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BofA Merrill Lynch does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Refer to important disclosures on page 54 to 56. Analyst Certification on Page 53. Link to Definitions on page 53. 11093300

Securitized Products Strategy

Securitization Weekly

Overview – Chris Flanagan 2-3 We continue to recommend slow and steady accumulation of higher quality securitized products: down-in-coupon agency MBS, prime jumbo MBS, last cash flow AAA CMBS, and consumer ABS.

Agency MBS – Dan Kleiman, Robert Marcus 4-15 The parade of mortgage-related headlines continued this week, as FHFA and SIFMA both considered plans that would impact MBS. At the end of the week, mortgages were back where they started. With the Fed set to begin purchases of MBS next week, we continue to favor an overweight to the mortgage sector.

Non-Agency MBS – Ryan Asato, Tim Isgro, Jimmy Nguyen 16-26 The non-agency market continues to reflect a risk-off sentiment, with low investor participation amid broader market distress. We think the time is ripe for taking a new look at many sectors, and we profile jumbo floating rate bonds off of hybrid ARM collateral. Favorable net supply technicals continue to be a tailwind here.

CMBS – Alan Todd, Catherine Abrams 27-37 Continue to slowly and cautiously add exposure at the top of the capital structure. We favor newly issued A2 bonds over shorter-duration legacy A4s. This trade offers investors the opportunity to pick spread, take out dollars and is likely to offer better liquidity over time as older vintage bonds become increasingly difficult to source.

ABS – Theresa O’Neill, Matthew Carr 38-48 YTD excess returns show auto ABS performing well, as stable credit ratings provide a safe haven. Ratings have not fared as well on FFELP ABS, creating opportunities in the sector. Higher auto ABS volume should be offset by lower FFELP ABS volume. Credit statistics for private student loans remain stable. We continue to overweight ABS.

CLO – Nicolas Gakwaya 49-52 Flat to slightly wider spreads on very low volumes this week, as CLOs continue to adjust to the new pricing levels across risky fixed income. We remain market weight but believe the re-alignment process has already gone a long way, and expect value to already be found at these levels. Equity continues to outperform, but going forward we are beginning to see equal value in high quality mezz tranches, which results in flattening our CLO barbell somewhat.

USA 30 September 2011

Chris Flanagan +1 646 855 6119 MBS/ABS Strategist MLPF&S [email protected] Dan Kleiman +1 646 855 9665 MBS Strategist MLPF&S [email protected] Robert Marcus +1 646 855 9574 MBS Strategist MLPF&S [email protected] Ryan Asato +1 646 855 6201 MBS Strategist MLPF&S [email protected] Timothy A. Isgro +1 646 855 9301 MBS Strategist MLPF&S [email protected] Jimmy Nguyen +1 646 855 9710 MBS Strategist MLPF&S [email protected] Alan Todd, CFA +1 646 855-6383 CMBS Strategist MLPF&S [email protected] Catherine Abrams +1 646 855 9669 CMBS Strategist MLPF&S [email protected] Theresa O'Neill +1 646 855 9285 ABS Strategist MLPF&S theresa.o'[email protected] Matthew Carr +1 646 855 9971 ABS Strategist MLPF&S [email protected] Nicolas Gakwaya +44 20 7995 7212 Research Analyst MLI (UK) [email protected]

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Secur i t ized Produc ts S t ra tegy 30 September 2011

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Overview The MBS market is currently trading at an aggregate dollar price of 107.47, down over 1 point from the historical high of 108.56 set on August 10, 2011, just after the US debt downgrade. A price comparison to the BofAML Government master index is shown in Chart 1. Not surprisingly, both indices are at elevated levels, but the MBS index is in far more unchartered territory. With the Fed intent on keeping long term interest rates down and the president focused on increasing the exercise efficiency of the prepayment option embedded in MBS, through enhanced refinancing, investors have legitimate reason to be concerned with paying such high premiums in MBS. Policy risk in the US and Europe remains extraordinarily high. In most instances, outcomes can be binary.

This week’s daily market volatility in premium agency MBS related to the mass refi story crystallized the core predicament faced by MBS investors in today’s low yield environment. On one hand, there are numerous economic forces and frictions creating the low yields and the related need to find sources of incremental yield. Agency MBS has long been one such source of yield enhancement and, given the spread widening observed since the US downgrade, would appear to be especially attractive at the moment. However, the economic weakness itself is naturally creating pressure for a policy response, which in the case of MBS, is the mass refi story. The decision confronting investors is whether to extrapolate past policy performance and assume government will again be unable to respond with an effective response to housing (think HAMP and HARP), or to assume government will get it right this time.

Credible policy solutions to the refinancing problem exist. As Chris Mayer highlighted in recent congressional testimony1, lowering or eliminating the Loan Level Pricing Adjustments on refinancings and converting the putback option into a fee that is rolled into the g-fee could help reduce some major sources of friction. Republican Massachusetts Senator Scott Brown argued in an op-ed piece in the Boston Globe in favor of reducing frictions and the potential benefits. But the FHFA can push back with what some would call equally if not more credible arguments that a mass refi program would not be consistent with the FHFA’s mandate to preserve the capital of the GSEs. From our perspective, the fact that it is the FHFA calling the shots in this case argues for “more of the same” or extrapolation of past performance as the base case scenario over the next six to twelve months. Despite political pressure, there is little evidence suggesting FHFA has had a change of heart on its approach to business. If that is the case (a big if), agency MBS are currently remarkably and historically cheap relative to treasuries.

Consider some index metrics in more detail. Chart 2 compares the government yield and MBS yield over the past 25 years. The yield differential between MBS and govies appears wide by historical standards. But given today’s low level of yields, where fixed costs can erode much of the yield, the pickup becomes even more valuable. To elaborate on this, we consider the historical OAS of the index along with the ratio between the OAS and the govie index yield in Chart 3. We see that the only time this ratio was higher was during the 2008 crisis. We also see that in both 2008 and 2010, the ratio subsequently narrowed sharply. In both instances, the narrowing occurred along with the initiation of a dramatic new Fed policy. Operation Twist commences October 3 with the likely purchase of current

1 http://banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=9f75ef1b-c248-4327-8e6b-a28754e224d3

Chris Flanagan MBS/ABS Strategist +1 646 855 6119 [email protected] Jimmy Nguyen MBS Strategist +1 646 855 9710 [email protected]

Chart 1: Price ($)

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Source: BofA Merrill Lynch Global Research

Chart 2: Yield to Maturity (%)

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coupon mortgage production. The odds strongly favor an overweight allocation to mortgages. We get it that a successful mass refi program could impair performance. But as we discussed last week, there are numerous frictions embedded in the refinancing process that will be difficult to overcome. We still favor a down-in-coupon bias but we would remain flexible on seasoned premiums as any further cheapening is likely to represent an excellent opportunity to add short duration paper. Also, Fannie 4.5’s and the 4.5 fly are looking cheap.

Similarly, IOs have been crushed since the beginning of August and currently are very cheap (Chart 4). They probably will cheapen further, as policy mistakes continue to unsettle markets. But we would strongly recommend accumulation over the next three months as this process unfolds. As this week’s tame MBA refinancing index showed (Chart 5), the prepayment environment remains remarkably benign. IOs would make you think it is 2003 all over again. It’s not. Table 1: Spreads across sectors Change Benchmark 9/29 9/22 9/15 8/9 7/1 9/22 9/15 8/9 7/1 Agency MBS FNCL CC OAS LIBOR 27 24 40 35 15 3 -13 -8 12 FNCL CC ZVOAS LIBOR 104 103 114 106 86 1 -10 -3 18 FNCL 4 OAS LIBOR 16 -2 23 23 15 19 -7 -7 1 FNCL 4 ZVOAS LIBOR 107 82 104 99 57 26 3 9 50 FNCL 6 OAS LIBOR 60 39 47 31 6 21 13 29 54 FNCL 6 ZVOAS LIBOR 109 80 104 95 82 28 5 13 27 Non-Agency MBS Prime Jumbo Swaps 460 460 450 490 425 0 10 -30 35 Alt-A Floaters LIBOR 775 775 775 725 600 0 0 50 175 Option ARMs LIBOR 775 775 725 755 650 0 50 20 125 ABS Autos (3Y) Swaps 29 29 29 34 30 0 0 -5 -1 Cards (5Y) LIBOR 23 23 23 27 27 0 0 -4 -4 FFELP (5Y) LIBOR 73 75 75 88 65 -2 -2 -15 8 CMBS A4 Swaps 330 325 300 295 180 5 30 35 150 AM Swaps 765 745 670 625 465 20 95 140 300 2.0 AAA (10Y) Swaps 210 210 205 225 145 0 5 -15 65 2.0 AA (10Y) Swaps 465 465 425 340 200 0 40 125 265 CMBX 3 AAA 282 265 234 257 110 17 48 25 172 CMBX 3 AM 670 668 564 575 285 2 106 95 385 CLOs AAA 200 200 190 185 170 0 10 15 30 Sovereign CDS Greece 5,157 5,350 5,426 1,676 1,861 -193 -269 3,481 3,296 Source: BofA Merrill Lynch Global Research, Markit

Chart 3: Mtge Index OAS vs. Mtge Index OAS / Gov YTM (RHS)

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Chart 4: IOS OAS (bps)

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Chart 5: MBA Refinancing Index

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Chart 6: Freddie Mac National Survey Rate (%)

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Agency MBS Fed steps to the plate After giving the market some time to digest the FOMC announcement, the Fed will begin its purchase program next week. Based on Fed holdings, we anticipate that they will have almost $18 billion of paydowns to re-invest in the next month, with even more to invest as we near year-end (Table 3). Despite the well-advertised buying spree, the mortgage market spent the week focused on a string of headlines (see below).

As we pass by Secretary Geithner’s self-imposed three-week deadline for government-sponsored refi reform, the benefits of owning MBS increasingly outweigh the risks. Long-dated volatility continues to inch downwards, and a relatively subdued refi index should keep convexity concerns under control.

While the threat of an improved government-sponsored refinancing program continues to hang over the sector, each passing week emphasizes the difficulty of combining bipartisan compromise with meaningful reform. We continue to advocate an overweight to MBS, with a core position in lower coupons.

SIFMA debates expansion of TBA eligibility SIFMA began a busy week in the mortgage market with a Tuesday conference call to discuss allowing 105-125 LTV pools to be TBA deliverable. The possible change was met with mixed reactions, although the largest concerns centered around two technical issues:

The exclusion of these pools stems from the tax treatment of REITs. Because REITs are restricted to assets that are based on real estate investments, the IRS has imposed a limit of 105 LTV before the income is no longer considered to be driven by real estate and the tax treatment changes. Assuming no changes from the IRS, every TBA trade REITs make would have to specify an LTV limit – a change which would introduce operational costs on multiple levels.

Loans over the TBA limit of 105 LTV are currently pooled with the “CQ” ticker. Since current REMIC and Mega rules prohibit mixing different tickers, the expanded eligibility would lead to pooling problems. These issues could be solved by issuing high LTV bonds under the “CL” heading or by amending REMIC rules to allow limited mixing of tickers.

We think that mixing high-LTV bonds with the existing TBA universe would create unnecessary stratification in the market. Chart 7 shows the difference in recent prepayments between CL and CQ bonds. The lower refinanceability – in all scenarios – makes CQ paper significantly longer than TBAs. The duration difference is reflected in the payups: lower coupons currently trade slightly behind TBAs, while higher coupons trade with payups well north of one point. Table 3: Estimated Fed paydowns for next four months ($B)

Estimated Paydowns Sep-11 17.9 Oct-11 17.6 Nov-11 21.8 Dec-11 21.1

Source: BofA Merrill Lynch Global Research, Federal Reserve

Chris Flanagan MBS/ABS Strategist +1 646 855 6119 [email protected] Dan Kleiman MBS Strategist +1 646 855 9665 [email protected] Robert Marcus MBS Strategist +1 646 855 9574 [email protected] Jimmy Nguyen MBS Strategist +1 646 855 9710 [email protected]

Chart 7: CL and CQ prepayment sensitivity

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Table 2: WoW FNMA OAS change (bp) 30-year 15-year 3.0 16 3.5 10 17 4.0 19 13 4.5 18 10 5.0 16 15 5.5 17 11 6.0 21 Source: BofA Merrill Lynch Global Research, Fannie Mae

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As most bonds are currently being originated at premium dollar prices, the immediate impact of modified TBA rules would be minimal. At slightly higher rates, however, lower coupons were trading close to a half-point behind TBAs. Although overall production of CQ bonds is much smaller than CL production (Table 4), TBA pricing always has to reflect ‘cheapest to deliver.’ Even if this initiative were eventually expanded to include 125+ LTV bonds, the overall size of high-LTV issuance would be a small fraction of the mortgage universe. The pricing impact, on the other hand, could be substantial.

