.4% core PCE inflation could induce the Fed to raise rates to perhaps 5% by the end of the year. The outcome for policy was in between these two scenarios as the fed funds rate target reached 5% by mid-year and was held at that rate for the rest of the year. In contrast, interest rate futures were pricing in a 4% fed funds rate by the middle of 2006. Our major forecasting error was again on the level of bond yields. From a fundamental perspective, we looked for a 10year Treasury yield of 5% by mid-year. However, we argued that the next most likely scenario was that recycling of Fed accommodation into the U.S. bond market by foreign official buyers in Asia could continue to hold long yields in check, which could result in the yield curve inverting in early 2006. The year has been a mixture of these two scenarios as fundamentals pushed 10-year yields up to a monthly average of 5.1% in June, but, seemingly triggered by the pause in rate hikes, foreign buying has helped lower these yields to 4.6% and we have seen the yield curve invert. Growth and Inflation Outlook for 2007 The starting point for our forecast is always our assessment of the stance of monetary policy. Our assessment of monetary policy is primarily based upon a neo-Wicksellian interpretation of the value of the dollar against an array of alternative stores of value, including gold, commodities and other foreign currencies. All of these indicators show that despite the rate hikes in 2006, the value of the dollar has lost ground. Thus far in 2006, the dollar has fallen roughly 17% against gold, 42% against a basket of industrial metals and 5% against major currencies. If monetary policy was accommodative at the end of 2005, it is hard for us, given the deterioration in the dollars value, to avoid reaching the conclusion that monetary policy is still accommodative and that interest rates remain below their neutral level. An accommodative monetary policy has cushioned the economy in the face of adjustments in housing and autos. This is the key difference between the slowdown in 2000, which was a precursor to recession and rate cuts in 2001, and 2006. In 2000, tight monetary policy (as signaled by gold and commodity price deflation and a strong dollar) provided no support to growth as the tech bubble burst and, as financial conditions tightened, cash-strapped corporations were forced to slash capital spending budgets, throwing the economy into recession by March 2001. At the present time, not only are household balance sheets in solid shape, but corporate profit growth and cash flows are strong and largely match investment spending levels. For the first three quarters of
December 19, 2006

2006, nonfinancial corporate capital spending has exceeded corporate internal funds by only $38 billion at an annual rate. Meanwhile, corporations have returned $387 billion to shareholders in the form of dividends on the same basis. In other words, nonfinancial corporate net funding needs are only one-tenth of the dividends that they returned to shareholders this year.
Figure 2. Price of Gold
800 700 $/troy ounce 600 500 400 300 200 1996 1998 2000 2002 2004 2006
Source: Wall Street Journal
We view the housing market as undergoing a one-time adjustment from unsustainable levels of construction and price appreciation. In our forecast, as this adjustment draws to a close, the dampening effects of lower residential investment are lifted and economic growth picks back up to a modestly above-trend pace. Also helping growth is a reduced drag on real incomes from energy prices, which have pulled back significantly in recent months. We see real GDP growth in 2007 averaging 3.1%, which is in line with the growth rate of consumer spending seen thus far in 2006. A year ago, we would have viewed 3.1% growth as being modestly below potential growth. However, the continued decline in the unemployment rate through 2006 suggests otherwise, and we now project that the unemployment rate will fall to 4% by the end of 2007 from 4% at the present time. The decline in the unemployment rate should put further upward pressure on wage increases, which in turn should help support the growth of household incomes. In our forecast framework, inflation is a function of the stance of monetary policy, not the unemployment rate. However, we view easy money as producing a further moderate rise in core inflation in 2007. We expect core PCE price inflation to rise to 2.7% in 2007 from a projected increase of 2.3% in 2006. Economy-wide inflation in the form of the GDP deflator is seen at 3.0% in 2007, which, combined with real growth of 3.1%, would put nominal GDP growth at 6.2% next year.
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December 19, 2006

Figure 3. Core PCE Price Inflation
3.0

quarter-point rate cuts in 2007. While we expect the Fed to hike rates in 2007, at a very minimum we judge rate cuts to be unlikely. As rate cuts fail to materialize, we would expect yields to drift highera move that is likely to gain momentum if the market begins to anticipate rate hikes. However, unless there is a major change to exchange rate policies, especially in Asia, we would expect continued strong official flows into the U.S. bond market, which we see supporting the intermediateto long-end of the yield curve. It seems likely to us, therefore, that the yield curve will remain inverted throughout 2007 and that the degree of inversion might increase. By the end of 2007, we look for 10-year yields to have risen back to the high yield level of around 5% that was seen in 2006. Forecast Risks As far as quantifiable downside risks to economic growth are concerned, the primary risk remains that the housing contraction becomes deeper than we currently anticipate and that this spills over into consumer spending. However, we think that GDP growth would have to slow to below 2% for at least two quarters and that core inflation would have to moderate towards 2% before the Fed would consider cutting rates under this scenario. Under unquantifiable risks, we have to acknowledge the ever-present risk of terrorism or severely heightened geopolitical tensions over the nuclear ambitions of Iran or North Korea. In this category, the greatest risk to economic growth is likely to be developments in relations with Iran, that have the potential to significantly impact oil prices. Our greatest concern, however, remains upside risks to inflation and yields, and downside risks to the U.S. dollar. Global liquidity has expanded rapidly in recent years as evidenced by the more than doubling of world foreign exchange reserves from the end of 2001, when they stood at $2.1 trillion, to todays level of $4.8 trillion. Much of this reserve accumulation has taken place in Asia, where the top seven official holdings of foreign exchange reserves account for about half the worlds total holdings. As far as can be identified, about two-thirds of these reserves are held in dollars. The primary source of this reserve accumulation is the U.S. current account deficit, which has totaled $2.6 trillion since the end of 2002, combined with the policies of many Asian countries pegging (or quasi-pegging) their currencies to the greenback. In turn, we believe this combination has kept yields in the U.S. well below levels that would prevail in a world of freely floating currencies as these reserves have been recycled back into the U.S. bond market. If there were to be a shift towards floating currencies in this region, we believe this would put significant downward pressure on the dollar and upward pressure on U.S. yields as reserve accumulation slows. While we think this development is unlikely, because of its potential impact, investors should be aware of this risk.
12-month change; %
2.5
2.0
1.5
1.0 1995 1997 1999 2001 2003 2005
Source: Commerce Department
Fed Seen Hiking Rates Twice in 2007 If realized, we think our growth, unemployment rate and inflation forecast would likely prompt the Fed to modestly tighten monetary policy in 2007. The Fed has made it clear that policy adjustments are dependent on incoming data relative to its forecast and the three primary variables that the Fed publishes in its forecast are real GDP growth, the unemployment rate and core PCE inflation. In July 2006, the FOMCs central tendency ranges for these variables for 2007 were: 3%3% for real GDP growth; 4%5% for the fourth quarter unemployment rate; and 2%2% for core PCE inflation. While we see real GDP in the FOMCs forecast range for 2007, the Fed has lowered its estimate for potential growth since July and our forecast for the unemployment rate, which is the principal driver of the Feds inflation model, is well below the Feds range. In addition, we see core inflation rising rather than falling in 2007. Under these circumstances, we would expect the Fed to snug rates higher in 2007 and we look for two rate hikes, to 5%, before the end of 2007. However, before the next hike takes place, we believe that growth would have to have picked up to about 3%, the housing market would have to have clearly stabilized, and that core PCE inflation would have to have edged up to at least 2%. We think that the earliest FOMC meeting at which these conditions would be satisfied is likely to be the May meeting. Until then, therefore, we expect that the Fed will hold rates steady at 5%, and maintain its bias to higher inflation and tighter policy. Yields Expect to Rise We recognize that for the last two years, bond yields have been lower than we were expecting as a result of strong foreign (especially official) purchases of U.S. fixed income (particularly out of Asia and, more recently, OPEC). The forward structure of interest rates is pricing in about two
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Table 1. Bear Stearns Forecast Summary.
2006* 1Q Real Economy Nominal GDP Real GDP Unemployment Rate Inflation Chain-Weight GDP Deflator Core PCE prices Interest Rates Federal Funds Two-Year Treasury Note 10-Year Treasury Note 4.4 4.6 4.6 4.9 5.0 5.1 5.3 4.9 4.9 5.3 4.7 4.6 5.3 5.0 4.9 5.5 5.3 5.1 5.6 5.5 5.3 5.8 5.5 5.3 3.3 2.1 3.3 2.7 1.7 2.2 2.5 2.1 3.0 2.6 3.1 2.7 3.0 2.7 3.0 2.7 9.0 5.6 4.7 5.9 2.6 4.6 4.0 2.2 4.7 4.9 2.3 4.5 6.0 2.9 4.5 6.4 3.2 4.4 6.2 3.1 4.4 6.1 3.0 4.3 2Q (percent) 3Q 4Q 1Q 2Q (percent) 2007* 3Q 4Q
December 19, 2006
2006+ (percent) 5.9 3.2 4.6 2.7 2.3 5.0 4.8 4.8
2007+
6.2 3.1 4.4 3.0 2.7 5.6 5.3 5.2
* Values are either quarterly changes or quarterly averages + Values are either 4- quarter changes or yearly averages Source: Bear Stearns
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December 19, 2006 Treasuries/Agencies
Repo Scrutiny, Steeper Curve and a New GSE Regulation

David Boberski (212) 272-1507 / dboberski@bear.com Market Outlook Treasury curve movements may gather momentum in 2007 after an utterly uninteresting year. On the heels of two years where the 2s/10s Treasury curve strongly flattened by about 100 bp each year, the curve stalled in slightly inverted territory and barely budged this year. While there may be another quarter or two of the same grinding torture that characterized 2006, the end may be in sight. In the past the curve has steepened at the end of the business cycle, and while no one knows when the end of the current cycle will be, none other than the Chairman of the Federal Reserve has signaled a softer outlook. In the December FOMC statement the committee called the cooling of the housing industry substantial, in a change in language from the October statement. The Fed also predicted a moderate expansion on balance over coming quarters, in a change indicating that not every quarter may see an expansion. The committee also called the latest economic indicators mixed, though it appeared generally upbeat. Using this signal as a guide we can expect the Treasury curve to show some signs of life if this mixed data ever turns negative, and we believe the next move will be a steepening of the curve. Right now Figure 1 illustrates that expectations of a cut in the fed funds rate to 5% are below 50% through the first half of 2007, although this chart is merely a snapshot in time and doesnt show just how dramatic the swings in expectations have been. It seems like there is a middle third of traders who swing between total convictions of a cut, to completely discounting it. Expectations have moved from the low 40% to the middle 70%, depending on the strength of the latest report. When the Treasury called in compliance officers from every Wall Street broker, we mentioned that it was having a chilling effect on the market for specials, and the impact hasnt subsided. Knowing that regulators and compliance personnel are looking at trades where issues finance in term repo below 100 bp, as per the New York Fed definition of a special, has prevented traders from writing those tickets. In quite an unusual turn of events, every issue in the 10-year Treasury futures basket is financing above 5%, with general collateral at 5.15%, around 10 bp through the funds rate. Without special financing rates, swap spreads have narrowed and the shape of the off-the-run Treasury curve has few local distortions. We dont expect this situation to reverse itself anytime soon, and 2007 may not have any unusual bids caused by the financing market, as were endemic of the squeezes in 2005.
Figure 1. Fed Funds Expectations
5.50 43% 50% 45% 40% 35% Probability of FOM C mov e 5.00 13% 7% 0% 4.75
Feb Aug May Sep Jan Jun Apr Dec Mar Jul Implied Probability of Move
Fed Funds Target
5.25
M ost likely Fed Funds path 5% 0% 0% 0% 0% 0%
30% 25% 20% 15% 10% 5% 0%
Steeper Curve in 2007 Economic indicators are mixed indeed! Traders are making much of news that the ISM manufacturing index has fallen below 50 for the first time since 2003and they should. Throughout the current tightening cycle we have been linking movements in the slope of the curve to the business cycle and emphatically emphasizing that nothing is likely to happen to the shape of the curve until we reach the end of the business cycle. Recent news has certainly changed perceptions about the timing of the end of the cycle, and the curve has steepened toward a well-established range from this fall, between -5 and -10 bp. There is reason to suspect that the curve may soon break out of this range and begin the long march toward substantially positive slopes.
Figure 2. ISM Falls Below 50, First Time Since 2003
65 60 55 50 45 40 35 Jan-99 Jul-00 Jan-02 Jul-03 Jan-05 Jul-06
A reading in ISM below 50 indicates contraction in manufacturing, and while the latest value of 49.5 is a relatively small dip into negative territory, it strongly contradicted the average expectation on the Street of 51.5. There is reason to think that fundamental data and the recent negative expectations of economic performance are tied to the 21
ISM Index

shape of the Treasury curve. Chief among them is the data in Figure 3, illustrating how the shape of the Treasury curve has responded to the average expansion in the U.S. between trough-to-peak of the cycle. The average length of expansions has been five years since World War II. The most recent expansion started in late 2001, indicating that we are now in the midst of a slightly longer than average cycle. Eventually it will end, and Figure 3 highlights that in the past the end of the cycle led to a dramatically steeper curve, to the tune of about 250 bp. Does the steepening start in 2007?
Figure 3. 2s/10s Treasury Slope, bp
300 250 Basis Points 200 150 100 50 0 -50 0 12 24 36 48 60 72 84 96 108
Months After T rough
December 19, 2006

Figure 4. 2s/10s Treasury Slope, bp
25 20 15 2s / 10s Slope, bp 10 5 0 -5 -10 -15 -20 -25 Jan-06 M ar-06 M ay -06 Jul-06 Sep-06 N ov -06
-12 bp
2/1/1961 11/1/1970 3/1/1975 7/1/1980 11/1/1982 3/1/1991 11/1/2001
Treasury Repo Scrutiny The Federal Reserve Bank of New York, administrator of the System Open Market Account (SOMA) that lends billions of dollars to Wall Street firms to help alleviate specials in the financing market, has been scrutinizing financing trades for possible manipulation. In a meeting with legal and compliance officers the New York Fed asked Wall Street firms to monitor their Treasury financing activity for trades far below general collateral rates. The Fed considers a financing rate more than 100 bp below general collateral rates as special, and not surprisingly, there have been very few of these trades ever since the meeting. Financing well below general-collateral rates has been characteristic of the note or bond that is cheapest-to-deliver into Treasury futures contracts for many years, but right now everything in the deliverable basket for 10-year Treasury futures is financing above 5%. In a forward contract the impact of lower repo rates and higher note prices are offsetting to some extent. Lower repo rates mean more carry, and lower forward prices. Lower repo rates also imply that the note in question is richening in price, which raises the forward price. However, in the past it has been typical for price increases to outweigh the effect of repo rates, leading prices in the frontmonth Treasury futures contract to rise and calendar spreads to widen over the course of the cycle. For the December/March Treasury futures calendar spread the repo specialness was most important to the 10-year contract, which recently fell from -0.5 to -2.5 ticks, indicating that the market was inverted since the March price was above the December price. If December fails to richen because the CTD note doesnt go special, then it may be difficult for this spread to continue to invert, possibly putting in a floor in the current calendar spread as well as the next several to come. Given that traders are already lining up to dabble in steepeners, there may be added pressure for the spread to move into positive territory. One of the leading factors in widening spreads in off-the-run maturities is repo specialness, especially in the 7-year sector, and if nothing ever goes special again there may be major
Technically speaking, there may be a very mundane reason for the December rally in the 2-year note. Earlier this month there were 48,879 December 2-year contracts delivered at the CBOT, representing $9.8 billion face of notes, out of an almost $25 billion issue. Consider that most of these notes were boxed for delivery days or weeks ago, so the market has already felt the buying pressure to accumulate the positions. The holders of long 2-year note futures, on the other hand, are probably not interested in actually owning the issues and would have preferred a less efficient delivery and to receive the notes later in the month. Traders who received the notes likely sold them to the street on November 30, handing Wall Street traders substantial positions on a day that is yearend for many firms. Knowing that there may be substantial selling of these notes, primarily 4.625 Sep 08, traders may have gotten short this sector in anticipation of a little dip in prices. Traders who were short in anticipation of this rather technical factor may have found themselves offside when the ISM report came out weaker than expected, requiring them to cover their short positions. The curve has already returned to the well-established trading range from earlier this year, centered on -5 bp, and for the rest of December it is unlikely to break out to higher levels. However, we think that the time is nearing to pile into steepening trades but we are waiting for a move through 0 bp before initiating the position. Our expectation is that when the curve starts to climb to steeper levels it will be the start of at least a 100 bp steepening, and were happy to give up the first few basis points as confirmation of the move.
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December 19, 2006

pressure on spreads to tighten. In the past its been the favorite trade of a number of hedge funds to pay a fixed rate in the front-end of the swap curve (or sell a strip of Eurodollars) and buy a 2-year note, as a conditional trade on the Treasury going special in the repo market and the yield spread between the swap and Treasury widening. With added scrutiny it seems that in the near-term this strategy is on hold and there may be less spread activity in the front-end because of financing. Interest rate swap spreads cant move without spilling over into agencies, and tighter swap spreads may be just one more positive factor in the agency market. Recently, the agency market has richened because of a lack of supply, and a $4 billion buy-back from Fannie Mae of busted callable deals emphasizes that overall supply of agencies has been shrinking. Off-the-run 10-year notes may richen the most in this environment as they roll down the curve to the 5-year point, which is the most inverted part of the agency curve. Agency Regulator Traders are focusing on agency debt spreads against Treasuries as Fannie Mae and Freddie Mac near completion of their combined $11.3 billion in accounting restatements. Debenture spreads had been narrowing as portfolio limits caused scarcity bid. In a head-scratching turn of events, traders are using the resolution of accounting problems to justify a further bid to the debt, even though it is likely to lead to greater supply over the long run. This year through October 31 the assets of Fannie Mae and Freddie Mac shrank 0.8% after dropping 7.7% last year, compared to an average above 10% between 1990 and 2003. Positive news for spreads isnt limited to the supply side of the equation. Foreign holdings of agency debt grew $13 billion in the last full quarter compared to a supply that was $44 billion lower over the same period. Not only has supply dropped but demand has increased as well. The fundamental question the market will be struggling with in the first part of next year is which is more important: the positive of removing the cloud of regulatory uncertainty weighed against the prospect of growing retained portfolios pumping more supply into the agency market. On Monday, December 18, OFHEO filed a Notice of Charges against three former Fannie Mae executives, former Chairman Franklin Raines, former Vice Chairman and Chief Financial Officer Timothy Howard, and former Senior Vice President and Controller Leanne Spencer. According to OFHEO, Director James Lockhard determined that the Notice of Charges was appropriate based on the findings of the special examination of Fannie Mae. There was a sharp move wider in short-dated agency spreads on the news, although its doubtful that any new investigation or trial could unearth facts that have not yet been detailed by OFHEO and the agencies themselves.

