Introduction to Inverse IO

Kumar Velayudham
Agency MBS/Derivatives Strategy

212-412-2099

February 17, 2009

Please see analyst certification(s) and important disclosures starting on page 19.

Why look at inverse IOs now?

Security

Loss Adjusted Yields

Super Senior Jumbo AAAs

8-10%

Super Senior Alt-A AAAs

13-15%

Super Senior Negam AAAs

14-17%

Subprime Cash AAAs

13-15%

CMBS Senior Cash AAAs

13-14%

Consumer ABS - Auto 3Yr AAAs

Inverse IO

7-8%
20-25%

Inverse IO yields shown above include the cost of hedging duration and convexity. Unhedged yields are
generally higher.

Inverse IOs look the cheapest across mortgage assets

They carry no credit risk and have limited exposure to the slowing economy

Inverse IO basics: Cash flows and risks

Creating an inverse IO
The inverse IO does not receive any principal, only the interest on notional
Inverse IO is equivalent to buying a synthetic premium with financing
Duration of floater ~0.

Floater

Inverse IO leverage ~107/7 =15

$75M Principal, L+1% Coupon,

8% Cap

Synthetic Premium

Price = $100

$75M, 8% Coupon
Price = $107

Pass Through

$75M Notional, $0 Principal

$100M, 6% Coupon
PO
$25M, 0% Coupon
Source: Barclays Capital. Prices shown are sample prices

Inverse IO
7%-L Coupon
Price = $7

Cash Flows
Price of the strip Inverse IO ~ $5 to $10 for $100 notional
Coupon payment ~ (7% - 1mth Libor)
Coupon calculated on remaining notional amount
Inverse IO cash flows are dependent on prepayments & 1mth Libor
Cash flows depend on prepays..

and prepays depend on rates

250000

50

10 CPR

40

30 CPR
50 CPR

30

CPR (%)

Monthly Cash Flow ($)

200000

150000

20

100000

10
50000
0
-200

0
0

Source: Barclays Capital

60

120

180

240

300

360

-100

100

Rate Incentive Change (bp)

200

Higher long-term rates benefit inverse IO

As rates increase, prepays decline and the average life increases, and vice versa
Longer average life implies longer stream of IO cash flow and, hence, higher yields
Inverse IO have negative duration to longer-term rates
and so does the yield (ZV)

In a backup, average life increases

50

10

Average Life (yrs, RHS)

50

30

20

10

0
-200

-100

-50

50

Change in Rates (bp)

Source: Barclays Capital

100

200

Inverse IO Yield (%)

40

Average Life (yrs)

CPR (%)

CPR (%, LHS)

40

30

20
-100

-50

0
10Y Rate Change (bp)

50

100

Lower short-term rates benefit inverse IO

Inverse IO coupon is defined as (Strike 1mth Libor)
In current environment, inverse IO cash flows are front-ended
Near-term forward 1mth Libor has a significant effect on valuation
Inverse IOs are inherent steepeners

Inverse IO cash flows are front-loaded

Forward 1m LIBOR Rates (%)

Lower short rates benefit valuation

8

250000

200000

150000
2
100000
1

50000

0
0

12

24

36

Month

Source: Barclays Capital

Inverse IO Price

Forward 1m Libor (%)

Inverse IO Cash Flow ($, RHS)

48

60

-200

-100

100

Change in 2Y Rates (bp)

200

Other risks: Government intervention

MBS purchase

FED/Tsy purchases have lowered mortgage rates to historical lows

Persistent low rates can cause a refinance wave

Loan
modifications

Reappraisal
removal

Off-market
program

FN/FH have instituted streamlined loan modifications

Increased moral hazard could cause involuntary prepays to increase
Removal of reappraisal requirements will increase callability
Unwind of agency fee/MI premiums will increase refinancibility
Government could institute an off-market 4.5% mortgage rate program
This would be the worst case scenarios for inverse IO valuations

Valuing a sample inverse IO

Bond details: What to look for

Bond summary (Cusip: 31282YE54, FHS 237 S22)
Price* = $7-16
Coupon = 7.15% - 1mth Libor
Current coupon = 6.82%
Collateral summary
Recent speeds: 1mth CPR = 23.9%, 3mth CPR = 12.6%, life =8.2%
Prepay characteristics: GWAC = 6.03%, Wala: 34, Current loan size: 201,870
Credit characteristics: Average FICO: 729, average original LTV: 72%