Table 4: TBA versus CQ comparison CL CQ

Coupon Price OAS Duration ZVOAS Convexity OAS Duration ZVOAS Convexity 4.0 104.67 16 2.7 111 -2.83 78 7.1 119 -0.18 4.5 105.92 36 2.2 121 -2.04 113 6.8 156 -0.16 5.0 107.38 48 1.8 121 -1.33 141 6.2 186 -0.40 5.5 108.42 58 1.7 109 -1.00 151 4.6 196 -0.92


FHFA focuses on improving refi efficiency FHFA hosted a meeting on Tuesday to discuss the next steps in advancing a government-sponsored refinancing. The meeting served as a follow-up to a similar summit, held two weeks prior; in between, FHFA met with leading mortgage insurance providers. With the three-week anniversary of President Obama’s kickoff speech coming up, expectations ran high that FHFA would lay out the guidelines of a program for a substantial change. Instead, the results of the meeting fell short of market concerns, triggering a rally in mortgages that was led by high coupons.

Risk of putbacks due to faulty reps and warranties remains the top concern for most originators, and many have suggested that rep and warranty risk is the single largest hurdle to meaningful refi reform. Because of this focus, conversation has centered around how FHFA and the originators can find common ground. Ideas have centered on the possibility of introducing a supplementary g-fee that would serve as insurance for the originators against putback risk. Reports out of the FHFA meeting suggest that this change is off the table. Although originators are gradually getting increased clarity around putback risk, the threat of putbacks continues to serve as a drag on full-scale refinancing efforts.

The possibility of changing LLPAs has also been cited as a potential path to refinancing reform. This change looked increasingly likely after FHFA head Edward DeMarco’s comments on LLPAs in his September 19th speech. In the next breath, DeMarco introduced the idea of an increased guarantee fee. The possibility of a tradeoff between LLPAs and g-fees remained in the spotlight at this week’s meeting. While a reduction in LLPAs looks probable, the impact on prepayment speeds will be muted if it is balanced against an increase in g-fees.

The idea of extending HARP was also discussed, and an extension seems likely. However, an extension of HARP eligibility has not gathered momentum and does not appear to satisfy the administration’s goal of ‘fixing’ HARP.

The biggest ripples in the mortgage market came from the lack of actionable progress. Without a clear direction emerging from the meeting, we believe it is

Table 5: CL versus CQ issuance in 2011 ($mm) Coupon CL Issuance CQ Issuance CL/CQ 3.5 9,633 8 1143 4.0 70,705 306 231 4.5 91,531 2386 38 5.0 28,370 2211 13 5.5 1,866 59 32 Source: BofA Merrill Lynch Global Research

Putback relief is not imminent.

LLPA changes could be offset by g-fee increases.

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reasonable to expect that it will take most or all of October to finalize changes. After that, additional time will be necessary to allow the agencies and mortgage banking community to prepare for implementation. We think that no material changes will be implemented before the beginning of the year – and possibly later.

Servicer reform on the table Independently of their meeting with servicers, on Tuesday afternoon FHFA released a white paper summarizing their year-long analysis of ways to re-engineer the mortgage servicing industry. Their paper outlined two proposals. From here, the FHFA is accepting comments for the next 90 days.

State of the servicing union Servicers currently receive payment from the borrower’s interest payments. TBA delivery rules stipulate that servicers keep 25 basis points of interest as Mortgage Servicing Rights (MSR). Beyond the required 25 bp, servicers are allowed to keep excess MSR: the excess MSR, in conjunction with g-fee buydowns, is often used to get MBS coupons to the half-point TBA standards.

For a typical $250,000 loan, the 25 basis points of required servicing equates to just over $50 per month. Servicing a performing loan typically costs between $4 and $8 per month. However, when a loan goes delinquent, the costs of servicing grow well past the income received.

The current concerns over rep and warranty risk are tied to the structure of servicing compensation as well. Servicers who refinance a loan originated by another servicer take on putback risk from the original loan, but receive no compensation for the added risk.

Exploring alternative options FHFA announced its intentions to explore alternate means of compensating servicers in January2. The goal of this exercise was to change the structure of mortgage servicing cash flows in order to develop a system that:

1. Better aligned the interests of servicers and borrowers;

2. More accurately matched servicer compensation to the cost of servicing;

3. Lowered barriers to transfer of servicing rights between servicers.

Two proposals share the spotlight Their first alternative involved minor changes to the servicing structure. In lieu of a 25 basis point servicing strip, servicers would receive 20 bp3. The remaining 5 bp would be paid into a cohort-specific reserve fund, to be administered by Fannie or Freddie. Disbursements would be made to servicers as compensation for the increased cost of servicing non-performing loans; however, servicers could also earn payments from the reserve fund for meeting incentive targets. In the event that a borrower refinanced into another servicer, the reserve fund would be transferred to the new servicer along with the MSR.

Option B outlines a more dramatic overhaul of mortgage servicing compensation. In this scenario, a larger reserve fund would be established. The traditional 25-bp strip is replaced by a flat payment of $10 per month for each performing loan.

2 For a discussion of the program kick-off, please see Securitization Weekly, January 28th 2011. 3 Because these plans are still in the comment stage, all values used in their description should be considered to be suggested values.

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The servicer of a delinquent loan would potentially receive additional payments in order to maintain incentives for proper servicing. In this dramatic scenario, the drop in servicing could potentially leave as little as 25bp between the passthrough coupon rate and the WAC of the underlying loans. It is worth quickly repeating that TBA rules currently call for a minimum of 25bp of retained servicing: in order to implement this plan, TBA deliverability requirements would need to be changed.

Looking forward While support is far from guaranteed, any voices from the servicer community in favor of this plan are likely to come from the CFO’s office, not risk management. Either plan – and in particular, the second option – would help servicers deal with the upcoming implementation of Basel III, which assigns a heavy regulatory capital requirement to MSR. By simply reducing retained MSR, this alternative would significantly alleviate the capital constraints.

Although tests are proposed to ensure that servicers would not unnecessarily refinance borrowers, it seems inevitable that concerns over the level of callability would arise from both the consumer and investor communities. If a servicer received significant capital relief from refinancing a loan, the market is likely to worry about increased callability of MBS.

It is also unclear how this approach would guarantee that servicers continue to act in the best interests of the underlying borrowers. Under the current model, agencies dealing with a substandard servicer can threaten to transfer MSR to a competitor – and since MSR is a source of profit, servicers are likely to toe the line. However, if servicing is turned into a lower-margin, fee-based business, the agencies’ leverage is reduced accordingly.

In an environment where retained servicing was reduced, excess MSR could evolve along several different paths. In one outcome, servicers would try to reduce capital requirements and would use buyups/buydowns to avoid retaining excess servicing strip. Alternatively, it is possible to imagine that these servicers would want to stick to their current economics, and these changes would increase the incidence of (retained) excess MSR deals. Down this road, it is possible to envision a scenario where excess servicing becomes as liquid as trust IO, possibly even leading to a situation where excess servicing is subject to mark-to-market requirements.

Any rule changes resulting from this report are still a long way down the road. The FHFA opened a 90-day comment period, which will likely lead to further refinements to one or both plans.

Borrowing from Ginnie A third option, which has been floated but has yet to gain significant traction, would be to implement a modified “Ginnie Mae” model of servicing. In conventional loans, a servicer has to advance initial missed payments. However, once a borrower reaches a certain threshold, the servicer applies for reimbursement from the agencies and passes the loan off. In contrast, in a Ginnie Mae loan, there is another level between the servicer and the government guarantee. For Ginnie loans the third party is typically FHA; for conventional loans it could be a private mortgage insurance company. The agency guarantee is only invoked once the servicer and MI provider are unable to pay.4 Because 4 Alternately, loss severity tests could be used.

Lower servicing spreads in Option 2 could increase convexity costs.

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servicers are higher in line to take losses, this structure creates a much greater incentive for servicers to carefully select borrowers and help them stay current. At the same time, the government (or agency) guarantee allows the TBA market to function without shifting the focus to credit analysis.

Pooling anomalies in high-LTV pools Because of the difficulties that high-LTV borrowers face in refinancing, high-LTV paper trades with a substantial payup. Bonds with 100% refi loans (i.e. MHA pools) command an even larger payup. Although these bonds trade in homogenous LTV buckets, there are substantial, predictable prepayment differences within each sector. By way of explanation, consider the two bonds highlighted in Table 7. Both are categorized by the market as “80-90 LTV” bonds. Borrowers with an LTV of exactly 80 – on the edge of the “high-LTV” universe - do not need any special help to refinance, whereas borrowers with an 81 LTV do5.

Table 7: Comparison of representative 80-90 LTV pools

Bond Coupon Issued WAC WAM WALA Median LTV Balance Refi %

Q03164 4.5 Sep-11 4.925 355 0 80 27.23 100 Q03286 4.5 Sep-11 4.831 355 1 85 25.65 100 Source: BofA Merrill Lynch Global Research

The difference in degree of difficulty can be seen in the prepayments. Chart 8 uses FGLMC loan-level data for refi loans to build three different prepayment curves. The first is for loans with an LTV between 75 and 79; the second shows prepayments for loans with an LTV of exactly 80; and the third shows prepayment sensitivity for 81-85 LTV loans. The drop-off in prepayment sensitivity from 79 to 80 LTV loans is marginal, while the difference between 80 and 81 LTV loans is far more substantial. The prepayment differences lead to an OAS difference of almost 25 bp (Table 6). Not surprisingly, bonds with an LTV of exactly 80 have a high prevalence in 80-90 LTV pools.

The distribution of 80 LTV paper in LTV-restricted pools does not seem to be accidental. To highlight this, we first separated all pools with a minimum LTV of exactly 80. Within this group of pools, we looked at the median LTVs. In plain English, if the lowest LTV is precisely 80, where does the middle-of-the-road LTV lie?

5 An alternate explanation would be that borrowers who can get their LTV down to 80 – and therefore avoid MI – signal that they have more flexibility and therefore are more able to refinance.

Table 6: A little LTV goes a long way LTV Price OAS 80 106-11+ 36 81 106-11+ 60


Chart 8: LTV prepayment comparison

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Chart 9: Distribution of median loan LTV for pools with minimum LTV of 80 ($mm)

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Chart 9 attempts to answer this question. While the majority of the pools have a “typical” median LTV, well away from the minimum, a substantial minority (just under 25%) have 50% of their loans sitting exactly at 80. A quick inspection shows that these pools are typically balanced out by a smattering of high-LTV loans. With high-LTV (and MHA) paper trading at a substantial payup, it doesn’t take much thought to understand why an originator would pool 80-LTV bonds so that they fall into the high-payup category.

Given the substantial difference in prepay characteristics between 80 and 81 LTV loans, we urge investors to take a moment to analyze the quartile data for these pools. While the sector offers significant value versus TBAs, it’s worth taking the time to ensure that an 80-90 LTV pool is not stacked with 80 LTV loans.

Model Portfolio The early-week widening pushed most mortgages back out close to their pre-Fed levels. Although lower coupons retained some element of sponsorship after the Fed announcement, higher coupons suffered from investor nerves generated by the early-week headlines.

Maintain overweight to MBS Our basic views around the sector have not changed. With Fed purchases beginning in earnest next week, technicals could continue to stack up in favor of MBS. With MBS providing a rare source of yield, we continue to advocate a core long in lower coupons.

Cautiously add higher coupons As we discussed last week, higher coupons offer value – as long as refi.gov reforms don’t squash the sector. With immediate, meaningful reform looking increasingly unlikely, we recommend adding higher coupons at current levels. With the 4.5 butterfly down to (6+) at Thursday, close, we are adding 4.5s against 2-year rates in the model portfolio.

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GN 3.5s offer value Most Ginnie buying has been focused on bonds that can be delivered in the front month, which has largely ruled out 3.5s. However, production has begun to rapidly increase and should stay high over the next several months. As we approach year-end, the larger tradeable float in this coupon will attract more bank interest, particularly in GN 2s. Ginnies also provide a monthly roll advantage of 2-3 ticks versus Fannies (through December). Taken together, this seems to be an attractive entry point for GNMAs.