According to OFHEO, there are 101 individual charges for specific violations of law and regulation for conduct and misconduct. As one might imagine, with so many line items the civil money penalty could be quite high if they were all provenon the order of $100 million. Although the regulation of the agencies is unique, the procedures in this case are not. OFHEO has already transmitted the charges to the Office of Personnel Management and an administrative law judge will be assigned. A public hearing is possible if the case is not individually resolved with all three individuals. After the administrative judge makes his or her determination the individuals involved have the option of appealing the verdict to a federal court for review. The process is worth mentioning because it is unlikely to be a speedy one. Just when many in the agency market believed that headlines were behind them, this Notice of Charges was released, promising to attract attention for many years in the future. While traders are taking notice, there is hardly a tsunami of trading. As is typical of the agency market the news will filter to traders who express their opinions with new transactions, rather than in the secondary market. In the mean time, the latest news of charges against former executives is a non-event. The backdrop for this unfolding story is one that may be broadly negative for credit in 2007. While it may be frustrating, there is nothing unusual about the slope of the Treasury curve losing all momentum toward the end of a tightening cycle, as the economy slows. As the expansion wears on, inflation pressures typically appear contained and, as Figure 3 illustrates, most of the recent business cycles have shown similar patterns where the curve not only has very little slope, but also was grinding sideways for several quarters until the peak of the expansion was reached.
Figure 5. AAA Corporate Yields
11 10 9 8 7 6 5 4 3 2 1 N ov -88 Jan-93 400 10y Sw ap M oody 's Seasoned Aaa C orp. Spread 350 300 250 200 150 100 50 0 M ar-97 M ay -01 Jul-05 Spread, bp
Though there hasnt been anything unusual about the behavior of the shape of the curve, the same cant be said of credit spreads. While swaps havent been traded long enough to graph their performance according to the business cycle in the same way we can with Treasuries, there is a long-running series on high quality corporates that we can use as a proxy. Figure 5 shows a long-term history of seasoned AAA
Yield, %
23

corporate yields reported by Moodys to the Federal Reserve Board of Governors, as well as 10-year swap rates. The correlation hasnt been perfect and one obvious reason is that swap counterparties are often not AAA rated, but somewhere in the AA range. Another reason may be that seasoned corporate bonds are likely to be old 10-year notes that have rolled down the curve a little, introducing some modest curve mismatch. These differences notwithstanding, its obvious from the graph that the two have roughly mirrored one another and we can draw meaningful conclusions about swaps from a history of high quality corporate yields. Given that agencies trade as a spread to swaps, its logical that movements in one market would spill over into the other. From a day-to-day perspective, it might be a stretch to imply future movements in agency credit from high quality corporate bonds, but over longer periods there is likely to be high correlation, given that agency debentures are high quality corporate bonds.
Figure 6. AAA Yields as Change from Start of Cycle
150 100 Basis Points 50 0 -50 -100 -150 -200 0 12 24 36 48 60 72 84 96 3/1/1975 7/1/1980 11/1/1982 3/1/1991 11/1/2001 108
December 19, 2006

Figure 6 takes the corporate yield history graphed in Figure 5 and subtracts 10-year Treasury rates, organizing the data according to trough-to-peak business cycles. What is striking about this graph is how unusual movements in credit spreads have been during the course of the current business cycle. In every previous cycle spreads have either moved sideways or gradually widened as the expansion in GDP neared its peak. What do we make of the recent uncharacteristic tightening? For one thing, the advent of the credit derivatives market may have permanently lowered credit spreads by making them easier to hedge and therefore less risky to hold. Although this story is getting a lot of play, consider what happened when interest rate derivatives were introduced into the rate market in the late 1970s. Has there been less volatility? Certainly not. Another story that might explain the move is that volatility is permanently lower because of greater transparency on the part of the Federal Reserve. The Fed is now releasing a sanitized version of its minutes and broadcasting its inflation assessment. Both arguments have some merit, but there is no such thing as a permanent condition in a market and credit spreads may be forced to give back much of the gains theyve made over the course of this cycle. Merely revealing that the direction and magnitude of spread tightening hasnt happened during any cycle for the past three decades should be unsettling for traders who are long credit spreads in one form or another. If the repo scrutiny is going to keep interest rate swap spreads narrow because there is unlikely to be any extraordinary bid in the Treasury market, then agency credit may face the full brunt of any general credit deterioration that may be coming.
Months After T rough
24
December 19, 2006 Interest Rate Swaps/Options
Swap Spreads in 2007: Grinding Tighter

Jon Blumenfeld (212) 272-2993 / jblumenfeld@bear.com David Boberski (212) 272-1507 / dboberski@bear.com With the Federal Reserve likely to be on hold or even raising rates in the first half of 2007, swap spreads should remain under narrowing pressure in the coming year. The continued reach for yield by investors faced with a low-volatility environment should continue to compress mortgage and credit spreads, pulling swap spreads narrower. A gradual grind in to the mid to high 30s in 10-year spreads and into the high 20s in 2-year spreads, punctuated by occasional but temporary moves to wider levels, is the most likely scenario. The major risk for wider spreads would be an economic downturn that leads to a widening of corporate credit and emerging market spreads. This seems unlikely, especially in light of our generally upbeat economic outlook for 2007. Figure 1 shows the history of the fed funds target rate, the 10year swap spread, and the single-A 10-year corporate spread. In 2000, credit spreads and swap spreads reached their widest levels just before the Fed began to ease. In the current Fed pause that began in June 2006, corporate credit and swap spreads have narrowed, not widened. In a scenario in which growth falls off but the Fed leaves rates high to fight inflation, credit quality could deteriorate, widening corporate and emerging-market spreads. This could take swap spreads wider as well. Once the Fed finally responded to the situation by cutting rates, spreads would likely contract as credit quality improves and negative-convexity hedging brings swap receiving into the market. In addition, this would likely steepen the yield curve, allowing corporate issuers to swap fixed issuance for floating rates, putting further narrowing pressure on spreads. In addition to credit spreads, a number of factors influence swap spreads over shorter or longer time frames, including:
Investors will continue to reach for higher yields in the context of a steady Fed and low volatility, compressing swap spreads. Credit is likely to be the main story for spreads. As long as demand for spread product stays high, and the economy continues to bump along, there is not much risk for a major widening in spreads. If and when credit begins to deteriorate, spreads could begin to widen.
Swap spreads have come in from their recent wider levels, but have some room to narrow further before they come up against historically narrow levels. As long as the economy remains reasonably firm, yield-hungry investors are likely to continue to buy spread products, pushing swap spreads narrower. At least for the first half of 2007, this should be the dominant flow. After that, it will depend on how the economy responds to the Feds ministrations, with the continued health of corporations first on the list of risks to swap spreads.
Figure 1. Fed Funds Target Rate; 10-year Swap Spreads, A Credit Spreads
250 200 Spread BP 150 100 50 0
b-0 5 b-0 2 b-9 7 b-0 0 b-9 9 b-9 6 b-9 8 b-0 1 b-0 3 b-0 4 b-0 6 Fe Fe Fe Fe Fe Fe Fe Fe Fe Fe Fe
Treasury supply Potential repo specialness Overall level of rates Negative-convexity hedging Shape of the yield curve
Relative Scarcity of Treasuries: Treasury Supply and Repo Specialness On a quarter-to-quarter basis, projections of Treasury supply show a strong connection with swap spreads.
Figure 2. Swap Spreads and Treasury Supply
Qtrly Borrowing Projection (Inverted) -100 -50 0 50 100 150 Projected Actual Spreads 140 120 100 80 60 40 20 0 Spread
7 6 5 4 3 2 1 0
Fed Funds Target Rate
Fed Funds Target
Source: Bear Stearns, S&P
Source: Bear Stearns, US Treasury
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S&P A 10-y ear C redit Spread
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Figure 2 gives 10-year spreads and two smoothed measures of Treasury supply on an inverted scale. The first is a fourquarter moving average of projections of supply. This is lagged to account for the fact that the market makes and begins to price in deficit projections well in advance of the official release of the Treasurys own projections. The second measure is a four-quarter moving average of actual Treasury supply. Both these series correspond well to spread performance over the long term. Repo specialness is another measure of the relative scarcity of Treasuries, and higher short-term rates increase the influence of repo specials. Recent developments in the repo market seem to have made specials less likely, and this may explain at least part of the recent compression in spreads. Repo traders have been warned by the Treasury and the Fed that they must not create artificial, extreme squeezes in the market in which securities cannot be borrowed at any price. It is likely that there has been some overreaction, as the market seems to have assumed that there is no risk at all of issues going special from now on. While this is unlikely to be true, repo may stay soft for some time to come. Because potential specialness has largely been priced out of the spread market, a return to a more normal market, in which issues sometimes get very tight, is likely to have a marginally widening influence on spreads. Overall Level of Rates and Negative-Convexity Hedging One of the strongest influences on swap spreads is negativeconvexity hedging, primarily coming from the mortgage market. With the greater part of the mortgage market out-ofthe-money for most of the past year, the influence of this kind of hedging has been reduced. Figure 3 gives a simple multiple-regression model of spreads using only the overall level of the 10-year swap rate and a measure of the duration of the mortgage market. At the end of 2005, the R2 of this regression (for the previous 5 years) was a hefty 0.91. After the market movements of the past year, the R2 for the trailing 5-year period has fallen to 0.70.
Figure 3. A Model for Spreads; 10-Year Swap Rate and Mortgage Duration
8 6 Rate/Duration 4 2 0 -2 -4 Resid (bp) M odel Spread 90 70 50
December 19, 2006

If rates stay where they have been or move slightly higher, negative-convexity hedging should continue to have a lessened influence on spreads, as convexity hedgers will not have a large need to enter the market. On the other hand, should rates fall, convexity hedging is likely to increase as mortgages come back into-the-money. Overall, the effect of negative-convexity hedging is therefore likely to be asymmetric, having less of an effect in a steady to higher rate environment than in a falling rate environment. Shape of the Yield Curve A steep yield curve puts narrowing pressure on spreads because issuers are likely to be attracted by low short-term rates, making them more likely to swap issuance into floating rates by receiving on swaps. Since there is no natural payer against this receiving, the swap causes narrowing pressure on spreads. With the curve flat-to-inverted, far fewer issuers are likely to swap from fixed to floating. Until the yield curve steepens, narrowing pressure from swapped issuance should continue to be relatively light. An inverted yield curve may have extra significance for swap spreads, possibly causing longer-dated spreads to widen relative to shorter-dated spreads. This is generally considered to happen when the Treasury curve inverts, but the swap curve resists inversion. In the 2000 period, this caused long spreads to widen considerably to short spreads, but the reaction has been mixed in the two episodes of swap curve inversion in 2006. In the first inversion at the end of February, there was no noticeable effect on the difference between 2-year spreads and 10-year spreads. In the second inversion in November, the spread-of-spreads widened, but this may have had more to do with a large move in 2-year spreads than the curve inversion. Risks to the Forecast
Credit: If credit spreads widen, swap spreads are likely to follow. There could be a significant widening in spreads before the Fed acts to stimulate the economy, easing credit and causing rates to fall. The fall in rates would be likely to reignite negative-convexity hedging and it would also likely cause the yield curve to steepen. Both of these effects would put narrowing pressure on spreads, but this would likely be from much wider levels. Deficit Surprises: Deficits in 2006 came in better than had been expected at the end of 2005. If this were to continue, causing Treasury issuance to be reduced, it could eventually translate into wider spreads.
Resid (bp)
30 10 (10) (30) (50)
12 /18
Source: Bear Stearns, Bloomberg
8/0 12 2 /18 /02 6 /1 8/0 12 3 /18 /03 6 /1 8/0 12 4 /18 /04 6 /1 8/0 12 5 /18 /05 6 /1 8/0 6
6 /1
/01
26
December 19, 2006

Higher interest rates: A significant rise in interest rates could put widening pressure on swap spreads. This could happen, for example, if foreign flows into Treasuries were to be reduced. Its hard to be certain what the overall effect of this would be, as a buyers strike in Treasuries could cause spreads to narrow rather than widen. In any case, this seems like a fairly remote possibility at this time.

Trading Strategies
Receive on spreads across the curve, looking for 10-year spreads to enter the mid to high 30s, and 2-year spreads to cross below 30. Keep a careful eye on credit and emerging market spreads for signs of trouble, and pay on spreads if credit begins to deteriorate.
Interest Rate Swaps/Options
Volatility in 2007: Watching the Fed

Jon Blumenfeld (212) 272-2993 / jblumenfeld@bear.com David Boberski (212) 272-1507 / dboberski@bear.com Since the Fed began tightening in mid-2004, volatility has been falling, and spreads between different points on the volatility surface have been compressing. Until it is clear that the Fed is ready to begin lowering rates, volatility is likely to continue falling. In recent months short-dated volatility has shown some signs of forming a bottom, and the volatility surface has begun to reshape itself, with options on shortermaturity underlying rates outperforming options on longermaturity underlying rates. Both these processes are likely to continue happening in advance of Fed rate cuts, with shortdated volatility remaining very sensitive to the direction of interest rates. Our volatility outlook for 2007 in brief:
The long-term moderation in interest rates and volatility should continue, so that even when volatility does rise, it is likely not to reach the peaks that have been seen in previous interest rate cycles.
The main risk for higher volatility is a sharp decrease in interest rates, which is most likely to happen in one of two ways:
The Fed stays steady or raises rates, but demand for longdated securities pushes the yield curve more and more inverted. This would increase volatility, but unless the rally could be sustained and extended, the overall effect on volatility would likely be limited. The economy does worse than expected, forcing the Fed to lower rates. This should steepen the yield curve and have the most dramatic effect on volatility.
Long-dated volatility should continue to be pressured downward. Investors looking to enhance yield and callable and structured product issuance are likely to produce supply, while the demand for long-dated vol is likely to remain weak. Later in the year, with a steady supply of mortgages and the possibility of a change in Fed stance that much closer, long-date volatility should find a bottom. Short-dated volatility should be market directional. If the market rallies, short-dated volatility is likely to spike higher from very low levels, falling back if and when rates ease back, although very short-dated options could get a lift from an increase in realized volatility even if rates rise. The volatility surface should continue to reshape even ahead of a change in policy by the Fed, with short-tail volatility rising relative to long-tail volatility.
Volatility Drivers Market risks to volatility are primarily driven by changes in Federal Reserve policy. If the Fed maintains the status quo or even adjusts rates higher in 2007, volatility is likely to remain low and probably go even lower. On the other hand, if the Fed changes stance sooner than expected and begins to lower rates, volatility is likely to increase dramatically. Supply and Demand in volatility are driven by a number of factors. The most prominent of these factors is hedging of mortgage-backed securities, mortgage origination, and mortgage servicing rights. Issuance of callable securities such as Trust Preferred Notes and the growing market in structured notes can also be significant sources of volatility supply. As the mortgage market grows, the size of mortgage servicing portfolios grows with it, increasing demand for options.
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The Federal Reserve: Market Risk The past history of Fed moves shows the following influence on implied volatility:
December 19, 2006

The volatility surface itself has flattened, with implied volatilities of options of the same expiration but on different tailssuch as 2y2y and 2y10yclosing in to similar levels as uncertainty shifted from the short end to the long end. This makes some logical sense, as the Feds measured pace made short end rates highly predictable, while long end rates behaved in less predictable ways as the yield curve flattened. The magnitude of the move in short-term rates was much larger, but long-end rates often defied the markets expectations. In the second half of 2006, the volatility surface began to show the first signs of decompression. Volatility on shorter underlying tails has begun to rise relative to volatility on longer underlying tails.
Figure 3. 2y2y vs. 2y10y Normalized BP Volatility
When the Fed is raising rates or remaining steady after a prolonged period of rate rises, volatility usually falls; When the Fed lowers rates, volatility usually rises; The market will sometimes attempt to anticipate the Fed, for example raising volatility before the Fed actually begins to cut rates.
Figure 1. 3y10y Volatility and Fed Funds Target Rate

9.0 8.5 8.0 7.5 7.0 6.5 6.0 5.5 5.0 4.5 4.0 3y 10y Vol Fed Funds Target (rhs) 10 9 8 7 6 5 4 3 2 1 0
Fed Funds Target Rate
Volatility BP/Day
1.60 1.40 1.20 BP/Day 1.00 0.80 0.60 0.40 0.20 -
8/0
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Uncertainty about the timing of Fed policy can eventually boost volatility as the market attempts to anticipate the Fed. Still, the biggest increases to volatility are unlikely to come until it is clear that the Fed is on the verge of cutting rates. One area that has already begun to anticipate the Fed is the volatility surface. Since volatility began to fall in 2004, the entire vol surface has become more and more compressed, with volatilities at various points converging on each other.
Figure 2. Volatility Surface Compression
10 9 8 7 6 5 4 3 2 1 0
This decompression is likely to continue in 2007 even if the overall level of volatility continues to come under selling pressure. Supply and Demand Good demand for mortgages from investors looking to enhance yield should create a steady supply of volatility in 2007. The main risk to this scenario is that interest rates fall sharply, with or without cuts from the Fed. Mortgage-backed securities carry primarily three types of risk:
Volatility BP/Day
6m2y 5y 5y 2y 2y 10y 10y 2y 10y
Interest rate risk Negative convexity risk Long-term volatility risk
Interest-rate risk from mortgages is frequently hedged with other interest rate products, such as Treasury notes or swaps. Because of the size of the mortgage market, hedging of mortgage rate risk can exaggerate rallies or sell-offs in the interest markets, increasing realized volatility.
12 /19
12 4 /19 /04 3 /1 9/0 5 6 /1 9/0 5 9 /1 9/0 12 5 /19 /05 3 /1 9/0 6 6 /1 9/0 6 9 /1 9/0 6
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December 19, 2006

Negative convexity risk is closely related to interest rate risk and is generated by the possible prepayment of mortgages. Mortgage duration falls as rates fall and mortgage duration rises as rates rise, so the holder of a mortgage position gets shorter as the market rallies and longer as the market falls. Short-dated options can be used to hedge this risk. Long-term volatility risk comes from the change in value of the long-dated imbedded option in MBS as volatility rises and falls. Every holder of MBS is implicitly short a long-dated option. Active hedgers buy long-dated or vega options to hedge this risk. Interest Rates and Prepayment As interest rates fall, mortgages become more likely to prepay. In the recent rate rallies, large portions of the mortgage market have moved much closer to levels at which borrowers are expected to prepay and refinance their loans. As interest rates approach important market levels, the overall negative convexity of the mortgage market increases, creating a short volatility position for active mortgage hedgers. In the first half of 2006, the bulk of mortgages were safely out of range of large refinancings, but in the second half of the year, and in particular in the fourth quarter, rates fell far enough to put large portions of the mortgage market at risk.
Figure 4. Mortgage Refinancing and Rate Level
$250.00 $200.00 $150.00 $100.00 $50.00 $Agency 30-Year Fix ed Outstanding C um Percentage Ex posed 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