* Indicative prices as of close on 02/11/2009

10

Bloomberg yield table: Yield to forward

11

Prepay and Libor effect: Yield to spot

12

Yield analysis
Yield analysis across prepay speeds is the most common valuation tool
Comparing breakeven CPR with current and estimated CPR provides a good benchmark
Estimating the months to outlay recovery is another tool cash flows are front-loaded
Yield to forward vs. CPR

Months to outlay recovery

50

80

Lifetime, 8CPR = 65% Yield

1m, 24CPR = 43% Yield

40

Estimated, 30CPR = 33% Yield

20
0

Breakeven

-20

Forward Libor

40

30

20

10

-40
0

10

20

30

40

50

60

CPR (%)

Note: As of close on February 11, 2009. Source: Barclays Capital.

13

Months to Outlay Recovery

Yield to Forward (%)

60

Spot Libor

10

20

30
CPR(%)

40

50

What drives inverse IO valuation?

The two main factors driving Inverse IO pricing are:
Strike on the inverse IO (Coupon = Strike - 1mth Libor)
The prepayment characteristics of underlying MBS collateral

Strike of inverse IO

The higher the strike, higher the coupon and cash flows

Underlying product GN vs. FN, IO vs. conventional

Collateral
characteristics

Pool prepay drivers Loan balance, GWAC, geography

Borrower credit FICO, LTV
Structure Strip, PAC, support, sequential

14

Choosing the right collateral

Conventional (TBA)

Most callable as cheapest collateral is delivered

Seasoned

Burnout: Seasoning removes refinance-sensitive borrowers

Ginnie Mae

Significantly weaker credit, but involuntary prepays are high

15yr
10/20 interest only

Low loan balance

High LTV, low Fico
15

Faster pay-down leads to lower balance, but good credit;

shorter cash flows due to 15yr final maturity
High current combined LTV due to high % second liens and
high concentration in bad HPA states (CA/FL)
Fixed refinancing cost and lower cost savings
$40 monthly savings for every 100bp rate difference
Borrowers are credit constrained by MI premium, agency fees

Prepayments across collateral: January 2009

Prepayments vary based on collateral characteristics
50

TBA
"10-20
GNMA
LLB

Prepayment Speed, CPR(%)

40

HLB
Seasoned
High LTV/Low FICO

30

20

10

0
0

Source: CPRCDR, Barclays Capital

16

25

50

75

Rate Incentive (bp)

100

125

Inverse IO valuation across collateral

The higher the prepay protection, the higher the price
Low loan balance (LLB) collateral offers the best protection, hence highest price
1-Mo Speed
(CPR, %)

Speed for 20%

Yield to FWD,
(CPR, %)

Zero Yield
to Fwd

Multiple of
Breakeven to
Current Speed

Collateral

Strike

Price

Px Multiple using
.45% LIBOR

FHS 246 S18

TBA

6.4

5.75

0.97

25

44

54

2.2

FHR 3303 SH

10-20 IO

6.43

7.58

1.27

14

33

45

3.2

GNR 07-59 SD

GNMA TBA

6.47

5.25

0.87

41

48

58

1.4

FNR 07-30 LI

LLB (85k MAX)

6.44

1.34

29

42

6.0

FHR 3274 SM

HLB (150k MAX)

6.43

7.125

1.19

18

34

46

2.6

GNR 08-40 SA

SEASONED

6.5

7.5

1.24

14

31

44

3.1

High LTV ,LOW FICO

6.55

7.12

1.17

13

36

48

3.7

NON AGENCY MBS

6.5

7.5

1.24

23

30

41

1.8

Bond

FNR 09-6 GS
MASTR 06-3 2A2

Source: Barclays Capital

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Positioning against forward: Inverse IO as a macro hedge

1mth Libor is dependent on fed funds rate and the level of economic growth
Market is pricing in a quick recovery relative to our forecast
Inverse IO valuations should benefit from slower recovery: macro economic hedge
Forward Libor rates

Lower Libor will increase yields

90

Current

Slower Recovery

70
3

Yield (%)

1 Month Libor FWD (%)

Market Pricing

Slower Recovery

50

30

10

0
0

10

20

30

40

50

60

10

15

20

25

30

Prepay Speed - CPR (%)

Source: Barclays Capital

18

35

40

Reg AC and Important Disclosures

Analyst Certification:
The views expressed in this report accurately reflect the personal views of Kumar Velayudham, the primary analysts responsible for this report, about the
subject securities or issuers referred to herein, and no part of such analysts' compensation was, is or will be directly or indirectly related to the specific
recommendations or views expressed herein.
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