Table 9: Model Portfolio as of 9/30

Model Portfolio Summary Notes

30yr Active Trades

Coupon FN FG GN 3.5 150 100 4.0 125 4.5 100 5.0 +50 MHA /-50 TBA 5.5 100 6.0

15yr 3.0 3.5 4.0 4.5 5.0 5.5

Long MBS basis, favoring down-in-coupon

50 MHA 5.0s (80-90 LTV) vs TBAs at +28

We moved FN 4s into Gold 4s at -4

100 FN 5.5s vs 50 2yr rates

We are adding 100 FN 4.5s against 60 2yr rates and 25 5yr rates

We moved 100 FN 3.5s into G2s up 1-11 (Dec)

Other Closed Trades 3.5 4.0 4.5 5.0 5.5 6.0

Hedges 2yr 5yr 10yr 30yr

Tsy Swap (110) (225) (70)

Source: BofA Merrill Lynch Global Research Blank squares indicate segments where we are marketweight.

Table 8: GN 3.5 issuance by month ($mm) GNSF G2SF

Sep-11 200 411 Aug-11 47 159 Jul-11 17 48

Jun-11 15 46 Source: Ginnie Mae, BofA Merrill Lynch Global Research

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GN buyout speeds rise Ginnie buyout speeds rose in August. G1 buyout speeds increased 0.7 points to 4.2% CPR, while G2 buyout speeds increased by 0.9 points to 4.5% CPR (Table 10). Voluntary speeds were also up, month-over-month. Overall, buyout speeds have remained close to the 4% range for both G1 and G2 collateral since April 2011 (Chart 10). With delinquencies climbing back from the same time period, we expect buyout speeds to increase over the coming months.

Table 10: Buyout and Voluntary CPR for G1, G2, and FN (%) July August Total CPR Vol CPR Buyout CPR Total CPR Vol CPR Buyout CPR GNSF 9.8 6.2 3.5 11.7 7.4 4.2 G2SF 9.1 5.3 3.6 10.9 6.5 4.5 FNCL 14.9 12.0 3.3 16.8 14.1 3.1 Source: Ginnie Mae, Fannie Mae, BofA Merrill Lynch Global Research Note: Fannie Mae buyout speeds are estimated using 120+ delinquency data reported by Fannie Mae, which are broken out by issue date

60+ delinquencies increased again in July. G1 and G2 delinquencies went up 0.2 and 0.1 points to 3.2% and 2.7%, respectively (Chart 10). Showing a similar trend in Table 11, 60-89 day delinquencies for G1 pools increased for Chase, Citi, and Wells-serviced pools, while 90+ delinquencies increased for BofA-serviced pools. 90+ delinquencies decreased for Citi and GMAC-serviced pools.

Table 12: Jul (Aug factor) buyout and voluntary speeds by coupon and vintage (%) GNSF G2SF FNCL Vol CPR Vol CPR Vol CPR '05 '06 '07 '08 '09 '10 '05 '06 '07 '08 '09 '10 '05 '06 '07 '08 '09 '10 4.0 5 2 4 2 10 6 4.5 7 6 5 4 15 10 5.0 13 14 12 13 8 8 13 13 13 12 8 8 18 19 18 23 15 10 5.5 12 16 17 14 10 12 16 14 12 9 15 19 20 21 13 6.0 7 15 12 13 9 16 13 13 10 17 16 18 Buyout CPR Buyout CPR Buyout CPR '05 '06 '07 '08 '09 '10 '05 '06 '07 '08 '09 '10 '05 '06 '07 '08 '09 '10 4.0 4 3 3 3 0 0 4.5 3 3 3 4 1 0 5.0 5 8 9 6 5 5 5 5 10 7 4 5 4 6 6 4 2 1 5.5 7 7 7 8 8 7 8 7 8 7 6 7 7 6 4 6.0 8 7 10 10 11 9 10 9 10 9 9 8 Source: Ginnie Mae, Fannie Mae, BofA Merrill Lynch Global Research Note: Fannie Mae buyout speeds are estimated using 120+ delinquency data reported by Fannie Mae, which are broken out by issue date

Chart 10: G1/G2 buyout CPR and DQ rates (%)

2468

101214161820

Jan-

10

Apr-1

0

Jul-1

0

Oct-1

0

Jan-

11

Apr-1

1

Jul-1

1

2.0

2.5

3.0

3.5

4.0

4.5

5.0

G1 CBR G2 CBRG1 60+ DQ (RHS) G2 60+ DQ (RHS)

Source: Ginnie Mae, BofA Merrill Lynch Global Research

Table 11: G1 delinquency pipelines by servicer Jul (Aug Factor) Aug (Sep Factor) Servicer 60-89 DQ 90+ DQ 60-89 DQ 90+ DQ BofA 1.2 1.5 1.2 1.8 Chase 1.9 1.5 2.0 1.5 Citi 1.6 0.2 1.8 0.0 GMAC 1.8 6.5 1.8 6.4 Wells 1.1 0.1 1.2 0.1 Source: Ginnie Mae, BofA Merrill Lynch Global Research Values are in percentage points

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Market News For the week ending 9/23/2011, the seasonally adjusted MBA Refi index increased by 11.2% to 4240. The MBA Purchase Index rose 2.6% to 177 (see Chart 11). The MBA 30-year mortgage survey rate rallied 5 bps week-over-week to 4.24%, as the Freddie Mac 30-year Survey Rate rallied 8 bps to 4.01% (which is a 0.7 point rate).

The H.8 data for the week ending Sep 14th showed that agency MBS portfolio holdings for domestically chartered commercial banks went up by $4.9 billion, while the residential loan portfolio decreased by $12.3 billion. Unrealized gains on AFS securities of all domestic banks were unchanged from the previous week at $35.4 billion. Table 13 shows assets and liabilities of all domestically chartered banks. Table 13: Assets and liabilities for all domestically chartered commercial banks, NSA ($bn) Change Dec-09 Dec-10 9/7/11 9/14/11 2010 WoW 3Q-QTD 1Q 2Q YTD Bank Credit 8,240 8,133 8,147 8,137 -107 -10 137 -144 11 4 Securities in Bank Credit 2,094 2,188 2,257 2,261 93 4 82 13 -22 73 MBS 991 1,090 1,181 1,186 98 5 57 13 27 96 Loans and Leases in Bank Credits* 6,146 5,945 5,890 5,876 -201 -14 55 -158 33 -69 Commercial and Industrial Loans 1,031 987 1,042 1,043 -44 1 23 10 23 56 Closed-end Residential Loans 1,528 1,524 1,507 1,495 -4 -12 27 -48 -8 -29 Interbank Loans 188 161 98 101 -27 3 -32 -46 18 -60 Cash Assets 815 780 891 901 -36 10 5 77 39 121 Trading Assets 168 166 212 215 -2 3 52 -12 9 49 Other Assets 1,201 1,162 1,137 1,147 -39 10 -5 12 -23 -15 Total Assets 10,421 10,196 10,306 10,322 -225 16 165 -110 71 126 Deposits 6,686 6,903 7,440 7,434 218 -7 323 47 160 530 Borrowings from others 1,157 1,148 946 943 -9 -4 -82 -55 -69 -206 Net unrealized gains (losses) on AFS Securities -2 11 35 35 13 0 11 -7 20 25 Source: Federal Reserve H.8

Primary dealer positions of MBS decreased 5.2% to $69.9 billion for the week ending 9/21/11. Agency securities held in custody foreign official and international accounts fell $1.25 billion to $731.2 billion for the week ending 9/28/11.

Table 14 summarizes the cumulative MBS purchases by the Fed and the Treasury as a percentage of the float (excluding pools locked up in CMOs).

Table 14: Comparison of Fed Purchases and Float (Fed + Treasury) Purchases/Float (%) (Fed + Treasury) Holdings (billions, $) Float of Agency MBS (billions, $) CPN FHLMC FNMA GNMA FHLMC FNMA GNMA FHLMC FNMA GNMA 30 YR 4.0 37% 31% 4% 46.1 86.7 5.2 124.5 279.4 135.5 4.5 52% 51% 20% 155.3 226.5 56.0 299.3 446.0 273.6 5.0 50% 32% 15% 87.0 95.1 26.5 174.8 293.0 174.3 5.5 12% 28% 1% 13.6 68.9 1.0 110.1 247.3 78.3 6.0 3% 9% 1% 1.8 12.7 0.3 65.7 146.9 45.1 6.5 3% 2% 0% 0.4 0.8 - 13.0 45.5 11.9 15 YR 4.0 4% 15% 1.9 14.7 - 50.8 97.8 4.5 5% 12% 1.7 7.3 - 34.1 59.9 5.0 0% 0% 0.1 0.0 - 19.6 35.6 5.5 0% 0% 0.0 - - 9.9 18.5 6.0 0% 0% - - - 4.1 9.3 Source: BofA Merrill Lynch Global Research *Settled Fed purchases are based on current face as of 9/28/11 *Float includes Mega pools and excludes pools locked up in CMOs

Chart 11: MBA Refi and Purchase Indices

1500

2000

2500

3000

3500

4000

4500

5000

Jan-11

Mar-11

May-11

Jul-11

Sep-11

160

180

200

220

M BA Refi Index (4239.64)

M BA Prch Index (RHS, 176.61)

Source: BofA Merrill Lynch Global Research Note: These numbers reflect the new MBA indices

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Table 15 shows inverse IO and trust IOS price changes.

Table 15: Inverse IO and IOS pricing and OAS change Price OAS 12M CPR Life CPR Issuer WAC WAM WALA Strike 9/29/11 9/22/11 Change 9/29/11 9/22/11 Change 9/29-12/31 Yield Fwd. Yield 9/29/11 9/22/11 9/29/11 9/22/11 G2 30Y 5.0 5.29 359 1 625 15.81 15.75 0.06 267 171 95 -377 9.7 8.5 27.5 32.2 22.3 24.7 G2 30Y 4.5 4.89 359 1 625 18.75 17.75 1.00 -87 -65 -22 -382 8.0 8.2 18.8 25.2 19.5 23.0 FG 30Y 6.0 6.56 333 23 620 13.00 13.63 -0.63 499 233 266 -142 12.8 9.2 31.6 34.6 25.6 27.2 FN 30Y 6.0 6.60 357 2 610 14.25 15.19 -0.94 456 169 286 19 13.1 9.8 27.1 30.4 22.1 23.8 FG 30Y 6.5 6.90 357 2 634 14.00 14.38 -0.38 543 399 143 251 13.5 9.8 29.0 31.6 23.4 24.6 IOS 350 2010 4.16 355 3 18.53 19.22 -0.69 103 28 75 -2.3 7.9 12.8 14.7 16.9 17.7 IOS 400 2009 4.57 347 10 15.02 15.56 -0.55 487 380 107 197 -2.4 9.8 26.0 28.3 23.6 24.5 IOS 400 2010 4.50 354 4 17.03 17.64 -0.61 293 198 94 -4.4 7.7 25.5 28.0 23.1 24.0 IOS 450 2009 4.94 348 9 13.20 13.33 -0.13 949 894 55 480 1.0 11.8 31.5 33.4 26.4 27.1 IOS 450 2010 4.94 350 7 15.13 15.19 -0.06 776 743 33 0.5 11.4 27.7 29.7 23.7 24.4 IOS 500 2003 5.47 256 93 13.98 14.28 -0.30 669 587 82 -0.6 8.3 31.8 33.2 28.1 28.7 IOS 500 2008 5.63 320 35 11.80 12.09 -0.30 917 814 103 0.0 8.5 38.8 40.0 33.1 33.7 IOS 500 2009 5.41 350 7 14.17 14.47 -0.30 1153 1072 81 351 5.3 13.5 27.4 28.7 24.0 24.5 IOS 500 2010 5.36 349 8 16.52 16.84 -0.33 1015 945 70 5.0 13.9 21.0 22.4 20.7 21.2 IOS 550 2003 5.92 254 94 14.59 15.36 -0.77 936 753 183 3.4 10.6 30.3 31.3 26.3 26.8 IOS 550 2005 5.98 284 68 15.08 16.38 -1.30 815 553 263 3.0 9.7 31.4 32.4 26.2 26.6 IOS 550 2008 6.00 333 23 12.81 13.20 -0.39 1189 1075 113 332 6.5 11.6 34.8 35.6 28.4 28.7 IOS 600 2008 6.51 334 22 14.39 14.77 -0.38 1115 1019 96 -2 5.6 11.5 35.0 35.9 28.3 28.7 FNCL 4.0 4.53 339 6 104.67 105.06 -0.39 16 11 6 -2 2.3 3.1 30.4 32.9 25.7 26.7 30yr CC (%) 3.09 2.88 21 5yr swap rate (%) 1.25 1.07 18 2s10s swaps (bps) 158 139 19 Source: BofA Merrill Lynch Global Research

Table 16 shows TBA (Oct settlement) runs using our prepayment model, as well as speeds with 50 bp up/down shocks to the curve.