Figure 5. 10-year Swap Rate and 1y10y Swaption Premium
560 1y10y Swaption Premium 540 520 500 480 460 440 420 400
12 /19 /0 1 /1 5 9/0 2 /1 6 9/ 3 /1 0 6 9/0 4 /1 6 9/0 5 /1 6 9/0 6 /1 6 9/0 7 /1 6 9/0 8 /1 6 9/0 9 /1 6 9 1 0 /0 6 /19 1 1 / 06 /19 / 06
4.5 1y 10y Vol 10y Sw ap 4.7 10-year Swap Rate (Inverted 4.9 5.1 5.3 5.5 5.7 5.9 6.1
Once rates go low enough, demand for options comes from several places:
Mortgage Servicers Mortgage Originators MBS Hedgers
Mortgage Servicers Mortgage servicers own the rights to service mortgages, and the are very active hedgers of interest rate and volatility risks. If the mortgages prepay, the servicers lose the income streams associated with the underlying mortgages. Servicers are very sensitive to the level interest rates, and they are often looked at as barometers of the state of the mortgage market. Servicers are likely to have a much larger need for options if interest falls from current levels. Also, with the overall mortgage market expected to grow 7% in 2007, the size of mortgage servicing portfolios will grow with it. Mortgage Originators Mortgage originators create new loans, and when they do they become short options. This is because borrowers can lockin rates when they apply for a mortgage, forcing the originator into the loan if rates rise, or demanding lower rates if rates fall. When mortgage applications spike higher, mortgage originators can have significant demand for options. This typically happens when refinancing increases. MBS Hedgers Anyone holding a position in mortgage-backed securities can hedge, but many do not, preferring not to give up any of their enhanced yield. Traditionally, GSEs have been the largest active hedgers of MBS, but in recent years they have been less active, both because their portfolios have been shrinking and because the mortgage universe has been out-of-the-money. While hedgers have been quiet, a sufficient fall in rates could bring them back into the market, creating a large bid for
At the end of each of the past three months, as rates have fallen, short-dated options have been bid up. Each time interest rates push lower, even without Fed rate cuts, volatility is likely to rise as market participants hedge against the possibility of a sustained rally that leads to a wave of refinancing. On the other hand, Figure 3 shows that ever lower lows in interest rates are needed to keep swaption premiums rising.
<
4.7 5 5 .0 0 5 .2 5 5 .5 0 5 .7 5 6 .0 0 6 .2 5 6 .5 0 6 .7 5 7 .0 0 7 .2 5 7 .5 0 7 .7 5 8 .0 0
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volatility. Should rates move higher, mortgage hedgers are likely to have much less need for options. All of these hedgers face asymmetric interest-rate risk as they enter 2007. A fall in rates should create large demand for volatility, while a rise in rates should be much less important. Furthermore, a rally generated by Fed rate cuts should be more likely to be sustained and extended. The longer rates stay low, the more likely refinancing becomes. A speculative rally that comes without Fed cuts is less likely to be sustained, and the more the yield curve inverts, the harder it becomes to extend the rally. For these reasons, a rally without Fed cuts is likely to lead to less demand for volatility. Trust Preferreds and Structured Products Additional supply in long-dated volatility is likely to come from both the Trust Preferred market and the market for structured products. Trust Preferreds are special instruments that combine the attributes of debt and equity. Large banks can use them as an efficient way to raise as much as 15% of Tier I capital. They are frequently issued in callable form such as 60nc5, continuously callable after the lockout period. They are typically swapped, leaving the dealer community with a large long-dated volatility position to be hedged. In addition to the regular issuance of Trust Preferreds, a large block of outstanding issues are eligible to be called in the first quarter of 2007. Structured products such as range-accrual notes also generate volatility supply. Buyers of structured products are often enhancing yield by selling options, once again leaving dealers with long positions in volatility. The MBS Coupon Stack As mortgages are originated either from new purchases or from refinancing of older mortgages, the shape of the coupon stack gradually changes, especially if interest rates remain in a fairly narrow range. The outstanding size of the current coupon mortgage increases, as the size of the premium coupons falls. This has a tendency to reload negative convexity, as current coupon mortgages are more negatively convex than premium mortgages. While this is a slow process, it does impact the market after enough time passes. With over $700 billion in agency fixed-rate mortgages expected to be originated in 2007, the overall negative convexity of the mortgage market and associated servicing should gradually increase, creating new demand for volatility. Combined with the overall growth of the mortgage market already mentioned, this should keep a steady bid for both long- and shorted-dated volatility under the market, perhaps creating a floor at lower levels. Summary
December 19, 2006
All eyes are on the Federal Reserve. With a quiet Fed, volatility should be pressured downward as spread products and MBS remain popular with investors looking to enhance yield through option sales. Short-dated volatility should be highly rate sensitive, rallying whenever the market approaches new lows in yield, and then falling when yields rise. Supply of options, particularly long-dated options, should continue to outstrip demand in 2007, pushing volatilities ever lower, until the Federal Reserve is finally ready to begin cutting rates. We think thats still well in the future. Risks to the Forecast
The Fed: If the economy turns down and the Fed begins to cut rates sooner than expected, volatility is likely to rise dramatically. In this case, short-dated volatility will lead the way, but long-dated volatility is likely to rise sharply as well. The reshaping of the volatility surface will accelerate as well, as short-term interest rates lead the way. Demand for Spread Product: If spread products, including mortgages, become less popular, perhaps due to credit concerns, the supply/demand dynamic in volatility could change. This could occur in a rising rate environment, catching volatility sellers offside and causing a spike higher in both short- and long-date volatility. Geopolitical Risk: Volatility can be very sensitive to external shocks to the market. While it is true that there have been no major shocks since 9/11, any shocks that do occur may have a large effect on volatility.
Trading Strategies
Play for the continued reshaping of the curve by buying short-tail volatility and selling long-tail volatility. For example, buy 3y2y and sell 3y10y. Sell long-dated volatility outright, but protect it by buying low strike receivers or floors when short-dated volatility drops to low levels. Time after time, the market has shown how sensitive short-dated volatility is to the threat of lower interest rates. Later in the year long-dated volatility may have more value.
In the first quarter of 2007, sell or stay short very long-dated volatility, such as 5y30y or 10y10y. These long-dated, longtail volatility structures are the ones supplied to the market by Trust Preferreds or structured products. Hedge by buying shorter tails.
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December 19, 2006 Agency MBS
MBS in 2007: The Case for Tighter Spreads

Steven Abrahams (212) 272-2206 / sabrahams@bear.com Victor Gao (212) 272-3082 / vgao@bear.com Although MBS ends this year at tighter nominal and optionadjusted spreads than where it began, both trends should still have some life in 2007. Market conditions should help nominal MBS performance in the first half of next year, with other spread markets tightening slightly and key elements of volatility coming down. Its unclear whether the spread and volatility trends can run beyond mid-year. Demand, however, looks likely to pick up where market conditions leave off. Both foreign investors and banks look likely to have a strong bid for MBS, and the amount of capital in those hands should keep MBS biased to tighten through the second half of 2007. year. Higher yields in the spread markets help mitigate losses from depreciation.
Figure 1. Foreign Investors Should Still Favor Agency and Corporate Debt in 2007
450 400 350 300 $Billion 250 200 150 100 50 0 U STs Agency Debt and M BS 2006 2005 C orporates
MBS Demand
MBS demand depends on the appetite of the key marginal buyers, and foreign investors and banks have been the most important bids in the last year. The bids should continue, possibly joined by investors skittish about credit in mortgagerelated ABS. Demand from Overseas Foreign investors have been one of the bright spots in MBS demand in the last year and look likely remain so in 2007. Those investors look likely to have plenty of new cash in the year ahead, and a good appetite for spread product. One obvious source of cash will be the likely continuing surge in global foreign currency reserves. Measured reserves grew by 20% last year and now stand at close to $4.8 trillion. An estimated 66% of those reserves sit in dollar assets. While there will surely be talk of diversification away from the dollar, the action is likely to be limited given the potential financial and political costs. Foreign reserves should grow again in 2007reserves in China alone could easily grow by $250 billion through foreign direct investment, currency intervention and interest on existing reservesand flow back into U.S. debt. And while flows from private foreign portfolios may weaken a little next year (see The Resilient Rates Markets elsewhere in these pages), they should still be significant. MBS, along with other spread product, should capture a rising share of foreign investment. While foreign purchases of Treasuries this year fell well below earlier levels, foreign purchases of spread productsagency MBS, agency debt and corporate debtran well above (Figure 1). Spread product helps foreign portfolios offset some of the potential losses in dollar portfolios depreciation of the dollar. China, for instance, allowed its currency to appreciate by 3.1% against the dollar this year and should allow further appreciation next
Ja n Ma r Ma y
b Ap r Ju n Au g Oc t Ja n Ma r Ma y
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Source: TICS
Demand from foreign central banks should remain concentrated in pass-throughs with occasional forays into structure. Demand for foreign banks and insurers should show up mainly in structured MBS. Demand from Banks Net demand for mortgages and MBS from U.S. banks should be as good or better in 2007 as it was in 2006, when large commercial banks added a net $222 billion$148 billion in mortgage loans and $74 billion in MBS. Although an inverted yield curve and rising funding costs should continue to put pressure on bank net interest margins, banks may nevertheless have few alternatives beyond mortgages and MBS for adding spread income. Most of the bank demand for mortgages in 2006 came from a handful of the largest institutions. For example, holdings of both securitized and unsecuritized mortgages at Bank of America through 3Q06 had jumped $17 billion from the start of the yeareven after a $46 billion sale of MBS in September. Total mortgages held by Citigroup rose by $81 billion, with $54 billion of the rise in MBS. And mortgages at JPMorganChase grew by $55 billion, with $49 billion in MBS (Table 1). MBS have become increasingly concentrated in the hands of large banks in recent years, with the top three bank holders of MBS todayBank of America, Wachovia and JPMorganChaseaccounting for 64% of all MBS held by large U.S. commercial banks. The mortgage market has consequently become increasingly subject to the needs of particular balance sheets.
Ju l Se p
Fe
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Table 1. Large Banks Continue to Dominate the Mortgage Market
Total Mortgages Bank BoA Wachovia JPMorgan Citigroup Source: FDIC 06Q3 464 184 223 254 05Q4 447 187 168 173 Chg +17 -3 +55 +81 06Q3 163 79 71 64 MBS 05Q4 196 89 21 10 Chg -33 -10 +49 +54
December 19, 2006

If the economy slows in 2007, banks will likely turn to MBS for assets as they have in the past. From 2001 through mid2003 as recession and its aftermath helped trim large commercial bank portfolios of C&I loans by $160 billion, mortgage and MBS portfolios grew by $305 billion. The tradeoff between other parts of banks asset base and mortgages is unlikely to be as dramatic, but a slowing economy should keep bank interest in MBS healthy. Demand from GSEs GSE portfolios look likely to grow more slowly than the overall growth in 1-4 family mortgage debt outstanding. Outstanding debt should grow by 7% in 2007, according to Freddie Mac, but GSE portfolio growth will likely fall shy. The clearest obstacle of GSE participation is increased regulation. Although Freddie Mac now operates under a portfolio cap that would allow growth to track mortgage debt outstanding, Fannie Mae is limited to holding only the $727 billion that it did in December 2005. Even if Freddie Mac grows in line with outstanding debt, combined GSE portfolio growth should be only half of that rate. However, some signs of a turnaround have emerged both from Fannie Mae, which recently completed filing its 2004 Form 10-K restatement, and from the Treasury Department, which has reversed calls for a reduction in GSE portfolios. Nevertheless, the odds of relief for Fannie Mae in 2007 look low. The other obstacle is the spread of mortgages to agency debt. While agency debt funding levels have improved this year spreads on 10-year agency debt tightened from a high of LIBOR-12 in January to LIBOR-19 recentlymortgages have not looked wide enough to draw a GSE bid (Figure 3). The GSEs have had continuing interest in AAA non-agency floating-rate paper, but lackluster interest in other mortgage sectors. The likely good demand from foreign investors and banks in 2007 will probably keep MBS spreads at levels that leave the GSEs indifferent.
Figure 3. Option-Adjusted Spreads (bp) of MBS to both Agency and Treasury Look Uninspiring
60 50 40 OAS (bp) 30 20 10 0 -10 -20 -30 OAS to Agency OAS to Sw ap
Rising funding costs have put pressure on banks margins all year, and thats likely to continue. The national median cost of funds ratio, as reported by the Office of Thrift Supervision, rose from 2.86% at the end of last year up to 3.57% as of October (Figure 2). Cost of funds has risen 83 bp year-overyear through October, nearly the fastest rate of increase since 1995. Deposits have also grown. Large banks took in $104 billion in new deposits in 2006, with small banks adding $154 billion. Next year, banks should not only face rising funding rates, but a rising base of liabilities. Some banks may counter the rising funding costs by allowing assets to mature or prepay and by retiring their most expensive funding, but most will likely add leverage and try to squeeze more margin out of investment opportunities.
Figure 2. Banks Face Progressive Higher Cost of Funding
9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0
Cost of Funds (%)
Ja n00
Ja n02
Ja n98
Ja n04
Ja n92
Source: Office of Thrift Supervision
Ja n01
Ja n03
Ja n00
Ja n02
Ja n04
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Ja n05
Ja n06
As banks go hunting for assets, a slowing economy should squeeze the supply of commercial and industrial loans and consumer assets. In the second half of 2006, for example, the growth rate in large bank C&I portfolios fell from 10% in the first half of 2006 to 6% in the second. The growth rate in consumer portfolios moved up marginally from 2% to 3%. But growth in holdings of mortgages and MBS moved from 16% in the first half to 20% in the second. The Feds Survey of Senior Loan Officers corroborates the view that demand for C&I loans is slowing. In the most recent quarter, more banks reported weaker demand for C&I loans than any point since 2003, at the turn of the last recession.
Ja n94
Ja n96
Ja n90
Ja n06
December 19, 2006

Demand from Total Return Accounts and Insurance Companies Tight spreads in agency MBS have encouraged a wide range of total return portfolios to hunt for returns in housing-related ABS. And while that sector will still offer good opportunities in 2007, new concerns about credit should push some cash back into the agency market. Recently, MBS backed by home equity loans originated in 2006 have taken a hit from decelerating home prices and the layering of credit risks. Originators in 2006 made loans to borrowers with multiple red flagslow FICOs, high LTVs, low documentation and so on. Subprime deals have shown both elevated delinquencies and defaults. Furthermore, as a significant portion of the hybrid subprime market approaches its first rate adjustment in 2007, borrowers should face much larger monthly payments. These credit-driven concerns further slowing in housing, eroding credit and impending resetsmay drive cautious investors away from housingrelated ABS and into agency MBS. Although tougher lending standards should improve the performance of ABS issued in 2007, investors may hedge a little of that bet. Insurance companies have not been major players in the MBS market in the past few years, as they have invested heavily in credit-sensitive assets. Whether they play a bigger role, MBS in 2007 hinges heavily on how credit is likely to play out. Watch for them to have slightly higher demand for MBS in 2007 than they had in 2007.

Figure 4. 30-Year MBS Growth Has Rebounded
3000 2500 2000 $ Billions 1500 1000 500 0
Ja n94 Ja n95 Ja n96 Ja n97 Ja n98 Ja n99 Ja n00 Ja n01 Ja n02 Ja n03 Ja n04 Ja n05 Ja n06
30-Year M BS
15-Year M BS
ARM
With outstanding residential mortgage debt likely to rise by 7%, outstanding agency MBS should rise by roughly that amount although the flow of new pools might fall from last years levels. Total mortgage origination should fall 11% in 2007 as housing turnover slows, bringing issuance of new pools down, too. Issuance in conventional agency MBS should drop from $908 billion this year to $826 billion next. But issuance of agency MBS as a percentage of total MBS issued should remain steady at around 46%. Our projections show that, in percentage terms, hybrid ARM issuance should shrink more than fixed-rate issuance (Table 2).
Table 2. MBS Issuance On Track to Fall in 2007
Issuance All Mortgages All MBS Agency MBS Fixed Agency MBS ARM Agency MBS Source: Bear Stearns Projected 2006 2,990 1,987 908 758 150 Projected 2007 2,666 1,773 826 703 123 Change -11% -11% -9% -7% -18%
MBS Fundamentals
The fundamentals risks in MBS should shift as the housing market slows down in 2007. Slower housing should trim the growth of outstanding mortgage debt and reduce the call risk in MBS. Supply Supply of 30-year MBS rose steadily in 2006, after falling the previous years. Since June, the sector has increased in size by $136 billionthe fastest 5-month increase since 2001 (Figure 4). A flatter yield curvereducing ARM production combined with a shrinking 15-year MBS sector should keep growth in 30-year MBS strong in 2006.
The conforming loan limit will remain unchanged at $417,000 for 2007. Unlike 2006, where a rising loan limit caused more than 15% of the jumbo fixed-rate pass-throughs to be agencyeligible, 2007 should see much less refinancing of jumbo loans into agency loans. This should take away from potential sources of supply. The ARM market has also shown signs of leveling off. The agency hybrid ARM market grew by 9% in 2006, significantly slower than the 15% growth of 2005 and well below its peak of 40% growth in 2003. Although ARMs remain a significant share of new applicationsmainly reflecting the refinancing of old ARMs into newthey should not be a growing share of the agency market. Expect ARM production to slow in 2007 as 30-year fixed-rate mortgages rebound. In 2006, the shrinking universe of Ginnie Mae MBS reversed trend in April and began to grow. Although still a far cry from the beginning of the 1990s, when Ginnie Mae MBS held 40%
33

of the outstanding agency MBS market share, this sector should continue to recover some share. The turnaround has been largely the result of prepayments of Ginnie Mae MBS significantly decliningreflecting borrowers more sensitive to falling home price appreciation than other agency borrowers while issuance has held steady at around $7 billion per month in 2006. As supply increases, valuations in Ginnie Mae MBS may fall. Prepayments 2006 saw rising rates leave behind a discount-dominated, nonrefinance MBS market for the first time in more than five years. Home price appreciation slowed appreciably. The explosion in affordability over the past few years gave way to a stable menu of mortgage products. Overall, prepayments in 2006 were consistent with higher rates and weaker underwriting standards, but did not reflect the full impact of a slowing housing market. As we move into 2007, according to Dale Westhoff and his team, speeds have room to fall. Prepayments on discount collateral, which constitute the vast majority of the mortgage universe, are poised to decline in 2007. The slowdown in discount speeds from an average of 20 CPR in mid-2005 to 12 CPR in mid-2006 came along with a 100 bp rise in mortgage rates. Controlling for distance from par and seasoning, discounts this year have still prepaid significantly faster than 1999-2000. These elevated speeds can be attributed to the spread of affordability products and to home price appreciation. First, the widespread availability of affordability products such as hybrid IOs gave borrowers even with discount loans some incentive to refinance. Second, home price appreciation of 12% HPA in 2004-2005 gave borrowers equity to take out. Thus, they were less affected by the slowdown in housing. As home prices slow in 2007, prepayments on premium collateral should also fall. History suggests that the steepness of the refinancing curveprepayments as a function of economic incentive to refinancehas been strongly correlated to the strength of the housing market. In 1996, after a few years of paltry HPA, the response to a rally in rates to within 10 bp of the 1993 lows was underwhelming. While the refinancing curve should not flatten to the extent it did in 1996, it is very unlikely to regain the steepness seen in 2003. In other words, prepayments on premium mortgages should be muted despite the borrower having significant incentive to refinance. As the market rallied in the second half of 2006, there has been ample talk of an impending refinancing wave. The recent surge in the Mortgage Bankers Association Refinancing Index has added cause for concern. Dale Westhoff and his team believe this concern is misplaced. Despite lower rates, less than 20% of the mortgage universe is currently exposed to a refinance incentive of 40 bp or more. In order to trigger a refinancing event, the majority of the 30-year 5.5% universe would have to be at least 40 bp in-the-money. That translates
December 19, 2006

into a mortgage rate of 5.60% to 5.40%another 70 bp rally. Until then, factors other than rates will also play a significant role in defining call risk. Falling prepayment speeds, a flattening refinancing curve and a low risk of a refinancing wave all suggest that the current environment may provide the best opportunity to take on call risk since the mid-1990s. In an environment of marginal call risk, par and premium coupons should generally outperform discounts, loan balance should lose value, and IOs should outperform the most. Other Market Factors Both swaps and volatility will play a role in MBS performance, as they always do, and the role looks constructive. MBS tend to trade in sympathy with swap spreads, especially in markets free of the noise of refinancing waves. A grind toward tighter swap spreads should pull MBS along. As for volatility, the heavy supply of callable bank trust preferred debt in 1Q07 should keep long-dated volatility headed lower. For a largely discount MBS market, that should clearly help. CMOs In 2006, CMO production was down 12% from 2005, more than twice the drop in production of new pass-throughs. Notably, the growth of the CMO market as a percentage of MBS rebounded in the first half of 2006 before plummeting in the second half of the year (Figure 5). Agency CMO issuance as a percentage of agency MBS rose above long-term 35% average in the first half of the year only to drop in the second half. CMO issuance in the 15-year sector has been virtually nonexistent, falling to just $1 billion in 2006 from $8 billion in 2005. The lack of issuance in this sector has robbed the 15year market of much of its structured bid, widening it to 30year paper and muting activity in the 15-year dollar roll markets.
Figure 5. CMO Production as a Percentage of Pass-Throughs Issued Has Moved with the Shape of the Curve
80 70 60 $ Billion 50 40 30 20 10 0
Ja n01 Ju l -0 1 Ja n02 Ju l -0 2 Ja n03 Ju l -0 3 Ja n04 Ju l -0 4 Ja n05 Ju l -0 5 Ja n06 Ju l -0 6
80% Agency C M O C M O as % N ew M BS 70% 60% 50% 40% 30% 20% 10% 0%
% New MBS
Source: Bloomberg, Bear Stearns
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December 19, 2006

The Trust IO/PO market saw $42.6 billion deals price in 2006, its highest year ever, beating out 2002 by more than $6 billion (Figure 6). This market has largely been fueled by investors taking views on prepayments and the direction of the housing market. With a flat yield curve, Trust IOs were also among the few sources of good carry for investors. Towards the second half of the year, when the drop in rates pushed discount MBS closer to par, other investors have used Trust POs as a way to bet on continued yield curve inversion and Fed cuts on the horizon. The Trust IO/PO market should remain active as housing slows and possibly turns a corner next year.
Figure 6. A Record Year for the Trust IO/PO Market
45 40 IO/PO Issuance ($B) 35 30 25 20 15 10 5 2000 2001 2002 2003 2004 2005 2006

rich IO valuations, higher rates and falling HPA. If more of the mortgage market falls underwater, look for other servicers to consider issuing excess servicing deals as a means of booking profits as net interest margin continues to shrink.
Playbook for 2007
Take basis risk. The good prospects for tighter spreads in the first half of the year argue for taking basis risk in MBS. If demand for foreign portfolios and U.S. banks turns out as strong as we anticipate, the bet should pay-off all year long. Sell call protection. The prospects for muted prepayments in MBS next yeareven in a modest rally make selling call protection attractive. Slowing housing stands to lower speeds in both discount and premium MBS. Some of the normal safe-havens in MBSlower loan balances, specific geography stories and others stand to lose relative value in 2007. Securities that take on call riskIOs, premium pass-throughs and others stand to gain. ***
New Issue CMO Spreads: http://www.bearstearns.com/bscportal/pdfs/appendices/2006/ agencymbs_01_121906.pdf Benchmark Trust IO Performance: http://www.bearstearns.com/bscportal/pdfs/appendices/2006/ agencymbs_02_121906.pdf Or see the Bear Stearns Research Library
Source: Bloomberg, Bear Stearns
The excess servicing IO market saw eight new dealsfive Fannie Mae Trusts and three Freddie Mac Trustsprice in 2006. The total notional amount was smaller than 2005 although still significant. Excess servicing IOs trade at a sizable concession to Trust IOs due to the lack of a perfect PO hedge in the market, and consequently give even higher carry. Both SunTrust and Wells Fargo securitized strips of excess servicing IOs for the first time in 2006, taking advantage of
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Across the Curve and Across the Grade: Outlook 2007 Adjustable Rate Mortgages
December 19, 2006
Agency Hybrid Outlook 2007

Gyan Sinha (212) 272-9858 / sinha@bear.com Aditya Bhandari (212) 272-1490 / abhandari@bear.com 2006 marked the formal emergence of hybrid ARM product as a player on the agency mortgage stage, with the decision by Lehman to create a hybrid ARM index. This is likely to further increase the acceptance and use of hybrid ARM products in investors portfolios, further broadening the base of agency hybrid investors. In our outlook report, we provide a discussion of issuance trends, prospective prepayments in the sector and valuations. Issuance We expect gross agency ARM issuance for 2007 to be around $125 billion, about 18% lower from 2006 levels. Agency hybrids are expected to compose 15.0% of total agency issuance for 2007, down from 16.5% in 2006. As we write this, agency hybrid issuance for 2006, excluding December, stands at $139 billion. Total issuance in 2006 will likely be in the $147-$151 billion range, about 17% lower from 2005. Looking back on the year, hybrid issuance surpassed initial expectations of $125 billion. The share of agency hybrids within the agency MBS sector (as measured by issuance) has remained steady even as the mortgage curve has continued to flatten in 2006. There are three main reasons for better-than-expected issuance in 2006. To summarize, we expect agency hybrid issuance for 2007 to be around $126 billion, down from 2006 due to a flat mortgage curve and an 11% decrease in overall mortgage production, but supported by a continued high securitization rate and higher IO hybrid ARM production.
Table 1. Agency Hybrid Issuance Has Remained Steady Even Though the Mortgage Curve Has Flattened
Agency Hybrid Issuance (%) 21.1% 19.4% 19.5% 21.9% 25.1% 17.9% Mortgage Curve 30-Year Fixed Rate Mtg. - 5/1 Hybrid Arm Rate (bp) 32 43 53 70 87 105
2H06 1H06 2H05 1H05 2H04 1H04
First, overall mortgage origination has been relatively strong in 2006, when compared with expectations for the same year. Second, the securitization rate for 2006 came in at an alltime high of about 72.5%. Third, increased production in Interest Only hybrids has supported issuance in the hybrid sector.
In 2006, 5/1 hybrids have dominated issuance, constituting about 60% of all hybrid ARM production. This rate held firm even in the second half of 2006 when the slope of the hybrid mortgage curve, defined as the 10/1 ARM rate over the 3/1 ARM rate, was only 20 bp. We believe 5/1 hybrids will continue to dominate issuance among resets in 2007 and once again constitute about 60% of mortgage production (Figure 1) in 2007. Unless the curve can steepen 20-30 bp from current levels, production in 3/1s and short-reset ARMs (1/1) is likely to be minimal in 2007. We expect 3/1 and short-reset issuance to be about 5% of overall production. We expect 7/1 and 10/1 hybrids to constitute about 30% of agency ARM issuance as more borrowers should prefer the interest rate protection, versus pay-up in mortgage rate, provided by these longer resets. Finally, with option ARMs continuing to find better execution in the non-agency sector, we expect option ARM production to be only 5% of the total agency ARM issuance in 2007.
Figure 1. Projected Percentage Agency ARM Issuance in 2007 by Reset
5% 30% Option ARM <5/1 5/1 >5/1 5%
Agency IO hybrids as a percentage of total agency hybrid issuance were above 70% for 2006, compared to 55% in 2005. In the current flat mortgage curve environment, an IO 5/1 hybrid lowers monthly mortgage payments by approximately 15% compared to a level pay 30-year fixed rate mortgage. On the same scale, level pay 5/1 hybrids lower mortgage payments by only 3%. However, over the last three months hybrids as a percentage of total mortgage applications have dipped to a 2-year low of 24%. This leads us to believe that more borrowers are becoming risk averse, preferring to take less interest rate risk on their loans.
60%
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December 19, 2006

Prepayments For 2007, we believe that speeds in the agency hybrid sector have the potential to slow 15%-20% from their 2006 levels. This past year saw prepayment speeds on hybrids ARMs continue to outpace their fixed rate counterparts. However when comparing 2006 to 2005, agency hybrids slowed by 15%-20% more than fixed rate mortgages after adjusting for relative coupon and seasoning. We view the slowdown in hybrid speeds in 2006 as a moderate correction to the abnormally fast prepayment speeds observed in 2005 and believe that the slowdown due to decreasing HPA is yet to be fully realized. With a flat mortgage curve and expected slower housing turnover activity, there is little support for hybrid speeds in 2007. Tail speeds and valuations will be subject to re-valuation as 3/1s originated in 2004 and 5/1s originated in 2002 will reset in 2007. In the agency hybrid sector about 45% of the 3/1s originated in 2004 are outstanding as of November 2006 while only 13% of the 5/1s originated in 2002 are outstanding as of November 2006 (Table 2). As a result the total number of hybrid ARM loans resetting in 2007 is substantially larger than any prior year before this. The current GWAC of the 2004 vintage 3/1s is between 4.10% and 4.90%. With 6MLIBOR/1Y-LIBOR above 5.30%, most of these 3/1s are likely to be capped at a mortgage rate between 6.10% and 6.90%. However assuming a conforming 3/1 hybrid mortgage rate of 5.95%, these borrowers will have an incentive of 15 bp to 95 bp, respectively, to refinance their mortgage. On the other hand 2002 vintage 5/1 hybrids will not get capped and will reset to a GWAC of about 7.50% and will have 150 bp of incentive to refinance, assuming a 5/1 mortgage rate of 6.0%. Empirically, speeds at reset have been proportional to the refinancing incentive for the borrower. As shown in Figure 2, prepayment speeds at reset for 3/1 hybrids have increased from 40 CPR to 70 CPR as the refi-incentive increased from -5 bp to 80 bp.
Table 2. 3/1 and 5/1 ARMs Resetting in 2007
Reset 3/1 5/1 Orig Yr 2004 2002 Agency FH FN FH FN Orig. Bal 10.4 25.0 15.9 28.1 Curr. Bal 5.0 11.3 2.2 3.6 % of orig. 47.6% 45.1% 13.9% 13.0%

Valuations Agency hybrid spreads will finish 2006 at their widest on OAS for the year to both 15-year and 30-year collateral (Figure 2). We believe that investor reach for carry has caused longer duration assets, like 30-year MBS, to tighten more on OAS especially as the yield curve has rallied over the last 3-4 months and funding has remained unchanged.
Figure 2. Par Agency 5/1 OAS Over Par 30-year MBS OAS
40 35 30 25 20 15 10 5 0 -5
c-0 5 Ja n06 Fe b-0 6 Ma r-0 6 Ap r- 0 6 Ma y-0 6 Ju n06 Ju l -0 6 Au g06 Se p06 Oc t- 0 6 No v-0 6 De
Supply and demand technicals are pointing towards a substantial tightening of spreads in agency hybrids in the first half of 2007, both on a nominal and OAS basis. As previously discussed, we expect agency hybrid issuance in the next year to be lower by 18%. While supply is expected to be low there are potentially two events in the first half of 2007 that can cause demand for agency hybrids to spike up. The most significant event is the addition of agency hybrids to the Lehman MBS index (10%) and the Lehman Aggregate Fixed Income index (3%), starting April 1, 2007. Our research shows a $25-$45 billion net increase in demand for agency hybrids from institutional investors who will attempt to replicate or outperform the MBS index. Most of the available float in the agency hybrid sector comes from new to slightly aged issuance as a majority of the players in agency hybrids are buy and hold investors, making seasoned paper hard to come by. A second item that may improve liquidity in the agency hybrid sector is the potential introduction of synthetic hybrid ARM forwards. The product is likely to start trading in the first half of 2007. Trading in synthetic hybrid forwards will be on a nominal spread (Z-curve) basis, similar to CDS spreads. This product will give investors the ability to short hybrids and hedge agency or AAA jumbo hybrid MBS. Considering that agency hybrids are trading at their wides for the year, we expect agency hybrids to tighten by 10-15 bp on an OAS basis to 30-year collateral by the end of April 2007.
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Across the Curve and Across the Grade: Outlook 2007 Structured Credit
December 19, 2006
The Structured Credit Markets in 2007: Opportunities and Challenges

Gyan Sinha (212) 272-9858 / sinha@bear.com Mary Ann Thomas (212) 272-7431 / mthomas@bear.com Beau Paulk (212) 272-2152 / jpaulk@bear.com Karan PS Chabba (212) 272-1978 / kchabba@bear.com Aditya Bhandari (212) 272-1490 / abhandari@bear.com Jesse Singh, CFA
The structured credit markets (composed of the private-label RMBS, non-mortgage ABS and CDO sectors) had another banner issuance year in 2006, despite the steady rise in interest rates through most of the first half of the year. The reasons werent hard to identify: the steady drop in risk premia implied continued investor interest in earning spread by selling volatility, which combined with a healthy calendar of issuance in most of the underlying collateral markets, made for a steady pace of activity throughout the year. As we close out 2006, the cost and the consequences of some of the inevitable slippage in underwriting standards have begun to be felt in at least the subprime and near prime segments of the market. In looking ahead to 2007, some of these themes are likely to impact issuance and spreads in the next year. It is our purpose in this outlook to highlight a few of the most salient trends that will occupy investors conversation in the months ahead. Before we delve into the details, it would be useful to our readership to lay out our views on the broader macroeconomic elements for 2007. First, we expect a range-bound interest rate environment in which a stagnant housing market and tame inflation are likely to keep the Federal Reserve on the sidelines. The risks to our forecast, if they exist, are a fed funds rate that is bounded within 25 bp of its current level of 5.25%. Overall housing price appreciation, as measured by the repeat transactions OFHEO index, is likely to fall to just over 4% from its last reported 7.7% level. Housing markets nationwide, and particularly on the coasts and the Southwest, are likely to slow down further to 3% as activity levels and prices adjust to a new equilibrium in rates, affordability, and consumer wages and incomes. In addition, as we mentioned in our outlook at the beginning of this year, 2006 has been characterized, for the most part, by tight spreads, low volatility, and an increasing divergence in performance and spread trends between the corporate and mortgage credit sectors. It is the extent and direction of this divergence, along with innovations in structure and the effect of regulatory changes, that should continue to be one of the overriding themes in 2007.
Supply Trends in 2007

With overall rates remaining unchanged and Home Price Appreciation (HPA) slowing to moderate levels, refinancing activity will be decidedly muted next year versus 2006. We forecast supply for non-agency MBS to be down 12% in 2007. Within this figure is a bifurcation between prime and subprime collateral. For jumbo prime loans, we are forecasting a 9% drop in originations next year. The volume of mortgages from borrowers with poorer credit, however, will slow much more than 9%. This is due to a combination of factors, the first of which is the lack of refinancing incentive. Higher mortgage rates and lack of home equity brought about by slowing HPA and pervasiveness of piggyback second mortgages account for this. Also playing a factor is headline risk and losses in the 2006 vintage causing some originators to tighten underwriting guidelines (or in some cases, follow underwriting guidelines). This last point is exacerbated by recent guidance by federal and state regulators aimed at curbing layered risk in nontraditional mortgages. Already, 19 states and the District of Columbia have agreed to implement the guidelines at the state level, with more planning to do so in the near future. The cumulative result of these factors is a decrease in subprime mortgage originations of 15% in our estimation. As can be expected, origination in the near prime sector will fall somewhere between the prime and subprime, with prime Alt-A being down closer to 9% and Alt-B and gap collateral down closer to 15%. Finally, many investors/analysts often take note of a large portion of the subprime universe that will be resetting in the next 12-18 months. We would remind them that, because the majority of subprime loans are in the 2/28 hybrid ARM structure, by definition roughly 50% of these will reset in any given year. Assuming that most refinance, this does not reflect any large bubble of origination making its way through the pipeline, but rather the normal course of business in the subprime space. Thus, we are comfortable with our projected decrease of 15% of the origination in the subprime sector. Coming to the CDO space, 2006 has again proved to be a banner year with record issuance volumes driven by the perennial favorites, CLOs and ABS CDOs. In addition, the year saw resurgence in asset classes like Investment Grade Synthetics and the coming of age of newer asset classes like CRE CDOs. U.S. Funded CDO issuance is up by more than 60% from the levels prevalent at the close of last year.
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December 19, 2006

Table 1. US CDO Funded Issuance ($ MM)
Asset Class ABS ABS Synthetic CMBS HY Loans IG Synthetic Tr. Pref. Other Total 2002 15,190.87 1,989.99 13,000.59 14,030.67 11,670.77 4,416.45 17,225.69 77,525.03 2003 21,369.95 451.35 5,513.51 20,525.65 17,362.64 7,573.62 9,093.07 81,889.78 2004 49,141.61 986.75 2,781.69 30,495.91 11,872.77 8,001.85 19,304.96 122,585.54 2005 83,225.72 11,223.66 3,665.11 53,363.60 4,379.72 9,803.09 19,316.12 184,977.02

and the anvil. Holding out to the bitter end and originating ever-more marginal credits as a way to boost volume only works for so long, especially if you write puts (EPD arrangements) along the way and those puts dont turn out to be the free lunch that you thought they were. As we look to 2007, we see it marked by further consolidation and exit from the industry, ultimately leaving it in the hands of commercial and investment banks and a handful of the largest mortgage banking institutions. The lack of barriers to entry and the desire of players in this space to control the flow of assets have left no real role for the traditional, independent aggregator of yore. Another potential entrant in 2007 could be hedge funds working to lock in a steady guaranteed supply of assets. This consolidation and exit can mean only one thing for subprime and near prime supply in 2007: down. We expect overall securitization volumes to drop by 15% in the subprime market regardless of what happens to rates. In the near prime segment, rates may play a larger role, but a 10% 20% drop from 2006 levels is not out of the question. In this segment, the largest drops in volume are likely to come in the riskpriced, high gross WAC segment that serves as the raw material for most of the floating rate supply created using OC structures. Overall, this can only be positive for spreads at the upper end of the capital structure. The uncertainty about credit quality and the noise from 2006 performance are unlikely to abate any time soon either, further creating a flight-to-quality effect for AAA paper in these segments. The wild card in spreads in the middle of the capital structure (single-A through BBB-) will be largely determined by the cost of capital for mezzanine ABS CDOs. As it stands now, the widening of the spreads has created an opportunity to create cash ABS CDO equity at around the 25%-28% yield level. The arithmetic is simpleassets have widened but sponsors are still counting on liability spreads to hold firm. Indeed, while single-A and BBB liability spreads are significantly wider than their CLO counterparts, the top end of the CDO liability structure has remained stubbornly stable. The key players here are the mezzanine AAA buyers and the super-senior risk takers. As long as they do not pull back from the market or start demanding more spread (which they very well might), the greater arbitrage is only likely to spur CDO issuance to even greater heights in early 2007. We will be watching these developments keenly since it is here where the fate of RMBS credit spreads in 2007 will be decided. Subprime RMBS Performance The 2006 vintage continues to underperform the past few vintages in terms of serious delinquencies and the impact of a slowing HPA environment (Across The Curve, November 14, 2006). In fact, a flat to slightly positive HPA scenario leaves many subprime bonds at the cusp such that there could be a large dispersion of losses across deals. Table 2 gives a snapshot of cumulative collateral losses across deals in the ABX.HE.06-1.
Source: Bear Stearns CDO Research
In 2007, funded ABS CDO volume should remain relatively stable while CLOs should continue to show solid growth (7%12%) based on robust credit fundamentals and a large pipeline of leveraged loan issuance. In addition, CRE CDOs and Trust Preferred CDOs should remain growth areas with issuance increasing almost in the order of 40%-50% over this year based on supply trends and fundamental credit characteristics in those sectors.
Mortgage Credit: Rise of the Phoenix?

As we wrote last week, the ABX.HE.06-2 index has suffered a bout of unprecedented volatility over the last few trading sessions, falling significantly in price amid wide bid-offer spreads. Amid all this, as in all dislocated markets, talk of issuer bankruptcies has continued to roil the markets, precipitated first by the closure announcement of Ownit Mortgages, a mid-size subprime originator. As we understand it, a very large accumulation of Early Payment Default (EPD) claims with no supporting reserves and the nervousness of its warehouse line providers proved to be the last straw, forcing the company to close its doors. Over the past few days, rumors regarding more closures have continued to circulate among nervous market participants, further adding to the pressure on the index. Indeed, it is a testament to the lack of volatility in almost every other segment of the fixed-income markets that even swap spreads moved by a few basis points by the rumors regarding a rumor. There has been no dearth of calls from interested parties in this regard. As one of our colleagues remarked, conversation seemed to flow seamlessly between the prospects of a refinancing wave on 6.5% coupon MBS one moment and the potential for a further widening on the ABX.HE.2 index next! The events of the past few weeks are revealing in terms of both whats on the surface and what lies beneath. While Ownit (and whoever else may shut up shop over the next few months) may have finally closed its doors now, the seeds of its demise were put in motion almost 12 to 18 months ago (hence the parallels to the butterfly effect!). Margin compression due to rising rates in the face of increasing competition from vertically integrating mortgage platforms has meant that entities like Ownit (small, monoline specialty-finance mortgage originators) have been caught between the hammer
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Table 2. ABX.HE.06-1 Cumulative Loss Across HPA Scenarios
HPA Scenarios ABX.HE.06-1 ACE-05HE7 M9 (M-9) AMSI-5R11 M9 (M9) ARSI-05W2 M9 (M9) BSABS-5HE11 M8 (M8) CWL-05BC5 B (B) FFML-5FF12 B3 (B3) GSAMP-05HE4 B3 (B3) HEAT-058 B1 (B1) JPMAC-5OPT1 M9 (M9) LBMLT-05WL2 M9 (M9) MABS-5NC2 M9 (M9) MLMI-5AR1 C4 (B3) MSAC-5HE5 B3 (B3) NCHET-054 M9 (M9) RAMP-5EFC4 M9 (M9) RASC-5KS11 M9 (M-9) SABR-05HE1 B3 (B3) SAIL-05HE3 M9 (M9) SASC-05WF4 M9 (M9) SVHE-0504 M9 (M9) Mean Median Expected Portfolio Loss 3.5% 2.63 3.07 3.90 6.69 3.42 3.61 4.04 4.13 3.51 4.29 3.02 3.17 3.01 3.59 3.42 4.09 1.86 3.94 3.87 5.96 3.76 3.60 0.00% 2% 3.00 3.71 4.61 7.65 4.06 4.38 4.67 4.83 4.04 4.99 3.60 3.72 3.46 4.18 4.00 4.71 2.12 4.58 4.55 6.95 4.39 4.28 0.00% 0% 3.72 5.02 5.95 9.37 5.29 5.86 5.85 6.14 5.04 6.26 4.69 4.77 4.32 5.25 5.11 5.92 2.61 5.77 5.83 8.73 5.58 5.53 7.41% -2% 4.81 6.96 7.72 11.53 7.01 7.90 7.43 7.87 6.41 7.83 6.25 6.21 5.57 6.71 6.70 7.61 3.39 7.36 7.58 10.95 7.19 7.18 26.67% -3.5% 5.83 8.60 9.10 13.15 8.34 9.42 8.65 9.18 7.49 8.97 7.56 7.40 6.63 7.95 8.03 9.05 4.19 8.61 8.86 12.58 8.48 8.60 42.38% ABX.HE.06-2 ACE-06NC1 M9 (M9) ARSI-06W1 M9 (M9) BSABS-06HE3 M9 (M-9) CARR-06NC1 M9 (M9) CWL-068 M9 (M9) FFML-06FF4 B1 (B1) GSAMP-06HE3 M9 (M9) HEAT-064 B1 (B1) JPMAC-06FR1 M9 (M9) LBMLT-061 M9 (M9) MASTR-06NC1 M9 (M9) MLMI-06H1 DC (B3A) MSAC-6WMC2 B3 (B3) MSC-06HE2 B3 (B3) RAMP-06NC2 M9 (M-9) RASC-06KS3 M9 (M-9) SABR-06OP1 B3 (B3) SAIL-064 M8 (M8) SASC-06WF2 M9 (M9) SVHE-6OPT5 M9 (M9) Mean Median Expected Portfolio Loss 3.5% 3.51 4.12 4.82 4.08 5.48 5.09 7.18 5.17 5.17 5.92 5.09 5.36 3.15 3.21 4.72 4.37 2.35 4.94 6.08 5.82 4.78 5.02 0.00% 2% 4.12 4.97 5.69 4.92 6.83 6.25 8.59 6.18 6.06 7.14 6.03 6.30 3.78 3.75 5.65 5.18 2.79 6.05 7.31 7.06 5.73 6.04 3.30%
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Table 3. ABX.HE.06-2 Cumulative Loss Across HPA Scenarios
HPA Scenarios 0% 5.27 6.56 7.26 6.53 9.34 8.39 11.06 8.01 7.60 9.25 7.77 8.03 5.04 4.83 7.40 6.72 3.64 8.02 9.56 9.25 7.48 7.69 24.93% -2% 6.93 8.61 9.22 8.73 12.38 11.01 13.83 10.30 9.46 11.59 9.97 10.26 6.95 6.48 9.60 8.75 4.91 10.40 12.23 11.77 9.67 9.79 55.29% -3.5% 8.32 10.19 10.68 10.43 14.36 12.70 15.54 11.87 10.79 13.11 11.58 11.93 8.56 7.94 11.26 10.37 6.00 12.01 13.94 13.41 11.25 11.42 72.90%
Note: Given HPA Scenarios are observed over the life of the deals
Note: Given HPA Scenarios are observed over the life of the deals
Table 3 gives a similar snapshot for ABX.HE.06-2. The divergence in collateral loss, especially as HPA decreases, highlights the increasing leverage of the 2006 subprime vintage to a slowdown in HPA. Moreover, the change in portfolio expected loss gives some perspective on the expected increase in the correlation of losses with a decrease in HPA. Alt-A RMBS Performance While the performance of subprime loans originated in 2006 and to some extent in 2005 has been poor on a much more systemic scale, performance of loans in the Alt-A space has tended to be much more idiosyncratic. The impact of 100 CLTV no money-down loans has affected collateral performance in this sector too, but in many cases the impact on performance due to these loan attributes has been offset by others like higher FICO so that serious delinquencies are much more idiosyncratic in nature.
Table 4. Cumulative Loss Across Varying Collateral Attributes