Table 16: TBA runs using the BofA Merrill Lynch Prepayment model, as of 9/29 Up/Down 50 bp Parallel Shifts TBA Assumptions Curve: LIBOR CPR 12-mo CPR Life Eff DV01

TBA Cpn Price Yield WAL WAC WAM WALA ACLS OAS ZVOAS Eff Dur Eff DV01 Eff Conv Up 50

Base Case

Down 50

Up 50

Base Case

Down 50

Up 50

Base Case

Down 50

FNCL 3.5 102.53 3.0 6.0 4.00 357 2 244,000 21 100 4.6 0.05 -1.9 2 7 27 8 13 25 0.06 0.05 0.01 4.0 104.67 2.3 3.2 4.53 357 2 244,000 16 107 2.6 0.03 -2.8 9 30 48 14 26 35 0.04 0.03 0.00 4.5 105.92 2.3 3.0 4.96 346 10 250,000 36 118 2.2 0.02 -2.0 18 34 45 19 27 33 0.04 0.02 0.00 5.0 107.38 2.2 3.0 5.48 336 20 235,000 48 118 1.8 0.02 -1.3 26 36 43 22 28 32 0.03 0.02 0.00 5.5 108.42 2.2 2.9 6.05 322 33 225,000 58 109 1.7 0.02 -1.0 30 36 41 25 29 32 0.03 0.02 0.00 6.0 109.61 2.1 2.7 6.46 325 30 225,000 60 109 0.9 0.01 -0.9 31 38 45 26 30 34 0.02 0.01 -0.01 6.5 110.25 2.2 2.6 6.98 325 30 170,000 78 129 0.5 0.01 -0.9 33 40 46 27 31 36 0.01 0.01 -0.01 FNCI 3.5 104.39 2.0 3.2 4.05 177 2 219,000 19 70 2.3 0.02 -1.4 13 26 39 14 21 28 0.03 0.02 0.00 4.0 105.45 2.0 3.0 4.41 171 7 205,000 30 79 1.9 0.02 -1.0 20 30 40 18 23 29 0.03 0.02 0.00 4.5 106.47 2.1 2.9 4.89 154 21 180,000 48 92 1.7 0.02 -0.9 22 30 39 19 23 28 0.02 0.02 0.00 5.0 107.42 2.1 2.8 5.57 146 30 128,000 59 100 1.4 0.02 -0.8 24 31 39 20 24 29 0.02 0.02 0.00 5.5 108.41 2.2 2.8 6.03 129 45 105,000 80 115 1.4 0.02 -0.6 22 29 36 19 23 27 0.02 0.02 0.00 6.0 108.44 2.8 3.0 6.47 123 51 83,000 144 173 1.7 0.02 -0.5 20 25 32 17 20 24 0.02 0.02 0.01 6.5 108.44 2.6 2.4 6.91 73 102 45,000 164 179 1.4 0.02 -0.6 14 17 22 14 17 20 0.02 0.02 0.00 FGLMC 3.5 102.45 3.0 5.7 4.00 356 2 257,000 22 103 4.6 0.05 -1.9 2 7 29 8 14 26 0.06 0.05 0.01 4.0 104.54 2.4 3.2 4.52 356 2 257,000 21 112 2.7 0.03 -2.9 9 30 48 14 26 35 0.04 0.03 0.00 4.5 105.66 2.4 3.0 4.96 346 10 250,000 44 126 2.3 0.02 -2.1 18 34 45 19 27 33 0.04 0.02 0.00 5.0 107.03 2.4 3.0 5.48 336 20 235,000 59 130 1.9 0.02 -1.4 25 36 43 22 28 32 0.03 0.02 0.00 5.5 108.06 2.5 3.0 6.05 322 33 225,000 76 128 1.9 0.02 -1.1 29 34 39 25 28 31 0.03 0.02 0.00 6.0 109.50 2.3 2.8 6.46 325 30 225,000 72 121 1.2 0.01 -0.9 31 36 42 26 29 32 0.02 0.01 0.00 6.5 110.56 2.3 2.8 6.95 325 30 170,000 83 134 0.8 0.01 -1.0 31 36 44 26 29 33 0.02 0.01 -0.01 FGCI 3.5 104.28 2.0 3.1 4.03 177 2 223,000 22 73 2.2 0.02 -1.3 14 27 40 15 22 28 0.03 0.02 0.00 4.0 105.31 2.1 3.0 4.41 171 7 205,000 35 85 2.0 0.02 -1.1 20 30 40 18 23 29 0.03 0.02 0.00 4.5 106.30 2.1 2.9 4.89 154 21 180,000 55 99 1.7 0.02 -0.9 22 30 39 19 23 28 0.02 0.02 0.00

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Table 16: TBA runs using the BofA Merrill Lynch Prepayment model, as of 9/29 Up/Down 50 bp Parallel Shifts TBA Assumptions Curve: LIBOR CPR 12-mo CPR Life Eff DV01

TBA Cpn Price Yield WAL WAC WAM WALA ACLS OAS ZVOAS Eff Dur Eff DV01 Eff Conv Up 50

Base Case

Down 50

Up 50

Base Case

Down 50

Up 50

Base Case

Down 50

5.0 107.30 2.1 2.8 5.59 143 30 120,000 65 105 1.4 0.01 -0.8 24 31 39 20 24 29 0.02 0.01 0.00 5.5 108.22 2.3 2.8 6.03 129 45 105,000 88 124 1.4 0.02 -0.7 22 29 36 19 23 27 0.02 0.02 0.00 6.0 108.44 2.8 2.9 6.47 123 51 83,000 147 176 1.7 0.02 -0.5 20 25 32 17 20 24 0.02 0.02 0.01 6.5 108.44 2.6 2.3 6.91 73 102 45,000 167 182 1.4 0.02 -0.6 14 17 22 14 17 20 0.02 0.02 0.00 GNSF 4.0 106.67 2.4 4.6 4.50 358 2 230,000 3 92 2.9 0.03 -1.7 5 12 27 12 18 27 0.04 0.03 0.00 4.5 108.38 1.9 3.6 5.00 349 9 215,000 -5 86 1.1 0.01 -2.6 12 26 44 15 23 33 0.03 0.01 -0.01 5.0 109.53 1.8 3.2 5.50 339 19 200,000 10 68 1.4 0.02 -0.9 24 34 41 20 25 29 0.02 0.02 0.00 5.5 110.36 2.2 3.5 6.00 336 21 154,000 51 105 1.7 0.02 -0.9 23 31 39 19 23 27 0.03 0.02 0.00 6.0 111.36 2.5 3.7 6.50 335 22 139,000 82 136 1.6 0.02 -1.0 22 30 38 18 23 26 0.03 0.02 0.00 6.5 111.75 2.9 3.8 7.00 335 22 113,000 127 175 1.7 0.02 -0.8 22 30 36 18 22 25 0.03 0.02 0.01 G2SF 4.0 106.64 2.5 5.2 4.41 358 2 205,000 9 94 3.2 0.03 -1.8 4 9 22 11 16 23 0.05 0.03 0.00 4.5 108.13 2.3 4.2 4.87 351 8 195,000 13 103 1.8 0.02 -2.6 10 20 37 14 20 29 0.03 0.02 -0.01 5.0 109.56 2.0 3.5 5.33 344 15 170,000 17 83 1.4 0.02 -1.5 20 31 42 18 24 29 0.03 0.02 0.00 5.5 110.48 2.2 3.6 5.92 337 21 158,000 49 105 1.6 0.02 -1.0 22 31 39 19 23 27 0.03 0.02 0.00 6.0 111.02 2.6 3.7 6.44 334 23 143,000 89 144 1.6 0.02 -1.1 21 30 38 18 23 26 0.03 0.02 0.00 6.5 110.23 3.3 3.8 6.87 334 23 122,000 159 210 1.8 0.02 -1.0 21 29 38 18 22 26 0.03 0.02 0.00 Source: BofA Merrill Lynch Global Research

Table 17 shows risk characteristics for CMOs.

Table 17: Model risk characteristics for representative CMO structures across the maturity spectrum, as of 9/28 Bond Type Description Price Yield WAL 12-mo CPR OAS Eff Dur Eff Conv PACs 3.5/4.75 G2SF PAC 105.67 1.18 2.6 20.5 -5 1.1 -1.3 4.5/4.5 FGJMT PAC 107.48 1.56 2.7 37.4 16 1.4 -0.5 3.5/4.5 G2JM PAC 105.63 1.37 2.8 15.8 -7 1.0 -2.0 4/5.5 FGIOH PAC 105.50 1.90 2.8 34.7 10 2.5 -1.5 3.5/4.5 G2SF PAC 105.25 1.52 2.8 14.9 -5 1.3 -1.8 4/4.5 G2SF PAC 107.25 1.41 2.9 14.9 3 0.7 -1.6 4/5 GNSF PAC 107.77 1.73 3.7 28.2 3 2.1 -1.0 4.5/4.5 FGHLU PAC 110.05 3.35 10.3 2.0 73 7.8 -1.4 4/5 FGLMC PAC 106.91 3.23 10.7 12.8 37 7.2 -3.0 5/5 FNCL PAC LCF 111.94 3.73 11.9 27.8 83 8.8 0.4 4.5/4.5 FGJMT PAC LCF 109.78 3.55 12.8 37.4 54 9.5 1.8 5/5 FGLMC PACZ 114.03 4.01 13.5 31.6 78 10.5 3.6 4/4.5 G2SF PAC LCF 107.63 3.31 13.9 15.2 34 8.4 -2.3 4/4.75 G2SF PAC LCF 105.63 3.49 13.9 20.4 50 9.3 0.2 4/4 FGLMC PAC LCF 106.86 3.43 15.2 20.1 42 8.7 -2.3 SEQs 5.3/5.5 FGLMC SEQ 101.13 0.33 0.3 34.3 2 -0.1 -0.3 5.3/5.5 FGLMC SEQ 101.25 0.65 0.3 34.4 35 -0.2 -0.3 4.63/5 FGCI SEQ 102.73 0.52 0.7 30.4 25 -0.4 -0.6 4.5/4.5 FNCI SEQ 103.88 0.05 0.9 27.2 -30 -0.5 -1.0 5/5 FGLMC SEQ 107.25 0.75 1.8 30.4 51 -0.6 -2.3 4/4 FNCL SEQ 105.53 0.73 1.8 23.5 -5 -0.2 -3.4 5/5 FGLMC SEQ 108.27 0.97 2.1 30.0 52 -0.1 -3.4 4/4 FGTW SEQ 105.48 1.66 2.5 23.0 19 1.0 -2.5 4/4 FGTW SEQ 105.36 1.76 2.5 19.4 25 0.9 -2.7 3.5/4.5 G2SF SEQ 105.06 1.39 2.6 14.9 -17 1.3 -2.3 4/5 G2SF SEQ 106.36 1.61 2.9 28.0 8 1.8 -1.2 4.5/5 G2SF SEQ 107.89 1.63 2.9 25.9 19 1.4 -1.6 5.5/5.5 FNCT SEQ 111.36 1.36 2.9 35.3 2 0.9 -0.7 4/4 FNCT SEQ 106.78 2.12 3.9 30.1 33 4.4 -1.0 4/5 FGLMC PT 105.22 2.61 4.3 18.7 21 3.4 -2.6 2.25/4.7 G2SF PT 99.05 2.47 4.6 14.7 -24 5.5 -1.7 5/5 FGTW SEQ 115.14 2.77 7.6 30.4 52 6.6 -0.7 4/4 FNCL SEQ LCF 105.83 3.19 8.6 23.5 33 8.7 -1.3 4/4 FGLMC SEQZ 102.64 3.71 9.3 33.7 38 14.0 -2.0 4/4 G2TW SEQ LCF 109.13 3.13 12.8 20.3 30 9.8 -0.4 Source: BofA Merrill Lynch Global Research

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Table 18 shows the market payups for loan balance and seasoned pools. Table 18: Payups for loans balance and seasoned pools (ticks), as of 9/28 100% Refi, High LTV (MHA) LLB MLB HLB Investor 2005 2004 2003 80-90 90-95 95-100 100-105 4.0 29.0 23.0 14.0 4.0 4.5 60.0 50.5 28.5 16.0 14.0 18.0 26.0 20.0 28.0 30.0 30.0 5.0 70.0 59.5 42.5 20.0 7.0 11.0 12.0 25.0 31.0 34.0 36.0 5.5 64.0 56.0 28.0 18.0 19.0 20.0 6.0 60.0 48.0 26.0 20.0 24.0 32.0 Source: BofA Merrill Lynch Global Research