HPI Rate Deal 1 (Alt-B) OC Structure Deal 2 (Traditional Alt-A) SeniorSub Structure % Loss % Loss 3.5 1.07 0.82 2 1.79 1.37 0 3.20 2.32 -2 5.61 3.93 -3.5 7.89 5.56
Table 4 shows the divergence in performance between a higher GWAC, more risk-layered pool as compared to a collateral pool composed of more traditional Alt-A borrowers with more solid credit attributes.
Table 5. Comparative Collateral Attributes
% Full Doc 6.8 18.5 FICO < 650 12.20% 10.00% % Investor 20.00% 9.20%
FICO Deal 1 (Alt-B) OC Structure Deal 2 (Traditional Alt-A) SeniorSub Structure 702 708
CLTV 91.4 85.9
GWAC 7.86 6.88
This seems to suggest that deal performance could vary quite widely across the spectrum especially due to the extremely tight credit subordinations in this sector. These subordination levels are typically based more on traditional performance
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measures and do not take into account the risk-layering that has been more prevalent in the near future. This should lead to interesting relative value opportunities within the Alt-A space and as compared to subprime deals that in many cases, could end up fine due to sufficient credit enhancements. Option ARMs Option ARMs continue to receive negative press across the nation and this has led to some very interesting opportunities across the space. However, the nature of the product and the high risks associated with its leverage profile has meant that there has typically been a beneficial selection process in terms of option ARM borrowers. The option ARM borrower has, in most cases, lower credit risk and is using the product more as a financing tool to manage cash flows due to the low payment requirement. These borrowers deliberately incur higher financing costs for greater discretionary income. In addition, the low initial payment on the loan implies that there is lesser stress on the borrower at the front end. Most of the risk in this product is pushed towards the back-end as the borrower recasts and resets to a higher rate. This essentially makes a deal backed by a pool of option ARM loans a residual friendly product. While there is no doubt that post-reset losses should tend to ramp up in this sector, all that implies is that any investment in the debt tranches of such deals should take into account higher defaults at the back end. Moreover, as long as borrowers are qualified at the fully indexed fully amortizing payment with reasonable verification of income (for stated income programs) they should have the ability to manage the higher payment at recast. Thus, the key to determining credit quality across the sector comes down to the quality of underwriting for the stated income segment of the market. Secure-Option Arms A new product that emerged in 2006, representing another step in the evolutionary cycle in the non-traditional mortgage segment, was secure option ARMs. The major difference between the regular and secure variants: a fixed negative amortization amount providing certainty of recast payment at the recast horizon. The new product should continue to gain market share as borrowers are attracted to the greater certainty around loan terms. From a cash flow perspective, these loans should be more negatively convex and have marginally better credit profile (all else held equal) than their pay option ARM peers. As more empirical data emerges from this sector, we will continue to provide performance updates in 2007. New Originations: Performance Outlook Going forward, we believe that there is reason to be optimistic about the credit quality of 4Q06 and 2007 loans. Our view is based on the pure economic self-interest of the originators, whoever is left that is. Loans going bad early on in a deals lifetime have a much greater impact on the value of a residual

than back-ended defaults, as seasoned market participants understand. Thus, while not every 80/20 mortgage will be culled from the rate-sheet (the impact on volumes would be too hard to stomach), the most risk-layered ones will. The calculus is simple: originators will systematically go through and strip out the 10% or 15% of the loans that generate a disproportionate share of losses.
Consumer Credit
The consumer ABS sector has shown robust growth and collateral performance in 2006 supported by a low unemployment rate coupled with the recent ease in energy prices. There have been no negative rating actions on U.S. credit cards and student loans in the past two years. Moreover, even if one were to include other consumer credit sectors, the number of upgrades exceeded downgrades by a ratio of 2:1 over the same period. Going forward, the performance of this sector should depend on, among others, the health of the economy, the direction of unemployment rate, and factors such as energy and home prices. We expect strong demand for consumer ABS from both domestic and international investors and this should continue to keep spreads near historical tight levels. Auto ABS Issuance in the auto ABS sector declined by 10%12% yearto-date to $75 billion compared to the volumes in 2005, primarily due to lower issuance from foreign captives and consolidations in this market. Although one of the Big 3 has been involved in whole auto loan sales to banks which typically hold them in their portfolio as opposed to securitizing them, 26% of this years supply came from the Big 3. Our analysts expect car sales to drop 2%3% in 2007; however, higher issuance from banks and finance companies that continue to use the capital markets for their financing needs, coupled with supply from the Big 3 that is expected to be in line with 2006, should bring issuance to around $85 billion for 2007. With increased competition for business, we expect longer term auto loans (72 or more months) to become popular. Prime auto loan indices as measured by Moodys have posted strong year-over-year performance with a 22% drop in net loss rate and an 11% decline in delinquencies. Meanwhile, the subprime auto loan charge-off indices posted a year-over-year increase during the third quarter of 2006 partly due to seasonal factors. On a macro level, the Manheim Used Vehicle Value Index remains stable as used vehicle sales are driven by job creation and growth. While we expect stable performance in the prime auto sector buoyed by a healthy economy and labor environment, the subprime auto sector could experience some volatility in performance. Other factors that could affect performance in the auto sector remain longer-term loans, high LTV and changes in underwriting standards due to competitive pricing strategies.
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Spreads on both prime and subprime auto securities have seen historic tight levels during this yearprime 2-year spreads as tight as -4 bp and non-prime 2-year spreads at -1 bp to swaps. Although spreads have widened in the last couple of weeks, we expect further spread compression in the sector for the near-to-medium term. The primary factor that could lead to softening in secondary spreads would be the uncertainty of the call option being exercised should rates back up. Credit Card ABS Despite consolidations in the credit card sector, year-to-date issuance has been in par with 2005 levels at $60 billion. As spreads in this sector have tightened, the economic incentive to securitize credit card receivables boosted issuance from banks. In addition, with the growing reduction in bank deposits, we expect similar issuance levels in 2007. Year-over-year charge-offs and delinquencies for credit card deals have exhibited improvement as a result of favorable economic conditions, while rating upgrades have reflected the improving servicer performance as a result of industry consolidation. In addition, tightened regulation over credit card lending practices has prompted issuers to focus on underwriting standards. The backdrop for future performance will be closely tied to the consumer credit outlook. Personal bankruptcy filings have been on a steady decline since October 2005 and our economics team projects the unemployment rate to stay around 4.5% for the coming year which should be favorable for credit card deal performance. However, it should be pointed out that with household debt burdens at historically high levels, borrowers who used home equity lines of credit in the past to consolidate credit card debt may not find the same protection without the home price appreciation that had aided them in the past. Like other consumer ABS sectors, robust demand has resulted in tight credit card spreads with the 3-year spread to swap as tight as -8 bp and the 5-year to -2 bp. With growing interest in these sectors from both domestic and international investors who have ample capital to invest, we expect spreads to hold up. Student Loan ABS Student loan issuance has grown in the past two years backed by consolidations and increased loan limits in part due to higher education costs. Volume has been significantly boosted by the private student loan sector growing to approximately 20%25% of the securitized market compared to 15% in 2004. The year-to-date issuance of around $63 billion to some extent was the spill over of consolidations that occurred in 2005. The significant changes to the Higher Education Act that was passed mid-2006 coupled with changes in borrower interest rates and increased loan limits could result in another wave of student loan consolidation, especially if rates decline next year. We estimate the supply for next year to be around $60 billion.
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Credit rating performance in the student loan sector, which has experienced negligible downgrades, remains strong. Net loss rates for FFELP pools have been minimal and, since consolidations lower the borrowers payment by extending the loan term, gross default rates have been low as loans were consolidated prior to default. In the private student loan sector, performance has been stable primarily due to the lenders underwriting and school eligibility criteria. Our outlook for student loan performance for 2007 remains positive. We expect spreads to continue to remain tight in this sector. Seven-year average life student loan spreads are at 7 bp over 3-month LIBOR. The lower average life variability and stable performance should continue to keep up the demand for this asset class, thus driving spreads tighter.
Corporate Credit Outlook: More of the Same

Credit fundamentals in the corporate sector continue to remain robust as can be gauged from default trends in the space. The lagging twelve month U.S. leveraged loan default rate, as reported by S&Ps LCD, is near its lows attained in 2004 and a similar trend is visible in high yield bond default rates too.
Figure 1. Speculative Grade Default Rates
14% 12%
Default Rate (%)
U S H Y Default Rate U S Lev eraged Loan Default Rate
10% 8% 6% 4% 2% 0%
Source: Moodys, S&Ps LCD
However, there has been some fraying at the edges as evidenced by the increase in leverage as seen through debt multiples (Current Debt / EBITDA) and interest coverage ratios ((EBITDA Capex) / Interest) that are close to levels prevalent at the beginning of this decade. Moreover, the distribution of loans this year has become more skewed towards higher leverage. This is especially true for large LBO loans where debt multiples increased to 4.9x in 3Q 06, according to S&Ps LCD, from 3.9x in the previous quarter. In fact, it is the robust growth in EBITDA for most corporates, driven by a resilient economy, that has been the one factor that has kept leverage in check in most cases. A similar trend can be seen in the number of covenants in typical first-lien leveraged loans. Not only has the average number of covenants come down but the share of deals with fewer covenants also has increased. However, covenant-lite loans per se, have not found too much traction in the market
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after having had a stellar first halfa sign of the fact that investors are trying to be cautious ahead of any possible turn in the credit cycle in the next few years. We believe that default rates could drift up but will be driven more by idiosyncratic factors, as was the case in 2006, and not due to any widespread systemic issues. One of the indicators for this is the share of performing loans rated CCC+ or lower by S&P which, at 2.4%, is at the lower end of its historical range. In addition, market action belies distress with the U.S. high yield bond distress ratio at its lowest since November 2004 (Across The Curve, November 28, 2006). Trends from other fixed income and equity markets also seem to portend a period of low volatility. The S&P VIX is typically a good predictor of market sentiment and the fact that it is near the low end of its historical levels seems to predict a period of low defaults. In addition, liquidity continues to remain plentiful and the increasing willingness of lenders to work with covenant-relief packages has meant that, coupled with a robust economy, more issuers have had the opportunity to work things out. Keeping this as a backdrop, barring any external shocks to the economy, we believe that spreads should continue to remain tight though the year could be interspersed with one or more episodes of spread widening either on account of mismatches in supply-demand technicals or idiosyncratic defaults. Leveraged loan issuance has remained fairly strong this year and we expect the trend to continue in 2007 based primarily on increasing M&A activity as increasing global competition forces a realignment of interests across the world. In most cases, the strength in issuance should be matched by robust repayments through the year and investor demand across the globe for levered corporate credit through CLOs.

impact on liquidity will be of any deterioration in the performance of deals. Unlike the corporate sector, it is highly unlikely that a deal that starts performing very badly has much curing. This implies that the true spread level on such deals becomes much more deterministic and much less uncertain, especially as the deal seasons. Moreover, at that point, it seems unlikely that there would be any natural seller of protection on such transactions. CDOs are the major buyers of risk synthetically at present and since the CDO structure is essentially a pure bet on fundamental credit, it would be surprising for any CDO manager to include such a transaction in the portfolio for a small probability of short-term gains. Any transactions beyond this point would be for a spread-play within a range based on slightly differing perceptions on the tail. This makes us believe that as a natural side effect of the nature of the product there is bound to be a time when liquidity will dry up fairly quickly in many bonds. The same reasoning should hold for the index too and liquidity should tend to decrease as any of the vintages of the index seasons. On the flip side, this implies that there should always be high liquidity in relatively new-issue transactions where there is much larger uncertainty around expected performance. The coming year should emphasize this trend as more investors ramp up their efforts to analyze recent vintages. CDO Credit Default Swaps The latter part of 2006 also saw the launch of credit default swaps on CDO tranches. There are two main variants of the contract that trade in the market with there being no clear indication of investor preference for either. We expect that as investors and dealers alike set up more sophisticated systems to analyze CDOs, there should be a better indication of any fair value of the basis between the two variants and this might lead to preferences for one or the other based on any mispricings or lack of. In addition, the impact of seasoning on liquidity in many of these transactions should be muted due to the re-investment structure typical in the first 3-4 years in a CDO structure. Moreover, the CDS contract allows investors to express levered opinions on structures that were earlier unavailable in the secondary market. The lack of information on many deals will be the single biggest impediment in the growth of this market, but we expect that increasing investor interest in the synthetic product will force dealers to make information more readily available and 2007 should be a year of growth in this space. Index Tranches One of the most awaited products in the New Year are going to be tranches on the synthetic ABS indices. These are expected to commence trading sometime in January 2007 as dealers flesh out the final details of the contract. On one hand it would allow investors to express levered opinions on subprime credit through a structure different from traditional
Structured Credit Synthetics: Fire Or Fizzle?

Asset-Backed CDS This year has been characterized by a growing interest in synthetic products across asset classes in the structured credit space. Asset-backed CDS, as a product, gained much more acceptability from both investors interested in going long risk and those interested in shorting risk. The synthetic ABX index, in fact, became one of the more widely followed barometers of the opinion of the market on 2006 subprime collateral in particular and expectations of the future of U.S. housing in general. However, liquidity in the space still remains a constraint and this is especially true in bonds from deals that, in terms of the serious delinquency pipeline and thus expected defaults, are performing at the two extremes: either quite well or quite badly. Moreover, the intellectual time and effort required to analyze deals in this space implies that there might be many bonds on which there might be negligible liquidity. 2007 will be interesting as it becomes a bit more transparent what the
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cash CDO structures. In fact, there might even be opportunities for relative value trades between a levered exposure to mortgage credit through an index tranche as against that through a cash CDO structure with its triggers and tests. On the other hand, it would also help dealers mark their bespoke transactions by implying a credit-adjusted spread from the traded spreads on the tranches. This in turn is expected to spur the growth of a market in bespoke synthetic CDO tranches as investors customize their pools and dealers try and delta-hedge their risk through deltas across tranches. However, the various layers of complexity in a bespoke mortgage transaction coupled with the lessons learned from the corporate correlation market model should ensure that dealers will probably take their time to become comfortable with the state of their models to hedge risk in such bespoke transactions. Loan-Only CDS This year also saw the launch of loan credit default swaps (LCDS), synthetic contracts on corporate loans as opposed to existing ones that reference bonds. However, the present stage of the corporate credit cycle, coupled with some nuances in the contract structure, has meant that liquidity on the contract has remained low this year. The biggest point of debate in the U.S. market has been the non-cancelability of the CDS contract with the repayment of a reference obligation so that the contract stays outstanding as long as there is any outstanding senior secured loan of the reference entity at the same lien level. There has been much debate on this and there is a possibility that the market could have two variants of the contract in 2007, one with the call option and one without, andsimilar to the asset-backed CDS spacevolumes naturally skew towards one. In addition, any signs of a turn in the corporate credit cycle should lead to higher interest in LCDS. The expected launch of a synthetic leveraged loan index in the U.S. in the early part of 2007 could also lend some impetus to the same. The existence of such a synthetic product will also lend itself to structuring synthetic CLOs and bespoke transactions similar to the investment grade and high yield bond sectors. While the large value of the non-callability option coupled with huge leveraged loan issuance volumes might preclude fully funded synthetic CLOs initially, it might be possible to structure interesting bespoke trades and long-short portfolios to specific investor interests. Moreover, as liquidity picks up, especially in the index, tranches on same could possibly be launched towards the latter half of next year and this could lead to interesting trades across different levered product types on the same asset class.
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certain market-value transactions. Hybrid cash-flow CDOs should be one of the largest parts of the ABS CDO sector in 2007 as managers utilize both cash and synthetics to ramp up transactions, especially since mortgage originations are expected to be much lower. This year has also seen some issuance of ABS CDO transactions without any form of OC tests and as investors reassess their risk profile based on the expected direction of the U.S. housing market and its impact on the timing of losses, there could be a trend towards or away from such structures. This is expected to be driven by the incrementally higher subordination in non-OC structures and expectations of investors about the timing and magnitude of losses. We believe that the continuance of a low yield environment will continue to spawn highly levered structures that enable investors to express a levered opinion on a combination of the fundamental credit performance of sector and the movement of spreads. In many such structures that combine fundamental credit risks and market value risks, investors should base their decisions more on their comfort with the expected risk-reward profile of the structure than with solely any ratings on the same. In line with the quick growth in the structured products, 2007 should also see some more interest in options in the mortgage credit space either in the form of callable CDS contracts or as stand-alone options contracts. Among other things, these could be used to take exposure to or beyond a fixed tenor or as a relatively cheap means (through highly out-of-the money options) of hedging tail risk on a portfolio. The next step would then be to use them with levered structures like CDOs to hedge a part of the portfolio or add yield to it.
Regulatory Changes: Impact of Basle II

Basel II is expected to come into effect in 2007 and this should impact the demand for the higher parts of the capital structure as the change in risk-weights much more clearly distinguishes between the risk-capital requirements for singleA and higher tranches and those rated below that. Within the U.S., most small and mid-size banks will in all probability phase through Basel IA before transitioning to using Basel II sometime in the near future. However, even Basel IA, in its proposed form, should lead to incremental demand for the higher parts of the capital structure. The themes laid out above in terms of fundamental outlook on credit and the emergence of new structures or regulatory guidelines that could impact demand-supply technicals drive, for the most part, our outlook on different CDO asset classes.
ABS CDOs: A New Cycle or End of the Road? Structural Innovations / Derivatives
This year has witnessed a range of innovation not just in the structure of traditional CDO structures but also in that of The ABS CDO sector should continue to provide the most avenues for relative value opportunities through next year. U.S. funded issuance volumes have risen more than 1.5 times
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in 2006 compared to issuance in 2005. This has been driven to a large extent by the emergence of the market for asset-backed credit default swaps, especially in mezzanine ABS CDO transactions that has allowed managers to ramp up their portfolios much more efficiently. We believe that issuance in 2007 should continue at these strong levels driven to a large extent by the synthetic market, especially since cash subprime mortgage originations are expected to be lower in the coming year. This should imply a much higher proportion of hybrid and synthetic transactions that should pick up most of the slack caused by any drop in mortgage originations. The movement of spreads in the ABS CDO space will be driven to a large extent by the collateral pool, especially the proportion of bonds from the 2006 vintage that is proving to be one of the worst performing in recent history due to a combination of poor underwriting and slowing home price appreciation (HPA). There has been a partial move higher across the capital structure, especially for 2006 vintage CDO structures that probably have a relatively higher percentage of exposure to the 2006 subprime vintage. There is already a distinct tiering across vintages with 2005 and 2004 vintages pricing, on an average, tighter than deals from the 2006 vintage. However, any secular spread trends based on just the year of origination would actually provide pockets of opportunity, since even in the 2006 vintage there have been some extremely robust performers, so that taking a hard look at the underlying collateral in each deal becomes imperative. While the earlier CDO vintages still have a preponderance of seasoned bonds, they are not going to be totally clean due to two reasons. One, many of those seasoned bonds should probably be near their peak delinquency/default age and this could lead to the usual downgrades in some of them. Two, any prepayments on these seasoned bonds would in many cases be reinvested in newer vintage RMBS bonds and this could provide another layer of risk. Consequently, while we believe that most CDOs from earlier vintages should continue to perform reasonably well, there could be some interesting relative value opportunities based on divergences in collateral composition. CDO structures issued in 2006 (and in some cases 2005) will have the largest exposure to the 2006 subprime vintage and this makes them the most susceptible to not only actual losses but also a spate of downgrades on the underlying pool, which could have a domino effect on CDO liability ratings. This is especially true since the valuation of CDO tranches depends not just on the performance of each of the underlying bonds but also on the distribution of their losses, which is driven largely by the correlation of losses between deals. Moreover, in subprime mortgage credit, in many ways a decline in HPA, especially on the coasts, could lead to a high correlation of losses in the CDO collateral pool.