Table 19 gives the ratio of market payups to model payups. Table 19: OAS% (market payup / model payup), as of 9/28 100% Refi, High LTV (MHA) TBA Px LLB MLB HLB Investor 2005 2004 2003 80-90 90-95 95-100 100-105 4.0 104.47 33% 38% 33% 9% 4.5 105.86 62% 81% 72% 55% -181% -1275% -706% 28% 20% 21% 18% 5.0 107.39 47% 55% 55% 46% 52% 119% 106% 25% 16% 17% 16% 5.5 108.52 70% 115% 105% 71% 48% 59% 6.0 109.72 49% 72% 65% 28% 31% 42% Source: BofA Merrill Lynch Global Research

Table 20 shows carry versus TBA. Table 20: Carry versus TBA (ticks), as of 9/28 100% Refi, High LTV (MHA) TBA Speed (%) Roll Specialness LLB MLB HLB Investor 2005 2004 2003 80-90 90-95 95-100 100-105 4.0 11 0.9 -0.3 -0.2 -0.2 -0.2 4.5 19 0.2 1.9 1.8 1.6 1.2 -2.8 -2.1 -2.0 1.9 2.1 2.3 2.3 5.0 32 3.0 2.6 2.7 2.2 1.2 -2.1 -2.2 -2.5 1.9 2.6 2.9 3.1 5.5 36 2.2 5.2 4.5 4.0 0.0 1.0 0.5 0.2 6.0 34 2.1 3.8 2.3 1.7 0.0 2.3 2.3 1.9 Source: BofA Merrill Lynch Global Research

Table 21: Comparison of MBS spreads: now versus 2004-1H'07 04-1H'07 11/24/08 5/26/09 6/11/09 12/31/09 12/30/10 9/22/11 9/29/11 CC MBS ZVOAS(Tsy) 111 230 85 127 91 99 123 123CC MBS ZVOAS(Swap) 61 197 63 92 71 87 103 1042-yr Swap Spread 39 113 44 46 28 19 32 3010-yr Swap Spread 48 23 17 35 13 8 19 183mo*10yr Swapt Vol 86 200 167 196 125 123 110 1133yr*10yr Swapt Vol 93 138 131 143 131 116 106 106CC MBS LOAS -6 78 -35 -9 -19 12 24 27Z-spread, AAA & AA Industrials 13 242 119 109 60 71 92 895YR AAA Credit Card Fixed to Swaps 1 525 210 135 60 43 38 38Source: BofA Merrill Lynch Global Research

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Non-Agency MBS Market View Markets remain volatile as weak economic data continues to come in. Although BWIC volumes have been on the lighter side throughout the summer, there has been some pick up this month. BWICs came in at roughly $3.0 billion this week, compared to $2.5 billion last week, and $5.2 billion the week prior. BWIC activity was primarily centered at the start of the week and tapered off on Thursday and Friday. Throughout the week, trading was relatively choppy with many bonds DNT. One large list of ~$200 million jumbo fixed and hybrids ended up not trading on Thursday. Subprime and non agency prices generally felt weaker, flat to down by a point. Clarity around option ARM prices remains challenging given the lack of trades this week.

Given the economic landscape, investors continue to be in risk-off mode. In the subprime LCF space, yields remain in the 10-11% range, while ABX prices were down between 0.5 and 1.0 point on average week-over-week across the PAAA and AAA tranches. Since the start of the month, the PAAA tranches from the 06-2 to 07-2 series are down anywhere from 3-4 points. The 06-1 series continues to hold in with prices relatively flat. Since the start of the year, 06-2 to 07-2 AAA and PAAA tranches are down from their February peaks by 25%-30%.

Valuations are attractive given further price declines but prices will remain unstable in the short- to medium-term. We have been recommending slowly accumulating risk and focusing on higher credit quality segments of the market. This week we profile the prime jumbo sector backed by hybrid ARM collateral. It is time to reassess many sectors in the non-agency space. Over the long term, we believe that supply technicals will re-emerge as a driving force in the non-agency market. This week we profile what remains outstanding and how supply in the high quality sectors and investment grade paper continues to contract.

Chris Flanagan MBS/ABS Strategist +1 646 855 6119 [email protected] Ryan Asato MBS Strategist +1 646 855 6201 [email protected] Tim Isgro MBS Strategist +1 646 855 9301 [email protected] Jimmy Nguyen MBS Strategist +1 646 855 9710 [email protected]

Chart 12: Non-agency market prices

30

50

70

90

110

1/10 3/10 5/10 7/10 9/10 11/10 1/11 3/11 5/11 7/11 9/11

Jumbo FRM Jumbo Hy brid Alt-A FRM

Alt-A ARM Option ARM


Chart 13: ABX AAA Prices

30405060708090

100

1/10 3/10 5/10 7/10 9/10 11/10 1/11 3/11 5/11 7/11 9/11

06-1 AAA 06-2 AAA 07-1 AAA 07-2 AAA

Source: BofA Merrill Lynch Global Research, Markit

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Market Yields Table 22: Non-agency Prices and Yields Faster Slower Lower Higher Base Fwd Prin. Speeds Speeds Severity Severity Mod Sector Sub-Sector Vintage Price Scenario WAL WAL 150% CRR 50% CRR 80% LS 120% LS Scenario Jumbo Fixed Rate 2005 95.25 6.1 4.3 3.4 6.8 5.6 6.5 5.8 5.2 2006 95.25 5.3 4.4 3.8 5.5 5.2 5.8 4.8 4.4 2007 94.75 4.9 4.4 3.8 5.2 4.7 5.5 4.3 4.0 5/1 WAC 2005 85.50 7.5 5.4 5.3 7.9 7.0 7.5 7.4 6.4 2006 78.25 6.4 5.0 5.1 7.1 5.7 7.2 5.5 5.3 2007 75.00 6.9 5.2 5.5 7.6 6.2 7.8 5.9 5.8 Alt-A Fixed Rate 2005 70.00 8.1 12.3 3.7 9.2 7.1 9.6 6.7 7.4 2006 74.50 6.6 8.0 4.2 7.2 6.0 8.4 5.1 6.0 2007 74.00 6.7 10.0 4.1 7.2 6.2 8.5 5.1 6.1 5/1 WAC 2005 63.50 9.7 8.6 6.6 10.2 9.2 10.8 8.6 8.9 2006 40.50 9.6 6.9 6.2 10.5 8.9 12.8 7.4 8.5 2007 52.50 8.6 4.7 5.0 9.7 7.5 12.2 5.5 6.9 5/1 Floater 2005 47.50 10.5 5.7 5.9 11.3 9.8 13.8 8.0 9.1 2006 41.50 9.1 4.1 4.8 10.8 7.6 14.0 5.9 7.3 2007 49.50 10.5 4.7 5.2 11.6 9.5 15.3 6.7 8.3 Option ARM 2005 63.50 10.5 5.9 5.8 10.7 10.2 11.6 9.2 9.4 2006 55.00 12.4 4.4 4.2 12.7 12.1 16.2 8.5 10.1 2007 56.50 12.2 6.4 4.9 12.8 11.7 14.9 9.4 10.3 Source: BofA Merrill Lynch Global Research

Table 23: Subprime Prices and Yields Faster Slower Lower Higher Base Fwd Prin. Speeds Speeds Severity Severity Mod Vintage Crossover Tranche Price Scenario WAL WAL 150% CRR 50% CRR 80% LS 120% LS Scenario 2005 Pro Rata Current Pay 94.50 6.0 1.1 1.1 6.5 5.6 7.2 4.7 5.0 LCF 81.50 8.0 3.1 2.9 8.7 7.2 10.1 6.0 6.7 Sequential Current Pay 95.50 5.8 0.9 0.9 6.3 5.2 6.7 5.7 5.8 LCF 82.50 6.8 3.6 3.3 7.4 6.4 8.7 6.3 6.7 2006 Pro Rata Current Pay 95.00 6.4 0.9 0.9 6.9 5.9 7.5 3.5 5.6 Mid Pay 50.75 5.3 24.1 5.4 6.2 4.4 12.5 -0.4 5.5 LCF 35.25 9.4 28.0 6.7 10.0 8.8 12.2 5.6 9.7 Sequential Current Pay 93.50 2.7 1.1 1.1 4.0 1.4 7.4 -3.5 2.2 Mid Pay 39.75 9.3 3.5 3.9 11.1 7.6 20.9 -1.0 8.4 LCF 18.25 7.1 5.8 11.0 7.8 6.5 13.0 2.8 9.3 2007 Pro Rata Front Pay 96.50 12.4 0.3 0.3 14.3 10.7 14.8 9.6 10.6 Second Pay 40.75 5.0 18.6 4.0 6.5 3.7 16.2 -4.0 5.0 Penultimate 27.25 9.8 21.1 5.2 10.7 8.9 17.1 1.5 9.7 LCF 27.25 10.1 21.1 5.2 11.0 9.2 17.3 1.8 10.0 Sequential Front Pay 96.50 6.9 0.6 0.5 7.3 6.6 8.5 5.1 5.6 Second Pay 79.50 9.8 2.0 2.0 10.4 9.1 15.4 -1.5 6.0 Penultimate 28.25 11.8 4.6 5.3 12.6 10.9 25.5 1.9 9.6 LCF 15.75 7.4 7.3 14.6 7.8 7.1 12.0 3.9 9.4 Source: BofA Merrill Lynch Global Research

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Table 24: ABX Prices and Yields Faster Slower Lower Higher Higher Base Fwd Prin. Speeds Speeds Severity Severity Defaults Mod Tranche Index Price Scenario WAL WAL 150% CRR 50% CRR 80% LS 120% LS 120% CDR Scenario PennAAA 06-1 80.10 -0.3 2.1 2.4 0.4 -0.9 5.7 -4.2 -1.6 0.3 06-2 69.65 3.1 3.1 3.0 3.8 2.3 11.1 -3.0 1.2 3.3 07-1 43.15 2.3 4.2 5.2 3.1 1.4 10.7 -3.6 -0.3 3.3 07-2 35.49 2.4 4.3 6.1 3.0 1.8 9.4 -3.1 0.0 3.7 AAA 06-1 86.83 2.2 3.5 3.3 2.3 2.1 5.0 0.2 1.7 2.4 06-2 43.95 2.7 6.2 8.2 3.4 2.0 9.6 -2.5 0.1 4.4 07-1 35.20 1.7 4.8 7.5 2.2 1.2 7.4 -2.9 -0.6 3.2 07-2 34.07 1.8 4.5 7.0 2.2 1.3 7.5 -2.8 -0.6 3.4 Source: BofA Merrill Lynch Global Research

A compelling case for jumbo floaters Overall investor interest in the non-agency space has certainly waned over the past few months. Prices have declined to the point that we think it is time investors take a fresh look at all sectors.

One sector that has been neglected by investors for some time is floating rate bonds off of jumbo prime or alt-A ARM collateral. These bonds have been neglected relative to fixed rate MBS for a few reasons. First, the bonds have relatively low carry compared to fixed rates. Second, ARM collateral performance is relatively worse, which introduces some risks around performance projections and loan modifications. The worse collateral performance also makes it less likely that these bonds will have retained investment grade ratings, one segment of the market that has maintained strong investor interest.

With all that in mind, there are bonds out there that have suffered too much in terms of price performance relative to fundamentals. Here, we take a look at a super senior WAC floater off of jumbo hybrid ARM collateral, preferring to stay with higher credit quality collateral given the market pricing that prevails.

A representative deal and collateral We profile here one super senior security off of jumbo 5/1 collateral originated in 2006. The bond is rated Caa2 by Moody’s and CC by Fitch. The collateral is indexed to the 1-year CMT index. Table 25 shows the characteristics of the collateral and Table 26 shows the deal structure. We will leave the exact name of the deal aside, but it should not be difficult to find deals like it.

Table 26: Sample Jumbo ARM Deal Class Original bal (mm) Current bal (mm) Factor Orig CE Curr CE Coupon Coupon Formula Moody's Fitch 1A1 $557,245 $265,585 0.48 13.74% 6.12% 2.50% lesser of 1yCMT+240bps and net WAC Caa2 CC 1A2 $61,916 $17,305 0.28 4.15% 2.50% lesser of 1yCMT+240bps and net WAC C D M1 $14,212 $0 0.00 1.95% 2.75% net WAC NR D M2 $4,844 $0 0.00 1.20% 2.75% net WAC NR D M3 $2,584 $0 0.00 0.80% 2.75% net WAC NR D B1 $1,938 $0 0.00 0.50% 2.75% net WAC NR D B2 $1,615 $0 0.00 0.25% 2.75% net WAC NR D B3 $1,616 $0 0.00 0.00% 2.75% net WAC NR NR XA $619,161 $282,891 0.46 0.25% net WAC - 1yCMT+240bps, floor of 0% Caa2 WD Source: Bloomberg, Intex, BofA Merrill Lynch Global Research

Chart 14 to Chart 16 shows the deal prepayments, defaults, and loss severities over the past few years. In addition, our roll rate credit model projections are appended to the historical data in each chart. Our base case model projects

Table 25: Deal collateral characteristics Num of loans 477 Balance $282,890,548 Factor 0.44 Avg loan size $593,062 Loan type 5/1 ARM Index 1yr CMT WALA 63 Vintage 2006 Geography 58% CA, 7% FL Avg orig FICO 741 Avg curr FICO 704 MTM CLTV 128% 3mo CRR 8.0% 3mo CDR 9.7% 3mo Sev 42.7% DQ 60+ 17.4% Always curr 58.7% Never 60+ 68.3% Source: LoanPerformance, Bloomberg, BofA Merrill Lynch Global Research

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prepayments to decline, given that these loans will be post-reset floaters very soon. We also project default rates to increase somewhat as foreclosure pipelines become more efficiently liquidated on the heels of process reviews and potential mandates from the Attorneys General. Loss severities are also projected to increase slightly on modestly weaker housing and increased timelines, and then projected to fall as we project housing to begin its recovery in 2013. We think that any recovery in housing tends to be ignored by investors pricing bonds in the space.

We start here as a base case to get a feel for valuation at current market pricing and then consider value across different risks scenarios.

Table 27 shows the results of valuing the super senior security in the context of its market price in the low 70s using our base case model inputs. We assume interest rates remain at their current levels for simplicity. Under forward rates, yields are higher on very modestly tighter DMs, as the bond benefits from increased coupon while marginally suffering due to increased defaults. In our base case, the bond is priced to yield 6.7% for a DM of 642bps on an average life of 4.7 years. The model projects that 20.6% of the currently outstanding collateral is lost, resulting in a writedown to the 1A1 super senior of 15.6%. The DM resulting from our model run is slightly higher than where we think the market prices similar bonds. Anecdotal evidence points to non-investment grade jumbo super senior floating rate bonds pricing in a market context of a 550-600bps DM currently. That pricing is a little tighter primarily since the market gives almost no credit for a distant improvement in severities. As a comparison, changing our model severity to 45% for life takes the DM down to 597bps.

Base case valuation for this bond certainly looks compelling. But what about risks around this scenario? We discuss a few of the most pertinent risks below and then present a valuation across various scenarios representing these risks.

Weak housing market While the valuation appears compelling in our base case, what if housing remains weak? How much of the cheapness is due to some accounting for potential credit deterioration and increases in losses due to a renewed housing downturn?

Chart 14: Historical and projected prepayments for the deal

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Chart 15: Historical and projected defaults for the deal

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Chart 16: Historical and projected loss severities for the deal

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Table 27: Base case model projections Price 72-16 Yield 6.7% DM 642 WAL 4.7 Mod Dur 3.7 Collat Liq 50.2% Collat Loss 20.6% Prin Writedown 15.6% Source: BofA Merrill Lynch Global Research

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To get a feel, we make the very bearish assumption of home prices being down 20% in the coming year, followed by no appreciation for 2 years, and then a modest recovery of 3% a year. This assumption would result in a CDR curve that peaks at 20% CDR with severities peaking at 62%. Lifetime severity is 15 points higher than in the base case (56% vs 41%). The results are shown in Table 28.

Heavy modifications The deal has been subject to some loan modification activity over the past three years. Currently, 13% percent of the outstanding collateral has had a loan modification, with 88% rate reductions and 8% capitalizations. Going forward, we anticipate that loan modification activity will decrease. The reasons for this are twofold: the exhaustion of distressed borrowers as they are evaluated for modifications once and the lower payments that 5/1 ARM borrowers will have post-reset. A 5/1 IO borrower with a $500,000 loan at an initial 6% rate pays $2,500 in interest per month pre-reset. Post-reset, even with an IO term that expires after 60 months, the payment drops to $2,067 at a floating rate of 1yrCMT + 275bps.

As an indication of modification activity, 2005 5/1s were modified at a rate of 0.13% per month in 2011 versus 0.15% per month for 2010. 2006 5/1s were modified at a rate of 0.19% over the past 6 months versus 0.30% for the 6 months prior. Resets are making a difference, and this has been reflected in lower transition rates into distress after reset.

Nevertheless, there is some risk that increased loan modifications come through as a result of mandated activity from the Attorneys General, for instance. Can we dimension a draconian scenario?

To do so, let’s imagine the extremely bearish scenario in which every borrower delinquent today in the pool has 30% of their principal forgiven tomorrow. Let’s also give no credit for the lower defaults that will result from the modifications. (At 20% 60+ DQ, this basically amounts to writing off an additional 6% of the pool.) The results are shown in Table 28.

Worse performance than modeled In addition to these explicit risks, we also analyze some generic large deviations around our model base case. These are shown in Table 28 as well.

Table 28: Valuation across base case and stress scenarios for super senior class 1A1, rated Caa2

Base Housing Down

20% Harsh

Forgiveness Severity 150% CDR 150% CDR 50% CRR 50% Severity 150%,

CDR 150% Price 72-16 72-16 72-16 72-16 72-16 72-16 72-16 72-16 Yield 6.7% 3.7% 5.3% 3.4% 5.1% 7.9% 5.5% 0.0% DM 642 354 512 323 493 760 524 -14 WAL 4.7 4.7 4.5 4.7 3.6 6.3 5.7 3.6 Mod Duration 3.7 4.1 3.8 4.5 3.1 4.3 4.6 4.2 Collateral Liquidation 50.2% 53.1% 53.2% 50.2% 63.3% 30.4% 57.4% 63.3% Collateral Loss 20.6% 29.9% 25.3% 30.8% 26.8% 12.0% 22.7% 40.1% Principal Writedown 15.6% 25.5% 19.9% 26.4% 22.4% 6.4% 17.6% 36.5% Source: BofA Merrill Lynch Global Research

Conclusions and the floating rate non-agency market Our analysis shown above makes a case for compelling valuation in the jumbo floating-rate sector today. Yields are robust in the 5-6% range for most scenarios considered, with DMs in the 500-600bps context. This puts the bond in the context of the BofA Merrill Lynch corporate high yield BB index, which currently trades to an asset swap spread of 564bps. The rating of the jumbo floater is Caa2, however and importantly, the high yield indices are not loss adjusted.

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Yields break down to levels in the 3% range only when very harsh severities are considered, like the scenario in which housing is down 20%. Average lives are relatively consistent as well, in the 4-5 year range. Only when defaults slow by a very large 50% does the bond extend to 6.3 years, however, it carries a much higher yield and DM at 7.9% and 760bps.

The bond yields a value of 0% only when we treat it very harshly, with defaults and severities increasing by 50%. A severity increase like that is consistent with a scenario worse than housing down 20%. And to have defaults increase that much implies very bearish performance given what should prove to be lighter post-reset debt service. We note here that this pool is composed of a borrower class that is 58% always current and 68% never 60+. This performance was maintained through the worst of the housing crisis with higher loan rates and mortgage payments than will prevail today post-reset, as mentioned.

All of this points to what we think is a compelling valuation for super seniors off of jumbo hybrid collateral, especially near reset. Bank portfolio investors may shun these bonds due to their low ratings, and hedge funds may as well due to yields (absent leverage) lower than their typical bogeys. As a result, investors unconstrained by ratings mandates and those able to take a longer term view, sacrificing carry for value, should find value in this space that has been vacated by others. With that in mind, we think unconstrained money managers and insurance company investors could benefit from some exposure. In fact, the bond here carries an NAIC 1 price of just over 87, so capital reserve issues need not apply. We think it is time to reassess many sectors in the non-agency space that have been ignored for too long.

What’s left? Supply technicals have been one of the key drivers of value in the non-agency sector over the past two years. Strong technicals dominated the markets at the beginning of the year until they became imbalanced with the Maiden Lane II sales which started in April. Macro fundamentals then took over as weaker than expected economic growth, the US debt crisis, then the turmoil in Europe weighed in on the markets. However, over time, to the extent we start to see signs of stability, supply technicals should again re-emerge as a support to the non-agency market. In addition to the shrinking universe of bonds, investors continue to receive paydowns which, at some point, will have to be reinvested. Parking the paydowns in cash earning next to nothing should become more and more painful for money managers.

The universe of non-agency bonds continues to decline with monthly paydowns coming in around $20 billion (Chart 17). Through August, there have been about $160 billion in paydowns so far this year. Outstandings, approximately $1.35 trillion, are about half of the market’s peak at the end of 2007. Also, if you factor in current prices, the market value of the outstanding securities is even lower. Chart 18 shows the market mix is still skewed towards subprime collateral which makes up a little more than a third of the market. Jumbo collateral makes up about 20% of the market and its share has decreased slightly since the peak of the market due to faster prepayments.

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Investment Grade Universe Shrinking Investment grade paper has continued to enjoy strong support and liquidity amidst the market upheaval. Many of the outstanding investment grade tranches are either seasoned or backed by stronger prime fixed collateral. Given the market volatility, investors have moved up in credit looking for safer havens. In addition, there are some investors with mandates requiring them to invest in IG assets. Other investors, such as banks, may be constrained by capital requirements against non-investment grade assets.

Currently, of deals issued prior to 2008 excluding ReREMICs, approximately $36 billion of the non-agency universe is rated triple-A with the majority, $21.5 billion, backed by prime jumbo collateral. In addition, $26.8 billion is backed by seasoned collateral from the 2004 vintage or prior. Broadening the scope to include all investment grade tranches, $187 billion remains. About 24% of the jumbo sector is investment grade compared to only 8%, 1%, and 12% of alt-A, option ARM, and subprime tranches outstanding, respectively.

Table 29 shows the distribution of ratings for the non-agency sectors comparing each tranche’s original versus its current rating. For example, of the alt-A tranches issued before 2008 which were originally rated AAA, $347 billion remains outstanding. Of those, only 1.5% remains AAA and 8.5% investment grade with the majority of the tranches having been downgraded to CCC or lower.

Chart 17: Non-Agency Outstandings ($ trillion)

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Chart 18: Outstandings by Sector

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Source: BofA Merrill Lynch Global Research, Loan Performance

Chart 19: Jumbo Outstandings by Rating

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Note: Lowest of Moody’s, Standard & Poors, and Fitch Source: BofA Merrill Lynch Global Research, Moody’s, Standard & Poors, Fitch

Chart 20: Alt-A Outstandings by Rating

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Chart 21: Subprime Outstandings by Rating