CDO originations in 2007, in many cases, might actually exhibit relatively improved performance, especially as underwriting quality has seemed to improve over the last quarter of 2006. Due to this we remain bullish on new issue ABS CDO equity and believe that it will continue to provide a window of opportunity for investors in case of a widening in asset spreads. However, increased idiosyncratic risk under a more optimistic HPA scenario should imply that such a trade should be expressed in consonance with some protection buying through the single-name CDS market. Moreover, the ease of expressing a short opinion through CDO CDS and a shift in the profile of super-senior investors from purely negative basis investors to more relative value investors like hedge funds implies that such windows of opportunity might be short. Spreads should widen much more consistently across the capital structure as opposed to earlier vintages when CDO liability spreads tended to be stickier.
CLOs: Another Robust Year

Driven by an outlook for robust credit fundamentals, investor interest in the sector should continue to remain high. Issuance should grow by around 20%-25% in the space as in addition to traditional demand, the growth in the LCDS market should spur the issuance of hybrid or long-short structures, among others. There should also continue to be more middle-market CLO issuance as investors look for avenues to pick up yield. However, there should be much more tiering by managers in the middle-market space as credit selection becomes that much more important. Spreads should continue to remain tight, especially at the top of the capital structure driven both by robust collateral performance and any incremental demand due to Basel II. However, we think there is no room to go much tighter from these levels otherwise total return investors would start turning to other asset classes to pick up yield. As an example, single-A CLOs are already pricing sub 70 bp as against 200 bp225 bp for ABS CDOs. CLO equity continues to remain on our recommended list. The positive implications for CLO equity in a low default rate environment are fairly obvious. In addition, the tight liability spreads enable CLO equity investors to lock-in low funding rates over the life of the deal. The kicker is that CLO equity investors have a free option on future asset spreads. New issue spreads on leveraged loans are at historical tights and any drift upwards will allow equity investors to increase their yields, since their cost of funding remains locked at todays levels.
Trust Preferred CDOs: Return Of Bank Trust Preferreds

The next year could see a reversal in the trend away from Bank Trust Preferred collateral and the start of a refinance wave in Bank Trust Preferred securities that could conceivably
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run for the next 3-4 years. The non-call period on about $25 billion of Trust Preferred securities issued in 2001-2004 expires in this time frame. Table 6 gives the details of Bank Trust Preferred securities issued in that time frame that are eligible to be called over the next few years. In addition, in 2005 about $6.5 billion was originated at much lower spreads of 1.30%2.10% and about $6 billion has been originated in 2006 year-to-date at spreads of 1.40%1.90%.
Table 6. Supply Outlook: Bank Trust Preferred Collateral
Year 2006 2007 2008 2009 Source: Bear Stearns Callable ($ Bn) 2.6 4.4 5.5 6.5 Issuers 220 461 676 800 Margin (3M L) 3.58% - 3.75% 3.20% - 3.85% 2.83% - 3.31% 2.20% - 2.90%
December 19, 2006

Relative Value Themes
One of the most important themes in the structured credit markets over the past few years has been the division of investor interest across the RMBS capital structure. In summary, while all underlying assets have appreciated in price with the decline in volatility, the value balloon has been squeezed the most in those parts of the capital structure dominated by buy-and-hold investors, e.g., CDOs. As a result, for every other buyer of the underlying assets subject to mark-to-market risk on their holdings, the credit barbell trade, i.e., buy triple-As and lever either on repo, on a bank conduit or an SIV or at the very bottom, below investment-grade slice of the capital structure, has been the only thing that has made sense. The ability to evaluate risk from an actuarial perspective fundamentally changes valuations and CDOs have an unprecedented advantage in this regard. It is no surprise to us that much of the investor base that used to play in this segment has transformed itself into a CDO issuer since there is no point in playing the game with one hand tied behind your back. Indeed, the emergence of the synthetic ABS market has created interesting opportunities for mark-to-market players to do true capital structure trades where the risk profiles can be customized using long-short positions within the different parts of the capital structure, at protection premium levels that are fairly inexpensive by historical standards. As we look ahead to 2007, we dont see the basic them about who play where in the capital structure change very much. What we do see happening however is much greater scrutiny of individual securities. The key to performance in 2007 in credit is likely to come from the ability to avoid the lemons in the market and the ability to spot them early on. Indeed, if investors are savvy enough to recognize them early enough in their life cycle, the basis for a profitable as single name longshort strategy to generate true alpha could well emerge out of this. Non-Agency Triple-As Various technical factors drove spread movements on nonagency AAA CMOs in 2006. Chief among them was the selloff and subsequent rally of the Treasury curve. Absolute yield buyers in the long end stepped in during the first half of the year, bringing in spreads as the Fed kept hiking rates (see Figure 2). Once these hikes stopped, however, the pattern reversed with rallying Treasury rates driving spreads wider.
As the statistics in Table 6 and the previous paragraph show, spreads in the current market are about 200 bp tighter than they were in 2001-2003. While spreads have trended up a bit since the beginning of this year, current levels are still much below those that existed even in early 2005. In addition, spreads on Trust Preferred CDO liabilities have continued to remain tight so that any widening in collateral spreads makes the arbitrage for a pure Bank Trust Preferred CDO structure attractive again. Moreover, robust performance characteristics along with the widening in spreads should maintain strong demand for Trust Preferred securities in the near future, which would balance much of the new supply coming into the market from the refinancing wave.
CRE CDOs
This has been a stellar year for CRE CDOs in terms of issuance as loan originators and investors in the lower pieces of conduit securitizations utilized the CDO technology to lay off risk and the growth of the synthetic market allowed easier access to higher yielding CMBS collateral. Investors continued to exhibit appetite for the product due to the fact that it allows them a pooled or diversified exposure to the relatively more credit sensitive pieces of commercial loans and CMBS securitizations. The sector should continue to exhibit robust growth in issuance next year as more investors become comfortable with the underlying credit quality packaged through the CDO technology and more issuers lay off their B note and mezzanine loan risk through such structures. However, as we elaborate in our CMBS section, investors will need to be more cautious about collateral credit quality going into 2007. Investors across the capital structure will also need to keep an eye out for nuances in CDO structure which might flow from other asset classes (trigger-less deals could be one example) and distribute value unequally across the tranches.
46
December 19, 2006

Figure 2. AAA Non-Agency Sequentials
190 180 170 160 150 140 130 120 110 100
2 /3 06 /20 3 /3 06 / 3 /3 20 06 1/2 4 /2 00 6 8/2 5 /2 00 6 6/2 6 /2 00 6 3/2 7 /2 00 1/2 6 8 /1 00 6 8/2 9 /1 00 6 5 1 0 /2 00 /13 6 1 1 /20 0 /10 6 /2 1 2 0 06 /8/ 20 06 /20

Figure 4. AAA 30-year Pass-through Spreads vs. 10-year
5.2
PT spread to average-life Treasury
5.4
170 160 150 140 130 120 110 100 30y r 5 y r Tsy
5.4 5.2 5.0 4.8 4.6 4.4 4.2 4.0
Sequential spreads (bp)
Yield (10 year Tsy).
5 4.8 4.6 4.4 4.2 4
3y r
10y r
LC F
N AS
10 y r Treas
Youll note the strong negative correlation between the longer tranches and the 10-year Treasury note. This is intuitive, but doesnt explain the movement in 3-year spreads. The 2s/10s slope, and relative attractiveness of the front end in the inverted curve, explains much of the movement here (Figure 3).
Figure 3. Three-year AAA Sequentials vs. 2s / 10s
A final technical market factor was the bid for PAC companion tranches. With volatility at historically low levels and a flat / inverted curve triggering a search for yield, investors became more active in companion tranches. This demand caused PAC tranches to trade relatively cheap, a market condition that continues today (Figure 5).
Figure 5. Relative Attractiveness, AAA PACs vs. Sequentials
6-month standard deviation
Sequential spreads (bp)
190 180 170 160 150 140 130 120 110 100 3y r 10y r 2s / 10s
00 6
12 / 23 / 1 /2 20 0 0/2 5 2 /1 00 7/ 6 3 /1 2 00 7/ 6 4 /1 2 00 4/ 6 5 /1 2 00 2/2 6 6 /9 00 6 /2 7 /7 0 06 /20 8 /4 06 /2 9 /1 0 06 / 9 /2 20 0 9/2 6 10 0 / 27 0 6 1 1 /20 / 24 06 /20 06
Another technical that in part caused these movements was the large raw loan bid from several banks. As yield levels approached certain bogeys for these investors, they entered the market in size, buying large prime quality loan packages. This reiterates the need for every basis point of yield, as the investors (particularly banks, which are sensitive to flat/ inverted yield curves) took on the added risk of assuming the first basis point of losses in these deals in order to capture that yield. As these buyers have entered the market throughout 2006, they drove spreads on loan packages in to levels that made CMOs uncreateable, tightening new issue and secondary AAA CMO spreads in the process.
So what does this mean for the sector for 2007? Given our views that the front end of the Treasury curve will remain mostly fixed, it is easy to envision an environment where the long end of the curve remains range bound, with a slight upward bias (i.e., 4.40 5.00% 10-year note). Given this rate view, and that some of the 2006 technicals will carry into 2007, these look to be some of the best trades in the sector for the upcoming year:
Trade #1: Buy long AAA Non-Agencies vs. Treasuries. Given an idle Fed and benign volatility, any backup in Treasury rates in the long end should entice yield buyers into the market, tightening this basis once again as during mid-2006. Trade #2: Buy 3 yr AAA PACs vs. Sequentials: While this is a negative-carry trade, the relationship is over 2 standard deviations wide, indicating the relatively cheap price of added convexity here. Also in play is the 2headed technical that any modest sell-off in long end rates should cause short sequentials to widen, while a strong
3 /1 00 6 6/2 0 4 /1 0 6 6/2 0 5 /1 0 6 6/2 0 6 /1 0 6 6/2 0 7 /1 0 6 6/2 0 8 /1 0 6 6/2 0 9 /1 0 6 6/2 1 0 00 6 /16 /2 1 1 0 06 /16 /20 06
/20
6/2
05
0.50 0.40 0.30 0.20 0.10 0.00 -0.10 -0.20 -0.30 -0.40 -0.50
12 /23
4.00 3.00 2.00 1.00 0.00 -1.00 -2.00 -3.00 P-S 2-Yr P-S 5-Yr P-S 3-Yr P-S 10-Yr
12 /16
1 /1
2 /1
6/2
0 0/2 5 0 2 /1 0 6 7/2 3 /1 00 6 7/2 4 /1 00 6 4/2 5 /1 00 6 2/2 0 6 /9 0 6 / 20 7 /7 06 / 20 8 /4 06 / 20 9 /1 06 /2 9 /2 0 06 9/2 1 0 00 /27 6 1 1 /20 0 /24 6 /20 06
1 /6
1 /2
/20
2s / 10s sprea
47

companion tranche bid and stickiness of PAC spreads will dampen any spread widening in that sector. Mortgage Credit
December 19, 2006
Trade #3: Premium 10/1 Hybrid ARMs: The combination of low HPA, piggyback seconds and Interest Only payments have converged to lower speeds on longer reset hybrids, boosting yield, TROR and OASs, the latter from a greater tail value.
The coming year should lead to some interesting relative value trades across the structured credit spectrum. We highlight some of the major relative themes below. 1. Long Residual / Short Mezzanine
Finally, a note on where AAA non-agency spreads are on a historic basis. When spreads are at or near their tights of a 1year range, it is difficult to convince investors of value in a particular sector. However, in the case of non-agency MBS, parallels can be drawn to the ABS markets in terms of a level of comfort being reached in the investor community that provides liquidity and price support. For example, many in the Credit Card ABS sectorafter seeing it rally to multi-year tights in 2002thought spread levels might approach swaps flat, but never break through that. Figure 6 shows that this was a false premise.
Figure 6. Credit Card ABS, Spread to Swaps
35 30 25
Basis Points
The front-ended cash flows on the residual of a mortgage origination imply that in most cases these are reasonably safe due to the fact that defaults in mortgages are typically backended. Even in a vintage like 2006 where there is a higher level of serious delinquencies it will still take originators 1218 months to flush out most of the loans from delinquency to foreclosure to REO and then to default simply because of the operational issues involved. The trade could be structured with a specific sector where investors could short subprime mezzanine bonds against subprime residuals or it could be structured as an up in credit trade where investors short subprime mezzanine bonds against Alt-A residuals. This trade allows investors to express a short opinion on the subprime sector without bleeding excessive negative carry. Another segment of the residual market that is attractively priced is the second-lien market. This segment went through its own growing pains in 2005, with lower FICO collateral significantly underperforming relative to origination expectations. With the ebbing of competitive pressures, new origination today is skewed towards higher FICO and generally more credit-worthy borrowers. Despite the adjustment of the collateral and at fairly realistic loss and prepayment expectations, the residuals in this segment still trade at a mid to high 20% range in yield. This sector will likely tighten as the year goes by. 2. Long BB / Short BBB-
3 yr CC 5 yr CC 10 y r C C
20 15 10 5 0 -5 -10
With swaps/LIBOR denoting a single-A liability, it is very easy to imagine more and more AAA assets tightening toward/ through swaps, especially given the dearth of AAA corporate bonds. Also, credit card ABS can be considered among the prime types of ABS in terms of quality and liquidity. We believe that prime non-agency AAAs can be viewed in a similar light. Compared with the non-agency market of the 1990s, which saw irregular issuance from several unknown shelves, prime jumbo origination has become somewhat homogeneous with regular issuance from several large prime single-originator shelves. Taken together with falling origination levels and an increasing investor base internationally, we believe prime AAA non-agency CMO spreads, even though tight historically, have further to go in 2007 and beyond.
c-0 0 Ju n01 De c-0 1 Ju n02 De c-0 2 Ju n03 De c-0 3 Ju n04 De c-0 4 Ju n05 De c-0 5 Ju n06 De c-0 6
De
This is a trade that takes advantage of a wide technical differential in pricing between two tranches that are next to each other in the deal capital structure and are in most cases separated by just 100 bp200 bp of cumulative losses. Spreads on the BBB- tranche are typically artificially compressed due to the CDO-bid while those on the BB+/BB-flats are artificially wider because they are non-investment grade tranches. The pick-up in spreads on the BBs, anywhere from 700 bp1000 bp in the present environment, seems to be quite excessive for just a 100-150 bp difference in cumulative losses over the BBB-s from similar deals. 3. Long Mortgage Triple-A Floaters
Spreads on AAA Floaters should continue to remain tight as the uncertainty around housing drives investors up in credit. Given our rate view of a continued curve inversion, AAA floater demand should increase in 2007 as a safe place to park money. For example, with current 1-month LIBOR rates at 5.35% and 2 year swap rates at 5.05, an investor would have 48
December 19, 2006

to earn roughly swaps + 40 on a 2-year AAA fixed rate asset in order to be yield neutral to a 2-year floater at 10 DM. Fixed rate assets at such levels are difficult to find. Moreover, the incremental demand from Basel II and levered vehicles like SIVs should keep spreads tight. Many of these SIVs fund their liabilities in the form of Asset-Backed Commercial Paper. As Figure 7 shows, with funding costs well below LIBOR, earning LIBOR plus is an easy trade for SIVs and others with cheap funding, and will thus keep demand strong. Finally, downgrade risk on these AAAs is low considering the subordination typically found in most mortgage securitizations and this should make these bonds suitable investments for typical buyers at the top of the capital structure.
Figure 7. ABCP and U.S. Dollar LIBOR Rates
5.40 5.35 5.30 5.25 Tier 1 ABC P 5.20 1 7 15 21 30 45 60 90 120 150 180 210 240 270 360 1M LIBOR

strategy might not always provide positive results in the CDO space since a change in the correlation of losses could lead to a large repricing at the top of the capital structure too. This is similar to putting on an out-of-the money low carry cost trade for investors with a bearish view on housing. b) Long MTA ABS CDO Equity Instead of a simplistic move up the capital structure, a move higher in loan collateral quality could prove to be a better investment. MTA Option ARM borrowers, for the most part, are much safer borrowers and robust historical performance across MTA deals has tended to provide evidence for the same. This move higher in loan credit quality could lead to reasonably robust equity yield profiles even in slightly bearish HPA scenarios. 2. Bullish On Housing
A more optimistic opinion on housing does not necessarily imply robust performance across the capital structure since a deterioration in underwriting standards could, per se, lead to worse collateral performance. This implies that it still becomes imperative to take a close look at collateral a) Long AAA to A ABS CDOs A strategy to be long the top of the capital structure should provide positive results since in a more optimistic housing scenario most of the risk should be idiosyncratic so that there should not be much of as risk of downgrades or repricings at the top of the capital structure. b) Long ABS CDO Equity / Short Specific Collateral Credits As we mentioned above, it is idiosyncratic risk that should dominate the sector in a bullish HPA scenario and this implies that investments in ABS CDO equity, while attractive could have significant tail risk due to losses in a few deals. This could be mitigated by paying more attention to security selection and by combining the investment with shorts on the index or certain specific credits. CLOs 1. Long CLO Equity
Days
4.
ABX.HE.06-2 BBB- vs. ABX.HE.06-1 BBB-
We believe that the fair spread difference between the two indices should be around 235 bp on a mid-to-mid basis. After accounting for a 50-75 bp bid-offer spread this difference comes down to around 175 bp. This makes the current spread levels near their fair value so that any major uptick in the spread differential from here should be viewed as an opportunity to go long the ABX.HE.06-2 and sell the ABX.HE.06-1. ABS CDOs Relative value in the ABS CDO will tend to be driven not just by the level of defaults but to a large extent by the correlation between defaults. This, in turn, should be primarily driven by opinions about the expected direction of the US housing market and expectations about HPA in the next few years. 1. Bearish on Housing a) Short AA / A ABS CDOs Contrary to the underlying mortgage credit sector, up in credit is not necessarily a safe investment under a deteriorating HPA scenario. A typical up in credit
As we mentioned earlier, expectations of a low default rate environment imply that a levered corporate credit investment should provide decent returns. Moreover, the tight liability spreads enable CLO equity investors to lock in low funding rates over the life of the deal and any drift upwards will allow equity investors to increase their yields since their cost of funding remains locked at todays levels.
49
Across the Curve and Across the Grade: Outlook 2007 CMBS
December 19, 2006
CMBS: A Year of Firsts

Marielle Jan de Beur (212) 272-1679 / marielle@bear.com Naynika Chaubey (212) 272-0894 / nchaubey@bear.com Kunal Shah The CMBS market is closing the year on a high note with many firsts to celebrate. The US market absorbed record supply this year with just over $200 billion in deals pricing. The average deal size approached $2 billion, breaking last years record average deal size of $1.7 billion.
Figure 1. Average U.S. CMBS Deal Size ($ billions)
2,200 2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 1,940 1,709 1,095 615 572 678 713 794
Retail, 32% Multifamily , 16%
Figure 2. Collateral Composition of U.S. CMBS: 2006

Industrial , 5% Hotel, 10% Other, 5% Office, 32%
$ billions
918 466
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Issuance Year
Source: Bear Stearns, Commercial Mortgage Alert
CMBS collateral achieved some firsts with interest only loans (IO) and hotel collateral accounting for a bigger piece of the pie than ever before. In 2006 about 75% of the loans in CMBS transactions contained some interest only component, a threefold increase from 2003 when IO loans accounted for only 25% of the market.
Table 1. Interest Only Loan Exposure
Fully Amort. IO then Amort. Interest Only Balloon IO then Balloon Total Source: Trepp, LLC 2002 2.1% 0.0% 2.2% 88.5% 7.3% 100.0% 2003 3.3% 0.1% 8.7% 70.7% 17.2% 100.0% 2004 2.0% 0.0% 14.5% 53.7% 29.8% 100.0% 2005 1.3% 0.2% 26.6% 33.2% 38.8% 100.0% 2006 0.6% 0.3% 32.3% 23.9% 42.8% 100.0%
The first two CMBS synthetic indices were introduced, proving additional liquidity to the non-AAA part of the capital structure. As the year progressed, trading volume in both CMBX.1 and CMBX.2 increased. On some recent occasions, trading volume in CMBS synthetics (CMBX and TRS) has surpassed trading volume in the CMBS cash market.1
Figure 3. BBB- Cash and CMBX Spread History
160 150 140 130 120 110 100 90 80 70 60 C ash BBBC M BX.N A.06.1 BBBC M BX.N A.06.2 BBB-
Source: Markit, Bear Stearns
Hotel loans accounted for 10% of the collateral in new issue transactions this year, the highest concentration since the late 1990s.
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3 /1 3 3 /2 /0 6 7/0 4 /1 6 0 4 /2 /0 6 4/ 5 /8 0 6 5 /2 /06 2/ 6 /5 0 6 6 /1 /06 9/0 7 /3 6 7 /1 /06 7 7 /3 /0 6 1 8 /1 /0 6 4 8 /2 /0 6 8/0 9 /1 6 1 9 /2 /0 6 5/0 10 6 / 1 0 9/0 6 /23 1 1 /06 / 1 1 6/0 6 /20 1 2 /06 /4/ 06
For more details on the CMBS synthetics market please refer to CMBS Synthetics: AAA Total Return Swaps in the August 8, 2006 Across the Curve and CMBX.NA.06-2: Prospects and Opportunities in the October 24, 2006 Across the Curve.
December 19, 2006

Concerns about deteriorating underwriting standards were not reflected in credit spreads. The AAA/BBB credit curve traded at historically flat levels for most of the year, averaging 60 bp. The AAA/BBB curve ended the year at 55 bp.
Figure 4. Investment Grade CMBS Spreads (to Swaps)
160 140 120 100
bp

Through November 30, all three rating agencies issued 3,812 rating actions, with a record upgrade/downgrade ratio of 14.2 to 1 (3,561 upgrades and 251 downgrades). In the past 10 years, the only year to come close to this positive ratings drift level was 2001 (12.6 to 1). Seventy-eight percent of the rating actions this year were on non-AAA investment-grade tranches (AA+ to BBB-). Among these, AA tranches took the lead with 422 upgrades and two downgrades.
80 46 38 25
AAA
AA
BBB
80 60 40 20 0
The most active rating agency this year was Fitch at 1616 rating actions, followed by S&P (1262) and then Moodys (934). Fitch also had the highest upgrade/downgrade ratio of 37.5 to one, more than double the average ratio for the year.
Table 3. 2006 Rating Actions by Rating Agency
Rating Agency Fitch Moodys S&P Total Upgrades 1574 1157 830 3561 Downgrades 42 105 104 251 Upgrade/Downgrade Ratio 37.5:1 11.03:1 7.99:1 14.2:1
The flat credit curve was more a reflection of solid CMBS credit performance rather than a focus on the credit of new issue transactions. During the year, delinquencies on seasoned transactions (aged over one year) declined 52 bp to 1.15% of current balances. The current level of delinquencies is the lowest it has been since late 2000, reflecting the continued positive fundamentals for commercial real estate.2 Record Positive Rating Actions Tighter spreads and a flatter credit curve were also a reflection of a continued positive trend in rating actions. In aggregate, the CMBS market achieved another first with the highest upgrade/downgrade ratio ever recorded for CMBS.
Table 2. Upgrade/Downgrade Ratios for U.S. CMBS
Year of Rating Action 1999 2000 2001 2002 2003 2004 2005 2006 Source: Fitch, Moodys, S&P, Bear Stearns Upgrade/Downgrade Ratio 9.7:1 6.5:1 12.6:1 1.5:1 1.8:1 3.2:1 7.7:1 14.2:1
Ja Man -0 2 Ju r-0 2 S en -0 2 No p -0 2 Fev-02 b-0 Ap 3 r Ju - 03 O c l -03 De t- 03 Mac-03 Ju r-0 4 A un -0 4 No g -0 v 4 Ja -04 A pn -0 5 r Ju - 05 S e l -05 Dep -05 M c-05 Maa r-0 y 6 A u -06 g O c -06 t- 0 6
Source: Fitch, Moodys, S&P, Bear Stearns
The vintages with the most upgrades this year were 2003 (696), followed by 2001 (582) and 1999 (434). The original ten-year classes in these transactions are now seven, five, and three-year classes.
Figure 5. 2006 Rating Changes by CMBS Issuance Year
800 700 600 500 400 300 200 100 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 13 3 41 2 166 6 19 16 30 61 30 14 48 109 20 18 2 308 U pgrade Dow ngrade 434 416 402 366 582 696
Source: Fitch, Moodys, S&P, Bear Stearns
For a detailed analysis of 2006 CMBS delinquencies, please see CMBS Delinquencies: A Great Year for Credit in the December 12, 2006 Across the Curve publication.
51

Table 3. 2006* CMBS Rating Actions Transition Matrix
AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BCCC+ CCC CCCCC+ CC CCC+ C CD AAA AA+ AA AA- A+ 0 0 1 0 0 260 0 0 0 0 332 90 0 1 1 144 55 60 0 1 114 44 48 55 0 104 53 86 64 81 57 37 61 62 55 27 16 38 26 53 21 10 22 16 30 9 5 3 12 23 4 0 2 0 3 2 0 0 0 1 0 0 0 0 0 1 0 0 0 2 1 0 0 0 0 1 0 1 0 0 0 0 0 0 0 1 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 A 0 0 0 0 2 0 88 65 58 26 10 2 1 0 0 0 0 0 0 0 0 0 0 0 0 0 A- BBB+ BBB 0 0 1 0 0 0 0 0 0 0 0 0 1 0 0 4 1 0 0 16 1 77 0 11 88 98 0 36 90 101 14 27 63 4 5 18 0 1 3 0 0 1 0 2 0 0 0 0 0 0 0 0 1 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 1 0 0 241 199 BBB- BB+ 0 0 0 0 0 0 0 0 0 0 0 0 0 0 1 0 7 0 0 6 69 0 52 81 20 45 1 10 0 3 0 2 0 0 0 0 0 1 0 0 0 0 0 0 0 0 0 0 0 0 1 0 151 148 BB 0 0 0 0 0 0 0 0 1 12 3 0 48 30 10 0 1 0 0 0 0 0 0 0 0 0 105 BB0 0 0 0 0 0 0 0 0 3 3 2 0 32 12 3 0 0 0 0 0 0 0 0 0 0 55 B+ 0 0 0 0 0 0 0 0 0 0 6 1 2 0 33 6 0 2 0 0 0 0 0 0 0 0 50 B 0 0 0 0 0 0 0 0 0 0 1 2 3 5 0 14 0 0 0 0 0 0 0 1 0 1 27
December 19, 2006
B- CCC+ CCC CCC- CC+ CC CC- C+ C 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 1 0 0 0 0 0 0 0 0 1 0 2 1 0 0 0 0 0 4 0 0 0 0 0 0 0 0 4 1 2 0 0 0 0 0 0 17 1 3 2 0 3 0 0 1 0 13 12 2 0 4 0 0 1 2 0 10 6 0 2 0 0 3 4 1 0 10 0 6 0 0 10 0 0 0 0 0 3 0 0 3 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 13 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 1 0 0 1 0 0 0 0 0 0 0 0 0 0 0 0 0 1 0 1 0 0 0 0 0 33 17 30 22 0 19 0 0 31
C0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
D 0 0 0 0 0 0 0 0 0 0 0 1 0 0 0 2 0 3 5 0 0 0 0 0 0 0
Total 2 260 424 260 264 393 377 314 351 326 206 174 127 89 88 59 24 35 7 0 13 0 0 3 0 5
Total 1,078 310 322 236 250 252 225
11 3,812
Source: Moodys, Fitch, S&P; * All rating actions through November 30, 2006
In 2007, Credit Matters After several years of stellar commercial real estate credit performance where the rising tide lifts all boats, we believe 2007 will mark a year of more market differentiation. Broadly, fundamentals appear solid* and capital flows continue to be robust; however, we believe next year investors will differentiate more among deals based on credit performance. We have already seen some of this market differentiation on credit tranches in the secondary market. In 2007 we anticipate this will become more pronounced in the primary market with a broader spectrum of pricing based on the underlying credit. Growth in CMBS synthetics provides investors with a greater opportunity to take specific views on credit. CMBX and single name CDS provide investors with the liquidity to express credit views on individual deals and specific points in the capital structure that were not previously available. We anticipate increased trading volume in synthetics next year.
U.S. Issuance In terms of issuance, we project 2007 U.S. CMBS issuance will be approximately $250 billion, a 22% growth above 2006 levels. Our projection is based on a regression of the forward 10-year Treasury rate, CMBS and ACLI debt maturities, the growth rate in the Russell/NCREIF Property Index and 2006 issuance volume. Our model was very predictive resulting in an R-squared value of 99.1% when we back tested the data. Based on our issuance projection, CMBS debt maturities next year will only account for 16% of issuance, indicating that liquidity will not be an issue for maturing CMBS loans.
We will provide a detailed analysis of property type fundamentals in a separate piece.
52
December 19, 2006

Figure 6. U.S. CMBS Issuance ($ billions)
300.0 250.0 250.0 200.0
$ billions

Table 4. CMBS Maturity Schedule
Maturity Year 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Source: Trepp LLC, Bear Stearns Number of Loans Maturing 1934 4281 8532 5438 4623 5211 4169 5401 4911 8868 7680 Expected Maturity Balance $18,910,888,895 $39,216,651,399 $64,768,570,560 $40,182,330,101 $51,961,203,363 $50,690,634,253 $37,348,207,298 $40,321,397,203 $44,094,583,017 $95,679,796,690 $90,201,118,453
203.8 169.0 93.1
150.0 100.0 50.0 15.7 26.4 36.8 74.3 56.6 46.9 67.1 77.8 52.1
*As of December 15, 2006; Excludes agency CMBS and resecuritizations Source: Bear Stearns, Commercial Mortgage Alert
Table 5. U.S. CMBS Deal Composition

Conduit Fusion Single Borrower Short-Term/Floating Rate Other Total 1998 31.0% 38.8% 6.9% 20.0% 3.3% 100.0% 1999 50.4% 13.7% 12.5% 11.2% 12.2% 100.0% 2000 50.9% 9.6% 10.2% 21.4% 7.9% 100.0% 2001 39.4% 12.8% 24.8% 15.6% 7.4% 100.0% 2002 33.1% 32.8% 6.6% 20.2% 7.3% 100.0% 2003 18.3% 49.6% 8.8% 18.7% 4.6% 100.0% 2004 6.8% 72.7% 5.5% 14.1% 0.9% 100.0% 2005 3.2% 79.8% 5.7% 9.9% 1.4% 100.0% 2006 0.3% 77.4% 5.0% 17.1% 0.2% 100.0%
Source: Bear Stearns, Commercial Mortgage Alert
19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 * 20 07
We anticipate that deal size will continue to grow next year with the average fusion deal breaking the $2 billion hurdle. The market should continue to be dominated by fusion and floating rate transactions next year with floaters accounting for a greater part of the market. We anticipate floating rate transactions will account for more than 20% of the new issue market next year. European Issuance
Figure 7. Annual CMBS Issuance Volumes (billions)
80 70 60 50 40 30 20 10 0 2002 2003 2004 2005 2006 2007*
European countries such as Spain are also likely to increase participation in the European CMBS market next year.
Figure 8. Distribution of European CMBS Collateral (%)
60 50 40 % 30 20 10 0 U .K. Italy Germany Other France The N etherlands Jun-03 Jun-05 Jun-04 Jun-06
Source: S&P 2006
Relative Value CMBS issuance this December has totalled $30 billion, breaking the record set last year for December issuance. Last December, the market experienced spread widening coupled with a heavy issuance calendar. This year, spreads have held constant in spite of a very active calendar. As we end the year AAA CMBS appear close to fair value when compared to finance company paper and are trading a bit rich to bank paper.
In Europe, we anticipate 2007 CMBS issuance will be approximately 75 billion, a 25% increase over 2006 issuance. In terms of collateral origination, the UK is expected to maintain the greatest market share. Germany is expected to experience an increase in issuance volume. Other
53

Figure 9. 10-year AAA CMBS vs. Single-A Bank and Finance Paper
140 120 Spread (bp) 100 80 60 40 20 0 AAA C M BS* Finance Banking
December 19, 2006

Recommendations/Trade Ideas Heading into 2007, we believe AAA CMBS offer value to other AAA investments. Within 10-year new issue AAAs we continue to believe AJ tranches offer value at current levels. We believe 6 bp of additional spread to 30% supersenior tranches is good compensation on any AAA security. We particularly like AJs that are structured to build credit enhancement fairly quickly as they age (due to 5- and 7year loans). Seasoned AAA 10-year tranches that have paid down to the 5- to 7-year part of the curve also offer value, particularly when compared to new issue 7-year paper (non-AAB tranches). These deals have fairly stable cash flows under various credit stress scenarios and were underwritten with more stringent assumptions than current new issue transactions.* We also believe there will be opportunities in interest only tranches (IOs) early next year since there will be more supply in that space than we have seen over the past year or so. *** For current market data, please go to the appendices below or see the Bear Stearns Research Library: CMBS Relative Value Matrix and Weekly Market Commentary: http://www.bearstearns.com/bscportal/pdfs/appendices/2006/ cmbs_01_121906.pdf CMBS Conduit and Floating Rate Statistics and Pricing Matrix: http://www.bearstearns.com/bscportal/pdfs/appendices/2006/ cmbs_02_121906.pdf
* Starting on 10/29/04, the spread series for super-senior 10-year AAAs are used. Prior to that, the spread series for traditional 10-year AAAs are used. Source: Bear Stearns
Single-A CMBS and BBB CMBS are also trading close to fair value when compared to the unsecured REIT debt market.
Figure 10. BBB & Single-A CMBS vs. REIT Spreads to UST
300 250 Spread (bp) 200 150 100 50 0 H igh Grade REIT Index A C M BS BBB C M BS
10 /3 1 /31 /01 4 /3 1/0 2 0 7 /3 /0 2 1 0 1/0 /3 2 1 /31 /02 1 4 /3 /0 3 0/0 7 /3 3 1 0 1/0 /3 3 1 /31 /03 1 4 /3 /0 4 0 7 /3 /0 4 1 0 1/0 /3 4 1 /31 /04 4 /3 1/0 5 0 7 /3 /0 5 1 0 1/0 /3 5 1 /31 /05 4 /3 1/0 6 0 7 /3 /0 6 1 0 1/0 /31 6 /06
11 /2/ 2 /2 0 1 / 5 /2 02 8 /2 /02 1 1 /02 /2/ 2 /2 0 2 / 5 /2 03 / 8 /2 03 1 1 /03 /2/ 2 /2 0 3 5 /2 /04 / 8 /2 04 1 1 /04 /2/ 2 /2 0 4 / 5 /2 05 / 8 /2 05 1 1 /05 /2/ 2 /2 0 5 5 /2 /06 / 8 /2 06 1 1 /06 /2/ 06
For more details see The Case for Seasoned 10-year AAAs in the November 28, 2006 Across the Curve and Amortizing AAAs CMBS: Not All Created Equal in the October 3, 2006 Across the Curve.
54
December 19, 2006 Portfolio Strategies
Challenges and Opportunities in 2007

Scott Buchta (312) 580-4161 / sbuchta@bear.com As we set out to look at the challenges facing portfolio managers in 2007, we soon realized that while there were many common themes, there were also some industry specific issues that began to arise in 2006 that will continue to play out in the coming year. Some of the more obvious challenges that we see investors facing in the coming year are the shape of the yield curve, absolute spread levels and the continued lack of volatility in the market. From an industry specific viewpoint, increased regulatory scrutiny on bank restructurings and the addition of hybrid ARMs to the MBS Index stand out as two of the nuances that certain investors will be dealing with in the coming year. The Yield Curve As we enter 2007 we clearly have a separation between the yield on fixed rate assets (Treasuries, agencies and swaps) and the short-term cost of borrowing (1-month LIBOR). Figure 1 outlines the current yield curve snapshot as of 12/18/06.
Figure 1. Yield Curve Snapshot as of 12/18/06
5.60 5.40 5.20 Implied Rate 5.00 Yield 4.80 4.60 4.40 4.20 4.00 1mo 3mo 6mo 12mo 24mo 36mo 60mo 84mo 120mo 360mo Tsy Agency Sw ap LIBOR
(economic slowdown, housing market crash, continuing foreign demand, etc.), the bottom line is that the market has a different view on the future path of interest rates than the Fed does.
Figure 2. The Divergence Between 1mo LIBOR and 2yr, 10yr Treasuries
5.60 5.40 5.20 5.00 Yield 4.80 4.60 4.40 4.20 4.00 2y r Tsy 10y r Tsy 1mo LIBOR
Figure 3. Forward Eurodollar Curve (As of 12/19/06)

5.60 5.40 5.20 5.00 4.80 4.60 4.40 4.20 Forw ard Rate
De
While the Treasury, agency and swaps curves are all inverted from the front end of the curve to the back, the most striking difference is the disparity between the yield that can be achieved from investing and the cost of borrowing the funds to invest. This negative carry impacts investors of all shapes and sizes as the high cost of borrowing diminishes the potential returns that can be achieved from putting on a particular trade. This is especially true if the inversion remains in place for an extended period of time. As the horizon expands, the impact of carry becomes greater than the impact of price on performance. This especially impacts highly leveraged investors such as hedge funds and many financial institutions that have relied on wholesale funding in the past to help build their balance sheets. Figure 2 demonstrates that this inversion really began to take hold back in July 2006 after the last interest rate hike by the Fed to 5.25%. While there are many economic theories behind the cause of this dislocation
Figure 3 outlines the forward LIBOR curve as of 12/19/06. From this picture we can determine that the market is anticipating a 50 bp reduction in the level of short-term interest rates by the end of 2007. The yield that can be achieved by investing in fixed rate securities is a function of supply and demand and can vary depending on the investment communitys opinion about relative value at any particular point in time. A big part of the decision making process is a view on the future path of interest rates. A bullish view increases demand and moves interest rates lower, where a bearish view decreases demand and moves interest rates higher. The cost of borrowing, however, is very closely related to the target fed funds overnight borrowing rate which is set by the Federal Reserve Bank. This rate is more stable than those found in the fixed rate markets as it is set by a small committee rather than a free market mechanism. An important 55
c-0 6 Ap r- 0 7 Au g07 De c-0 7 Ap r- 0 8 Au g08 De c-0 8 Ap r- 0 9 Au g09 De c-0 9 Ap r- 1 0