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Table 29: Outstanding Non-Agencies by Original and Current Ratings - 2007 vintage and prior Original Current Current Rating Sector Rating Balance AAA AA A BBB BB B CCC CC C IG Alt-A AAA 347,190 1.5% 1.6% 1.7% 3.7% 2.8% 4.4% 23.1% 16.6% 44.6% 8.5% AA 12,934 1.5% 7.1% 2.2% 3.5% 3.2% 4.5% 11.5% 10.7% 55.6% 14.3% A 3,436 0.7% 1.3% 4.5% 2.7% 1.9% 5.2% 12.9% 14.1% 55.9% 9.2% BBB 1,619 0.1% 0.7% 0.3% 7.6% 1.3% 1.5% 6.4% 17.1% 64.3% 8.7% BB 289 0.0% 0.0% 0.0% 0.0% 0.7% 0.4% 2.3% 25.9% 70.3% 0.0% Subprime AAA 304,640 3.3% 3.8% 2.6% 2.4% 4.3% 8.3% 21.3% 24.2% 29.0% 12.2% AA 99,561 0.0% 4.0% 4.4% 4.8% 7.5% 9.4% 10.2% 7.9% 51.6% 13.2% A 36,286 0.0% 0.1% 1.1% 1.1% 2.1% 3.5% 8.3% 12.9% 70.6% 2.3% BBB 14,987 0.0% 0.1% 0.1% 0.6% 0.9% 1.6% 1.9% 8.2% 86.2% 0.8% BB 1,054 0.0% 0.0% 0.2% 0.0% 0.8% 1.7% 1.2% 4.6% 85.6% 0.2% Jumbo AAA 253,206 8.2% 3.1% 5.6% 6.9% 7.3% 13.1% 20.7% 19.0% 14.6% 23.8% AA 11,543 2.1% 5.7% 2.0% 3.5% 3.8% 5.1% 10.7% 16.3% 39.2% 13.4% A 3,096 1.4% 2.5% 4.3% 3.2% 2.9% 7.8% 11.0% 21.1% 43.0% 11.3% BBB 1,447 0.7% 1.1% 2.3% 3.3% 2.6% 4.8% 9.5% 21.6% 49.8% 7.4% BB 638 0.1% 0.2% 0.9% 2.3% 1.9% 1.6% 5.6% 23.1% 60.0% 3.5% Option ARM AAA 156,013 0.0% 0.7% 0.2% 0.2% 0.8% 2.5% 41.3% 18.4% 35.8% 1.1% AA 5,052 0.0% 0.0% 0.0% 0.0% 0.2% 0.9% 2.6% 7.7% 88.1% 0.0% A 803 0.0% 0.0% 0.0% 0.0% 0.2% 0.0% 0.0% 12.2% 87.4% 0.0% BBB 224 0.0% 0.0% 0.0% 0.0% 0.0% 0.3% 0.0% 2.9% 96.2% 0.0% BB 48 0.0% 0.0% 0.0% 0.2% 0.0% 0.0% 0.9% 5.3% 93.4% 0.2% ReREMIC AAA 41,155 8.4% 5.2% 1.1% 4.1% 4.0% 4.6% 43.5% 11.9% 9.5% 18.8% AA 305 1.2% 7.6% 6.4% 1.5% 6.5% 1.0% 24.8% 7.6% 16.1% 16.7% A 408 0.6% 24.8% 25.4% 5.5% 0.7% 8.9% 1.5% 15.9% 5.7% 56.2% BBB 395 0.1% 0.1% 0.0% 13.8% 3.6% 1.8% 55.3% 7.5% 4.7% 13.9% BB 895 0.0% 0.0% 0.0% 1.3% 2.1% 2.6% 14.9% 28.1% 40.7% 1.3% Note: Lowest of Moody’s, Standard & Poors, and Fitch Source: BofA Merrill Lynch Global Research, Moody’s, Standard & Poors, Fitch

Also contributing to the shrinking size of the investment grade universe is the decline in ReREMIC issuance. This year, there has only been about $20 billion of ReREMICs issued, of which only $10 billion was rated investment grade (the remainder was not rated). This compares to $54 billion issued in 2010 where $34.6 billion was rated investment grade. In addition, a large portion, $7.5 billion, of the deals done this year have come from the NCUA. The decline in ReREMIC activity is primarily due to changes in rating agency criteria in conjunction with market pricing which has made the arbitrage unattractive.

CDOs Continue to Bring Supply to the Market CDOs have continued to be a source of supply. In September, there were four structured finance CDO liquidations amounting to $2.0 billion of current face coming into the market. This made up about 18% of total BWIC volume this month and an even larger portion of the bonds that actually traded. So far in 2011, based on Standard and Poors data, 30 structured finance CDOs have been liquidated. That brings the total to 165 CDOs liquidated since the start of the crisis. Chart 22 shows the number of structured finance CDO liquidations by year. As seen, this year saw a jump in the number of high grade CDOs liquidated over the past two years bringing more alt-A, option ARM, and jumbo collateral into the mix.

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Chart 22: SF CDO Liquidations by Year

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Source: BofA Merrill Lynch Global Research, Standard & Poors, Intex,

Table 30 shows total non-agency outstandings for vintages prior to 2008. The table breaks out by sector and vintage the amount of collateral that is currently held in CDOs or ReREMICs. Currently, about 20% of the remaining outstanding securities are in CDOs or back ReREMICs. The portion of collateral backing ReREMICs should remain out of the market taking out $106 billion of potential supply. Another $144 billion remains in CDOs, some of which will ultimately end up being liquidated. About 44% of the remaining structured finance CDOs have hit triggers and had an event of default called or have been accelerated. Table 30: Outstanding Non-Agencies in CDOs and ReREMICs - 2007 vintage and prior Outstanding ($MM)

Collateral Vintage Total Gross ReREMIC CDO Net of CDOs

and ReREMICs Alt-A <=2004 47,307 2,013 4,546 40,748 2005 99,764 9,484 11,148 79,131 2006 119,533 19,769 12,160 87,604 2007 101,302 16,222 6,826 78,253 Total 367,905 47,488 34,680 285,737 Subprime <=2004 73,464 1,284 15,957 56,223 2005 99,941 1,855 33,704 64,382 2006 176,805 2,613 26,021 148,170 2007 129,957 1,897 15,837 112,223 Total 480,167 7,649 91,519 380,999 Jumbo <=2004 90,013 3,451 3,473 83,089 2005 67,426 11,022 3,657 52,746 2006 60,687 11,787 2,932 45,968 2007 75,411 17,904 1,985 55,522 Total 293,537 44,164 12,047 237,325 Option ARM <=2004 4,550 44 439 4,067 2005 34,796 2,138 2,110 30,548 2006 68,625 2,762 2,637 63,226 2007 54,509 2,172 752 51,585 Total 162,479 7,116 5,937 149,427 Total 1,304,088 106,417 144,184 1,053,487 Source: BofA Merrill Lynch Global Research, Intex

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Potential near-term supply from Europe should be contained Last week, our European structured finance analysts detailed the amount of US legacy assets held by European banks as concerns of forced liquidations have risen given the European debt crisis.6 There have been concerns that this could be a potential source of additional non-agency supply in the near term. Based on bank disclosures, about $30 billion of non-agency securities are specifically broken out. Another $45 billion of US RMBS was disclosed but there was no breakdown between agencies and non-agencies. As such, the team estimated somewhere between $60-65 billion in US non-agency exposures.

At this point, they believe that while risks are rising, they remain manageable. During this crisis, the focus has been on sovereign risk and not structured products, as was the case earlier. With respect to structured products, the main issue is the ability to fund these positions. They believe the banks have strong incentives not to crystallize losses and instead find alternative funding to avoid forced liquidations. They point to secured funding trades and liquidity swaps allowing the banks to pledge illiquid assets in return for cash or liquid securities. In addition, they point to decreased exposures and leverage relative to the 2007/2008 timeframe as SIVs and conduits have wound down since then.

Conclusion Near term technicals will continue to be influenced by the demand side of the equation and concerns about potential supply coming from Europe. However, over the long term, supply technicals should again become the overriding force driving the market. Limited supply in high quality sectors such as prime fixed and investment grade bonds will continue to provide support for these sectors.

Market News S&P places Assured Guaranty on negative watch S&P placed Assured Guaranty on negative credit watch this week due to ‘concentrated’ risk in its “structured finance and public finance insured portfolios.” In early August, S&P placed Assured’s credit rating on negative outlook following S&P’s downgrade of US long term debt to AA+. According to Assured’s press release regarding the rating decision, the revised outlook stems from “S&P’s new criteria for determining financial strength of financial guaranty companies.” In response, Assured stated that it is in the process of implementing strategies such as rep and warranty putbacks and “negotiated comprehensive agreements,”.

Banks face broad investigations from SEC and FTC The Financial Times reported this week that the SEC is broadly investigating how banks have handled securitized mortgage loans. According to the article, the issues under investigation involve repurchase requests and whether banks have misled investors about the number of loans that need to be repurchased as well as the level of reserves for litigation. The SEC is also looking into whether banks knew about securitized loans that did not meet underwriting standards, as well as related settlements with originators. While RBS and Credit Suisse have been involved in the investigation, the SEC is probing a wide range of financial institutions such as JPMorgan and Goldman Sachs, according to the article.

6 European Structured Finance, 23 September 2011

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American Banker similarly reported that the Federal Trade Commission is investigating “abusive practices” by servicers such as “inaccurate payment records and charging excessive fees.” The FTC targeted Ocwen back in March, but is looking into practices at other servicers according to Joel Winston, an FTC associate cited in the article. It was also reported that the FTC is also working with the newly created Consumer Finance Protection Bureau (CFPB), which highlights the broad reach of investigations as they span across multiple government agencies including the Fed, as well as state Attorneys General. As we have mentioned above and in previous publications, credit will remain tight until banks can move past these issues, and the uncertainty and magnitude of litigation subsides. That appears to be a long way off.

Foreclosure fraud prevention law in Nevada goes into effect on Oct. 1 On May 20 this year, Nevada Governor Brian Sandoval approved Assembly Bill 284, which primarily revamps foreclosure processing and requires servicers to record all foreclosure-related documents with the county clerk’s office. The bill, which goes into effect on October 1, also ensures that servicers have proper documentation and legal authority to foreclose upon defaulted borrowers. Servicers have been under pressure from regulators to improve their procedures in order to avoid robo-signing issues that prompted consent orders from the Fed and foreclosure fraud laws such as Nevada’s. Although these new processes will be beneficial in the long run, higher compliance and implementation costs will keep loss severities elevated.

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CMBS Recap, relative value & recommendations Although market sentiment improved early in the week as German lawmakers approved the expanded EFSF, markets drifted lower into the end of the week as the third quarter left in much the same fashion as it began – poorly. Investor sensitivity to macro risk continued to dominate market activity this week, and markets rallied globally as European lawmakers continued to broadcast their commitment to reaching an agreement regarding the debt crisis in Europe. CMBS markets on Monday failed to follow the momentum of larger markets due to the roughly $600 million in for the bid, and although spreads tightened slightly on Tuesday, they leaked wider for the remainder of the week (Table 31).

There has been a significant amount of ink spent over the past few months to discuss the recent slowdown in loan origination volume, and hence, future issuance expectations. We, too, have reduced our 2011 issuance expectations as macro uncertainty and volatility ratcheted higher and currently look for gross issuance of about $25 billion, which means we believe only another $3bn will price by year end. To this point, one of the questions we get most frequently from investors is: are conduit originators making loans, and if not, why? The quick answer is that while conduit originators are actively quoting loans, the success rate is fairly low. Even without the recent spread volatility, over the past year conduit originators have lost considerable market share (especially among trophy assets in top-tier locations) to insurance companies (Chart 23). Because many of these companies have obligations in the 5-6% range, they want to earn a book yield of 4.5% or more. As a result, we have seen many insurance companies lending against trophy assets in top-tier markets at coupons in the 4.5% range, which is roughly 150bp through where conduit lenders can participate. While certain CMBS may offer comparable yields, these bonds are predominately lower in the capital structure than many insurance companies choose to currently invest. Instead, many have opted to originate CRE loans rather than buy securities since they can more accurately underwrite the risk in each loan, mitigate ratings volatility and the accompanying capital charges, and enjoy a wider spread than they could obtain buying triple-A CMBS.

Alan Todd CMBS Strategist +1 646 855 6383 [email protected] Catherine Abrams CMBS Strategist +1 646 855 9669 [email protected]

Table 31: A glance across markets indicates no underlying trend and lots of uncertainty

As of 9/29 Chg Wk Chg Mth Chg

YTD YTD

GSMS 07-GG10 A4 363 8 33 149 173 405 2006/2007 A4s 330 5 40 150 155 340 CMBS 2.0 10yr AAA 210 10 (20) 90 95 235 Equity Indices S&P500 1,160 31 (53) (111) 1,119 1,364 DJIA 11,154 420 (406) (521) 10,720 12,811 VIX 38.8 (2.5) 6.0 21.7 14.6 48.0 Corp Indices (bp) 5yr IG CDX 140 (6) 22 51 79 146 5yr HY CDX 800 73 144 367 382 806 US REIT Index 292 5 42 100 150 292 Source: ML Index, BofA Merrill Lynch Global Research

Chart 23: Insurance co and Agency origination volume have dwarfed that of conduits

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Within the CMBS market, spread volatility and dealers’ inability to accurately hedge their respective loan books are probably the biggest impediments to growing the collective pipeline. Without the ability to 1) predict the levels at which a dealer could securitize its whole loan pipeline, and 2) mitigate the significant basis risk between the whole loans and the hedges that are in place, dealers need to charge a higher coupon as a buffer to ensure they remain profitable. So, while dealers might still be quoting loans at a 6% coupon, borrowers may be facing sticker shock, especially when they consider that 10-year Treasury yields have plummeted.