Contract Date
c 26 -Ja n 26 -F eb 26 -M ar 26 -A p 26 r -M ay 26 -Ju n 26 -Ju l 26 -A ug 26 -S ep 26 -O c 26 t -N ov
26 -D e

lesson that we all learned back in Economics 101 was that the Fed writes the market letter. It is for this reason that we have been advocating taking a contrarian view to the forward curve and investing at least a portion of the securities portfolio in floating rate assets until the Fed tells us to do otherwise. One of the big challenges that investors will face in 2007 will be finding positive carry investment opportunities in a negative carry environment. As mentioned in the preceding paragraph, floating rate instruments can help add incremental yield and carry to a securities portfolio based on the current LIBOR rate versus other short duration fixed rate assets. In addition, floating rate assets combined with longer fixed rate assets in a yield barbell can outperform shorter fixed rate assets on a duration neutral basis under a variety of scenarios. Banks, Thrifts and Credit Unions Over the past several quarters we have seen a large number of financial institutions de-leverage their balance sheets as the inverted yield curve has continued to eat into their net interest margins. Many of these institutions have used the proceeds from the sale of securities to pay down high cost borrowings. As more and more institutions have sold underwater assets out of their AFS portfolios as part of a restructuring program, the auditors have taken note and have been refocusing their attention on the treatment of securities with regards to otherthan-temporary-impairment (OTTI). As outlined by Milton Miyashiro in the November 14, 2006 issue of Across the Curve in Accounting: Exactly What Are Your Intentions, Sir?, accountants are taking a closer look at the implementation of FSP 115-1 and have been playing a bigger role in the restructuring process. The increased level of documentation requirements combined with the unwritten constraint of one restructuring involving the sale of underwater AFS assets per 12-month period will probably lead to fewer, but larger, restructurings being performed by financial institutions in the near future. The limitation on the sale of underwater assets means that it will be imperative for financial institutions to diversify their portfolios and have components that will perform well in different interest rate scenarios for liquidity purposes. The aforementioned yield barbell that is created by combining floating rate assets with 5- to 7-year PAC bonds is a good example of this strategy. As compared to 2- to 3-year fixed rate securities, the floating rate bond should outperform from both a cash flow and mark-to-market viewpoint in a rising rate environment and the longer duration PAC bond should outperform in a falling rate scenario. A side effect of the de-leveraging of bank portfolios (through the outright sale of securities or through attrition) has been the increased percentage of the investment portfolio that is dedicated to the liquidity (pledging) needs of the institution. The pledging requirements of the banks counter-parties (i.e., the FHLB) restrict the types of securities the institution may use as collateral. It is for this reason that many banks have
December 19, 2006

been turning to the callable agency MTN market as a way to pick up yield and still fulfill their pledging requirements. The upside to this strategy is a pick-up in yield versus other fixed rate alternatives. The downside is that the institution is exposed to both a rising (extension risk) and falling (reinvestment risk) environment. One way to help protect yourself from a large sell-off in rates is to purchase one-time callable securities which will in theory tighten in spread to that of a bullet security should the bond not get called. On the other hand, if interest rates continue to fall (as they have by over 60 bp over the past six months) it will be harder and harder to meet the yield bogey without taking on additional risk. A strategy that we have been recommending to help protect against reinvestment risk has been to supplement efficiently called securities (Agency MTNs) with inefficiently called securities such as MBS and CMOs. This strategy performs well in a rates down scenario as the callable agency is usually called in full at the first opportunity, while the mortgage-backed security gets refinanced over time helping to mitigate reinvestment risk. Insurance Companies Life insurance companies may have some of the biggest challenges to face as they have a need for both yield and duration in an inverted curve environment. Insurance companies appear to be facing some of the toughest competition for assets as foreign investors continue to buy out to the 10-year part of the curve and have begun to branch out into various asset classes including mortgages and corporate bonds. One of the biggest risks facing insurance companies continues to be reinvestment risk. Locked out Z bonds and NAS structures can help mitigate the impact of prepayment from a rally in mortgage rates. One of the bigger issues facing insurance companies is credit as the majority of their portfolios are invested in corporate bonds. Diversification into alternative investment classes such as CBOs, CLOs and CDOs backed by higher quality collateral may help to enhance returns and diversify risk. Well-structured MBS can also look attractive versus corporate bonds, but insurance companies must be cognizant of their overall exposure to mortgages and the potential capital charges that can be imposed upon them by the rating agencies. Total Return Managers The biggest challenge facing total return managers in 2007 will be the search for incremental returns, or alpha. With a flat yield curve, low volatility and relatively tight spreads there are very few opportunities for a money manager to outperform their benchmark index without taking on some incremental level of risk. As compared with the environments of the past two years where interest rates were moving higher and the yield curve was getting flatter, these waters may prove tricky to negotiate. Minimizing duration and curve risk is probably one of the keys to success in 2007 as it is possible to make a case for a wide variety of interest rate scenarios to play out. Incorporating floating rate asset to help increase yield and
56
December 19, 2006

positive carry may prove to be a winning theme in 2007, especially if the Fed remains on hold for an extended period of time and the negative carry trade begins to take its toll on fixed rate assets. Although there are limited opportunities currently available in the dollar roll market on an outright basis, the super-cash strategy of supplementing the performance of a core mortgage portfolio with dollar rolls and MBS floaters should continue to be a good one. One curve ball that will be thrown at index managers in the coming year will be the inclusion of hybrid ARMs in the mortgage index. Many portfolio managers currently utilize hybrid ARMs as a way to help enhance the performance of their portfolios from a carry and convexity viewpoint. Effective April 1, 2007, hybrid ARMs will comprise approximately 10% of the mortgage index. The composition of this index was outlined in the October 17 issue of Across the Curve. One of the key challenges for money managers whose objective it is to match the index will be to find enough representative bonds to fill out the various components of the ARMs index. The majority of the index is comprised of seasoned discount securities which currently reside primarily in bank portfolios at prices that are above current market levels. The potential restrictions on banks selling underwater assets from their AFS portfolios in the future may limit the availability of these securities in the secondary marketplace. In light of this news, there have recently been some bid lists put out by banks and it is our recommendation that portfolio managers take advantage of the next three months to build up a core portfolio of ARMs in order to avoid a potential rush to the market at the end of March. Hedge Funds and Leveraged Portfolios Hedge funds will continue to face the challenge of an inverted yield curve. Many of the better trades that can be put on involve negative carry and a lot of the low hanging fruit has already been picked. In the case of hedge funds, economies of scale seem to work against some of the larger funds as they must diversify away from their core competencies in order to deploy capital and pick up incremental returns. Many of the best trade ideas are simply not scalable to the point where a large hedge fund can fully participate and hope not to strain the markets liquidity. In Agency CMOs, the steepness of the PAC curve should continue to provide opportunities to generate attractive ROE numbers, especially when hedged with a positive carry instrument such as an interest rate swap. The credit markets, especially mortgage credit, should continue to grow and continue to provide ample opportunities for hedge funds to participate from both sides of the plate.

This may prove to be especially true in the case of ABS CDO issuers and CDO Equity buyers where the recent volatility on the asset side of the equation (particularly in CDS) has not been met by volatility on the liability side of the equation. While over 80% of the mortgage universe is technically considered to be out-of-the-money from a refinancing viewpoint, the coming months and years may prove to be some of the most diverse from a prepayment viewpoint as there will be many more factors to consider when modeling prepayment behavior besides just refinancing incentive from interest rates alone. Loan size, LTV, HPI, geography and loan type will all play a bigger part in determining future prepayment behavior and these discrepancies can be captured in leveraged form through the specified pool and IO/PO markets. In addition, hedge funds should find that attractive financing will remain available to them at attractive rates (barring an industry-wide shake-up) in order to help facilitate their leveraged trading platforms. General Themes for 2007 One of the predominant themes of our Mortgage Research Department for 2007 will be that this will be the best opportunity to take on call risk in MBS since the mid-1990s. Leveraged borrowers and a cooling housing market may work to reduce refinancing activity. To read more about the Mortgage Prepayment Outlook for 2007 please reference the January 2007 issue of Short-Term Prepayment Estimates. Avoid negative carry trades whenever possible. The cost of waiting will continue to diminish returns for those who are waiting for the Fed to ease, spreads to widen or rates to sell off. Floating rate assets continue to be some of the highest yielding short duration assets available and should help enhance returns if the Fed is indeed on hold for an extended period of time. Diversify risks wherever possible. There are many potential outcomes for the coming year and each involves a different ending point for the yield curve. Combine securities that work well together in the base case as well as in the outer scenarios. The 2007 environment will be a challenging one with a number of developing technical factors such as net foreign inflows and the increasing diversification of overseas portfolios that may outweigh some traditional fundamental indicators such as the shape of the forward curve and historical relationships between currencies. Global liquidity and the reach for yield should work to keep spreads contained for the near term. The increasing use of leverage may provide some risk to the system, although recent blow-ups such as Amaranth have been absorbed by the system without much of an impact.
57
58
Spread (bp)
9 /2
140 190 240 290 340 40 90 100 120 140 160 20 40 60 80 0
Spread (bp)
Spread (bp)
100
110
40
50
60
70
80
90
9 /2 10 /6/
C ash
2/0 6 6 9/0
View Across the Grade
Credit Spread History

IG7. C DX C DS ABX-2 BSC H igh Grade C orporate Index - BBB C ash BBB Spread (sw aps) C M BX.1 BBB Spread C DS BBB Spread
Figure 3. Corporate: BBB Spreads
Figure 1. Home Equity: BBB Spreads
Figure 5. CMBS Cash/CDS/CMBX: BBB Spreads
3/ 13 3/ /06 27 4/ /06 10 4/ /06 24 /0 5/ 6 8/0 5/ 6 22 / 6/ 0 6 5 6/ /06 19 /0 7/ 6 3 7/ /06 17 7/ /06 31 8/ /06 14 8/ /06 28 9/ /06 11 9/ /06 25 10 /06 10 / 9/0 /2 6 3 11 /06 / 11 6/0 /2 6 0 12 /06 12 / 4/0 /1 6 8/0 6
0 10 6 /13 /0 10 6 /20 /0 10 6 /27 /0 11 6 /3/ 0 11 6 /10 /0 11 6 /17 /0 11 6 /24 /0 12 6 /1/ 06 12 /8/ 0 12 6 /15 /06
7 /1 7 /2 8/0 6 5/ 8 /1 0 6 8 / /06 8 /1 8 /06 8 /2 5/0 6 2 8 /2 /0 6 9/0 9/ 6 9 /1 5 /06 2 9 /1 /0 6 9 /2 9/0 6 1 0 6/0 6 1 0 /3/0 /1 6 1 0 0 /0 / 6 1 0 17 /0 / 6 1 0 24 /0 /31 6 1 1 /06 1 1 /7/0 / 6 1 1 14 /0 / 6 1 1 21 /0 /2 6 1 2 8 /06 1 2 /5/0 /12 6 /06
Spread (bp)
Spread (bp)
Spread (bp) 100 150 200 250 300 350 400 450 50
9 /2
100 150 200 250 50 0
160 150 140 130 120 110 100 90 80 70 60
300
Figure 6. CMBS Cash/CDS/CMBX: BBB- Spreads

10 /6/ 9/0 6

H Y7. BB C DX BSC H igh Yield C orporate Index - BB C ash BBB- Spread (sw aps) C M BX.1 BBB- Spread C DS BBB- Spread
Figure 4. Corporate: BB Spreads
Figure 2. Home Equity: BBB- Spreads
C ash C DS ABX-2
3/ 3 /2 6 /06 0/ 4 /3 0 6 4 /1 /06 7/ 5 /1 0 6 5 /1 /06 5 /2 5/0 6 9 6 /1 /0 6 2 6 /2 /0 6 6 7 /1 /0 6 0 7 /2 /0 6 4/0 8 /7 6 8 /2 /06 1 9 /4/0 6 9 /1 /06 8 1 0 /0 6 1 0 /2/0 /1 6 1 0 6 /0 / 6 1 1 30 /0 /13 6 1 1 /0 /2 6 1 2 7 /0 /11 6 /06 0 10 6 /13 /0 10 6 /20 /0 10 6 /27 /06 11 /3/ 06 11 /10 /0 11 6 /17 /0 11 6 /24 /06 12 /1/ 06 12 /8/ 06 12 /15 /06
7 /1 7 /2 8/0 6 5 8 /1/0 6 8 /8 /06 8 /1 /06 8 /2 5/0 6 8 /2 2/0 6 9 9 /5/0 6 9 /1 /06 9 /1 2/0 6 9 /2 9/0 6 1 0 6/0 6 1 0 /3/0 / 6 1 0 10 /0 /17 6 1 0 /0 / 6 1 0 24 /0 /3 6 1 1 1 /06 1 1 /7/0 / 6 1 1 14 /0 / 6 1 1 21 /0 /2 6 1 2 8 /06 1 2 /5/0 /12 6 /06
December 19, 2006
December 19, 2006 View Across the Grade
The Credit Spread Surface (as of 12/15/06)

Ratings Prime ARMs Prime 15-year1 Prime 30-year1 Alt-A 30-year1 MH Floating MH Fixed HILTV Home Equity Fixed Home Equity ABS - CDS Home Equity Floating (Cash) Basis CMBS - CDS CMBS Fixed (Cash) Basis Corporate - High Grade2 Corporate - High Yield2 ABS CDO CLO Trust Preferreds Spread to 3 mo LIBOR Spread to Treasury Spread to Treasury Spread to Treasury Spread to Treasury Spread to LIBOR Spread to Swap Spread to Swap Spread to Swap AA 107 115 135 168 85 100 110 90 20 30 -10 10 39 -29 64 A 145 130 155 188 130 150 125 110 35 41 -6 16 46 -30 91 97 113 40 48 -8 120 90 30 ABBB+ BBB 185 195 240 310 225 275 165 180 200 160 40 55 80 -25 128 250 300 350 -50 80 100 -20 147 211 55 40 60 190 70 140 Implied Ratings BBBCDX IG7. 5-year3 HV7. 5-year Index 35 84 0% -3% 24% 3% -7% 79 AAA 7% -10% 15 Implied Ratings BCDX HY7. 5-year4 HY7.BB 5-year HY7.B 5-year ABX.HE-1 Index Price Spread6 ABX.HE-2 Index Price Spread6 CMBX.NA.1 Index Spread CMBX.NA.2 Index Spread Index 274 171 260 ABX.HE.AAA.06-1 $ 100.28 11 ABX.HE.AAA.06-2 $ 100.10 8 CMBX.NA.AAA.1 5.58 CMBX.NA.AAA.2 5.98 0% - 10% 76% 10% - 15% 33% BB+ 15% - 25% 281 AA+ 25% - 35% 61 AAA 10% -15% 6 AAA 15% -30% 4 375 145 280 650 350 475 313 BBBBB+ BB 385 300 355 625 B 800 600 755 1200 NR 5 $35.75 $38.50 $36.00 $26.00
650 600
Spread to LIBOR
650
1000
Spread to Swap
OAS to Treasury Yield to Worst Spread
ABX.HE.AA.06-1 $ 100.60 17 ABX.HE.AA.06-2 $ 100.09 15 CMBX.NA.AA.1 11.96 CMBX.NA.AA.2 12.12
ABX.HE.A.06-1 $ 100.32 43 ABX.HE.A.06-2 $ 99.54 60 CMBX.NA.A.1 17.62 CMBX.NA.A.2 18
ABX.HE.BBB.06-1 $ 100.36 140 ABX.HE.BBB.06-2 $ 97.04 244 CMBX.NA.BBB.1 44 CMBX.NA.BBB.2 52
ABX.HE.BBB-.06-1 $ 100.09 263 ABX.HE.BBB-.06-2 $ 96.09 391 CMBX.NA.BBB-.1 69.08 CMBX.NA.BBB-.2 84 CMBX.NA.BB.2 189.83
(1) Prime 15 yr (5.50% cpn) ; Prime 30 yr (6.00% cpn); Alt-A 30 yr (6.25% cpn) (2) Corporate Index spreads for High Grade and High Yield; HY bonds are callable (3) 0%-3% quoted in percentage, all other single name tranches quoted in basis points (4) 0% -10%, 10% - 15% quoted in percentage, all other single name tranches quoted in basis points (5) Unrated quoted in dollar price (6) Implied spreads computed using durations calculated from Bear Stearns prepayment and default ramps
59
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The data underlying the information contained herein has been obtained from sources that we believe are reliable, but we do not guarantee the accuracy of the underlying data or computations based thereon. The information in this report is illustrative and is not intended to predict actual results, which may differ substantially from those reflected herein. Performance analysis is based on certain assumptions with respect to significant factors that may prove not to be as assumed. You should understand the assumptions and evaluate whether they are appropriate for your purposes. Performance results are often based on mathematical models that use inputs to calculate results. As with all models, results may vary significantly depending upon the value of the inputs given. Models used in any analysis may be proprietary making the results difficult for any third party to reproduce. Contact your registered representatives for explanations of any modeling techniques and the inputs employed in this report. The securities referenced herein are more fully described in offering documents prepared by the issuers, which you are strongly urged to request and review. Bear, Stearns & Co. Inc. ("Bear Stearns") and/or its affiliates or employees may have positions, make a market or deal as principal in the securities referred to herein or related instruments, while this document is circulating. During such period, Bear Stearns may engage in transactions with, or provide or seek to provide investment banking or other services to, the issuers identified in this report. Bear Stearns may have managed or co-managed a public offering of securities within the last three years for the issuers identified in this report, including regularly acting as an underwriter for Government Sponsored Enterprise issuers. Directors, officers or employees of Bear Stearns or its affiliates may be directors of such issuers. This document is not a solicitation of any transaction in the securities referred to herein which may made only by prospectus when required by law, in which event you may obtain such prospectus from Bear Stearns. Any opinions expressed herein are subject to change without notice. We act as principal in transactions with you, and accordingly, you must determine the appropriateness for you of such transactions and address any legal, tax or accounting considerations applicable to you. Bear Stearns shall not be a fiduciary or advisor unless we have agreed in writing to receive compensation specifically to act in such capacities. If you are subject to ERISA, this report is being furnished on the condition that it will not form a primary basis for any investment decision.
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December 19, 2006

A CROSS THE C URVE

A CROSS THE G RADE

Treasuries/Futures/Agencies Interest Rate Swaps/Options

Emerging Market Sovereigns: Emerging Market Debt: 2007 Outlook ........... 13

Adjustable Rate MBS

ABS and Non-Agency MBS

Corporate Credit Strategy

Emerging Market Sovereigns

Challenges and Opportunities in 2007 .................................................. 55

December 19, 2006

The Spread Surface (as of 12/15/06)

Current Coupon PAC9

Autos - Prime Credit Cards - Floating Home Equity - Fixed

HEL / HELOC Floating

4.595 5.068 4.899 125 334

Bear, Stearns & Co. Inc.

December 19, 2006 View Across the Curve: Rates

Across the Curve and Across the Grade: Outlook 2007

The Resilient Rates Market

Bear, Stearns & Co. Inc.

Across the Curve and Across the Grade: Outlook 2007

December 19, 2006

Source: Bear Stearns

Bear, Stearns & Co. Inc.

December 19, 2006

Across the Curve and Across the Grade: Outlook 2007

Source: Bureau of Economic Analysis

Bear, Stearns & Co. Inc.

Across the Curve and Across the Grade: Outlook 2007

December 19, 2006

Bear, Stearns & Co. Inc.

December 19, 2006

Across the Curve and Across the Grade: Outlook 2007

Bear, Stearns & Co. Inc.

December 19, 2006

Good, But Not Great, Outlook for Corporate Credit in 2007

315 4.6 2.3 -15 0 8.0 0.8 0.0 -0.9 7.8

360 5.1 2.3 30 50 8.0 -1.5 -2.6 -0.9 3.0

Source: Bear Stearns Credit Research.

Bear, Stearns & Co. Inc.

December 19, 2006

Across the Curve and Across the Grade: Outlook 2007

Bear, Stearns & Co. Inc.

Across the Curve and Across the Grade: Outlook 2007

December 19, 2006

Bear, Stearns & Co. Inc.

December 19, 2006

Across the Curve and Across the Grade: Outlook 2007

Where Could Potential Market Stress Come From?

Bear, Stearns & Co. Inc.

Across the Curve and Across the Grade: Outlook 2007

December 19, 2006

Bear, Stearns & Co. Inc.

December 19, 2006

Across the Curve and Across the Grade: Outlook 2007

View Across the Grade: Emerging Market Sovereigns

Emerging Market Debt: 2007 Outlook

Source: F.A.S.T., Bear Stearns Emerging Markets Research.

Bear, Stearns & Co. Inc.

Across the Curve and Across the Grade: Outlook 2007

December 19, 2006

Sources: IMF World Economic Outlook.