If CMBS spread volatility abates, however, as it has done recently (Table 32), originators should be able to remove some of the uncertainty regarding the level at which loans could be securitized and focus instead on hedging their respective pipelines. Table 32: CMBS spread volatility has declined over the past couple of weeks, which eliminates one source of uncertainty for conduit originators (one standard deviation of daily closing spread levels in bp) Tranche Week 1 Month 2 Months 3 Months 2007 A4 4 18 33 52 2007 AM 11 40 76 103 2007 AJ 11 83 204 267 Source: BofA Merrill Lynch Global Research

With limited new supply and dealers’ balance sheets at the lightest levels they have been in months, we expect investors will continue to look to buy bonds at the top of the capital structure, which will effectively backstop spread volatility into the year-end. As we wrote last week, while we believe that bonds at the top of the capital structure should remain a focus for investors going into year-end, there are several relative value opportunities we currently think look attractive within that. First, we continue to recommend that investors sell shorter-duration legacy A4 paper and swap into newly issued A2s. This trade offers investors the opportunity to pick spread, take out dollars and is likely to offer better liquidity over time as older vintage bonds become increasingly difficult to source. Furthermore, by staying at the 5-year part of the curve, not only will bonds roll down the curve better than they will at the 10-year part of the curve, but they will also be less sensitive from a DV01 perspective to any backup in Treasury yields or spike in spread volatility. A second recommendation would be to consider legacy A2 bonds that currently trade at premium dollar prices. Given the recent market dislocation, it is likely that larger balance loans that would have otherwise refinanced may now remain outstanding for several additional months. The obvious caveat is that in addition to the extension profile, investors need to be cognizant of the delinquency pipeline, as early liquidations will mitigate any benefit of loan extensions. Obviously, the caveat to this is that if conditions in Europe continue to deteriorate amidst political debate and ideological differences, risky asset prices will continue to deteriorate.

Away from the top of the capital structure, we continue to expect to see little investor demand over the near-term until there is more clarity with respect to whether or not European authorities can present a credible plan to solve the debt crisis and recapitalize the banks. Until then, we view it as reasonable that investors, who have little clarity or insight into what policy makers will say or do, are likely to remain largely on the sideline until markets once again begin to trade on fundamentals, not technicals. If one considers the price action of generic 2007-vintage AMs, spreads have widened steadily over the past few months and currently trade at levels last seen before QE2 was announced (Chart 24).

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It seems even earlier vintage AMs have fallen out of favor to a certain extent. With some names trading in the 500-600 bps over swaps range, cross-asset investors may instead choose to invest in high yield corporate debt at yields of around 9%. Even for strictly CMBS investors, a few days of spread stability hasn’t instilled enough confidence that the market is turning for the better, especially given the lingering uncertainty surrounding the situation in Europe. This uncertainty, coupled with concerns that economic growth is slowing, is why the credit curve has steepened, and is also the basis for our expectation that the CMBS credit curve will continue to steepen over the near-term (Chart 25).

Part of the dilemma investors currently face is that although defaults and losses may tick higher over the coming year as a result of the recent market dislocation and economic slowdown, the extent to which we expect fundamentals might deteriorate justifies neither the amount that AM or AJ bond spreads have widened, nor the levels at which many of these bonds trade. To be clear, we do expect fundamentals will deteriorate slightly over the coming months as consumers spend discretionary income less freely and as lenders tighten their credit requirements. The most likely near term result of that, however, will be a slight uptick in delinquency rates and a modest increase in loss severity rates (particularly for smaller balance loans), as has been the case over the past month or so (Chart 26).

Chart 24: Generic 2007-vintage AMs now trade at their widest levels in a year and a half

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With respect to delinquency rates, data from the September remittance cycle indicate that the rate at which delinquency rates have been declining over the past few months is beginning to slow (Chart 27). While it is too early to change our loss estimates, the recent burgeoning trends of less improvement in delinquency rates, marginally higher loss severities and tighter credit market conditions bear watching.

In synthetics, although prices rallied initially, they lost steam as the week progressed. By the week’s end, prices were predominately lower and the credit curves were steeper across the majority of the series (Chart 28).

While it remains likely that we will see this pattern repeat itself over the coming weeks until some of the current uncertainty abates, we remain marketweight on CMBX and do not advocate adding outright short-risk exposure. Limited liquidity will make it costly to enter or exit large positions, and with CMBX prices currently trading at or near their lowest levels of the year, each day that prices move lower the upside/downside skew becomes more positively biased. While the binary nature of the global political decision-making process will likely keep markets on tenterhooks until some of the outstanding issues are resolved, any credible plan put forth is likely to result in a knee-jerk reaction in which the markets rally significantly over the near-term – particularly in tranches that exhibit high levels of credit convexity and have fallen the most year-to-date.

Finally, TRX.II is slated to begin trading on Monday, October 3. As we wrote in last week’s publication, the index will reference last cashflow triple-A bonds from transactions issued since 2010. Although the index will contain a maximum of 25

Chart 26: Overall loss severity rates have increased, which suggests fewer loans are experiencing low losses (<=3% of original loan bal)

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Chart 27: The recent decline in delinquency rates appears to be slowing

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Chart 28: CMBX prices fell and credit curves steepened this week

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Table 33: The initial 18 bonds referenced by the TRX.II CFCRE 2011-C1 JPMCC 2010-C2 COMM 2010-C1 JPMCC 2011-C3 DBUBS 2011-LC1 JPMCC 2011-C4 DBUBS 2011-LC2 MSCT 2011-C1 DBUBS 2011-LC3 MSCT 2011-C2 GSMSC 2010-C1 WFCM 2010-C1 GSMSC 2010-C2 WFRBS 2011-C2 GSMSC 2011-GC3 WFRBS 2011-C3 JPMCC 2010-C1 WFRBS 2011-C4 Source: Markit Partners

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bonds at any point in time, its revolving nature will allow it to include new bonds as they are issued (and while the older bonds roll off), so the index may be used as a more accurate tool with which conduit originators can hedge their whole loan pipelines. Although liquidity may be limited over the near term, we expect the index will trade cheap to cash at first as dealers look to put on hedges and as trading desks look to create some momentum. We list the initial 18 bonds in Table 33.

Understanding the special servicers’ M.O. Within the CMBS conduit universe, about 13%, or over $75 billion, of loans currently reside in special servicing. This number has declined slightly over the past few months, however, as special servicers worked out, modified and liquidated loans. In fact, about $37 billion of loans (measured by original loan balance) have been modified to date. Of this total, about one-third of all modifications (again by original loan balance) have been related to either the GGP bankruptcy or Beacon DC & Seattle Portfolio (Chart 29). Of all modifications, over 98% have been performed since January 2009, at which time delinquencies and defaults first began to increase significantly and special servicers realized that speedy liquidations may not be in everyone’s best interest. Given the difficult refinancing environment over the past two years, modifications have served as an important stop-gap in the realization of losses to CMBS trusts. Not all problem loans, however, have been modified, and to date there have been over $35 billion of loan liquidations, which has resulted in losses to CMBS deals totaling close to $12 billion (Chart 30), or less than 1.5% of the amount of conduit CMBS issued.

Decisions by special servicers as to whether they should liquidate or modify problem loans are intended to be made according to what is in the best interest of the CMBS trust as a whole, without respect to any individual class of bondholders. The strategy chosen is also subject to constraints arising from characteristics unique to each loan, such as the debt service coverage ratio, debt yield or loan-to-value ratio. Given the broad powers that the special servicing community has, they are able, and have begun, to exercise a considerable amount of flexibility in their determination of what they believe is the ‘best’ workout strategy. This is apparent through the growing complexity and widespread use of ‘combination’ modifications, which now account for nearly a third of modified loans. Although it is likely that the loan workout

Chart 29: $37 billion of loan modifications have been performed cumulatively, with 98% occurring since January 2009

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Chart 30: Over $35 billion in liquidations have resulted in over $12 billion in losses to CMBS trusts

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strategies employed by the special servicing community will change over time, we have already seen a wide variety of approaches. Since a special servicer’s decisions can greatly impact CMBS bondholders, we decided to look at the actions that have been employed to date among the largest special servicers to determine if we could glean any trends or patterns that could be used by investors to help them value legacy securities.

Although there are over 20 special servicers listed on CMBS deals, the top three special servicers control close to 80% of the loans currently in special servicing, as measured by current balance (Chart 31). On a positive note, it appears that special servicers may be working through problems, as the volume of loans leaving special servicing has outpaced the volume of new loans added over the last six months, which has reduced the amount of loans in special servicing (Chart 32).

Liquidations Since January 2009, a total of about $24 billion of CMBS collateral has been liquidated, of which the largest dollar amount and percentage have come from loans that were specially serviced by LNR. Over this time period, liquidation volume by LNR has been over $9 billion, or more than twice as large as any other special servicer (Chart 33). Among the top five special servicers, LNR has also recorded one of the lowest average loss severities at 41%.

Chart 33: LNR has liquidated over $9 billion of CMBS loans since January 2009, which is more than twice the volume of any other special servicer

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Chart 32: The total volume of specially serviced loans has declined recently as servicers have worked out problem loans

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Modifications Excluding GGP and Beacon Seattle & DC-related loans, about $24 billion of loans have been modified since January 2009. We decided to examine this universe in order to determine the most prevalent modification types. The most common type of loan modification was the maturity date extension, which account for just under one-third of all modifications (Chart 34). Note that this is exclusive of extensions that may have also taken place in conjunction with other loan modification strategies. Loans that have also had a change in coupon or have been split into A/B notes have been labeled ‘combination’ modifications.

Chart 34: Including extensions falling under ‘combination’ and ‘other’ modification buckets, maturity date extensions have been involved in 50-55% of all modifications

Combination26%

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Source: BofA Merrill Lynch Global Research, Trepp, Table excludes GGP and Beacon Seattle & DC loans, as well as modifications prior to 2009

‘Combination’ modifications make up the second largest category of modifications at 26%. By our estimates, around 50% of combination modifications include extensions. Other common modification types that fall under this umbrella are amortization or payment changes and A-Note/B-Note splits. Of the 23% of modifications falling into the ‘other’ bucket, we have determined that about 40% of those include extensions as well. The breakdown of total balance and number of loans we determined to be in each modification type bucket are as follows (Table 34):

Table 34: Roughly half of all modified loans have received a term extension Modification Type Total Balance ($ mm) % by Balance # Loans % by Count Avg Loan Size ($ mm) Extension 6,990 29% 305 26% 22.9 Combination with ext. 3,148 13% 128 11% 24.6 Combination with no ext. 2,969 13% 182 16% 16.3 Hope Note 1,461 6% 70 6% 20.9 Amort Change 1,394 6% 78 7% 17.9 Principal Writeoff 1,302 6% 57 5% 22.8 Temp Rate Reduction 874 4% 46 4% 19.0 Other with ext. 2,132 9% 123 10% 17.3 Other with no ext. 3,339 14% 173 15% 19.3 Total in our universe 23,609 100% 1,162 100% 20.3 Source: BofA Merrill Lynch Global Research, Trepp,

Given the increasing use of ‘combination’ modifications and their tendency to be something of a black hole, we attempted to deconstruct this bucket further. We first split combination modifications into two buckets – those with extensions and those without extensions and then looked to identify the wide array of other historical combinations (Chart 35, Chart 36).

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There are a few notable trends among special servicers relating to historical modification types pursued. Although C-III has the most maturity date extensions (Table 35), other special servicers have more extensions falling into the ‘combination’ and ‘other’ buckets. If we consider all extensions (regardless of whether or not other modifications accompanied them), the four largest servicers included extensions in 50-55% of modifications. C-III had only 12% of all their modifications classified as combination modifications, a small percentage compared to the 20-40% seen among the other large servicers. For pure A-Note/B-Note splits, (not including A/B splits part of combination modifications), LNR was above average, granting this modification 10% of the time relative to the 6% average. Helios has utilized strictly the A-Note/B-Note split less than 1% of the time, had the lowest percentage of extensions (42% across buckets), and utilized the temporary rate reduction often (22% of modifications by balance or 13 of 66 loan modifications, by count).

Table 35: Among the largest special servicers, the breakdown of historical modification types has been mixed (weighted by original balance) Special Servicer Extension

'Combo' with extension

'Combo' with no extension

A-Note / B-Note split

Amortization Change

Principal Write-off

Temp Rate Reduction

'Other' with extension

'Other' with no extension Total

LNR 32% 11% 10% 10% 2% 1% 1% 12% 21% 100% CWCapital 27% 17% 12% 6% 6% 2% 5% 10% 14% 100% C-III 39% 7% 5% 6% 12% 12% 6% 8% 6% 100% Midland 26% 17% 18% 5% 7% 1% 0% 10% 16% 100% Helios 22% 21% 20% 0% 10% 0% 22% 0% 5% 100% Average 30% 13% 13% 6% 6% 6% 4% 9% 14% 100% Source: BofA Merrill Lynch Global Research, Trepp

Extension terms among special servicers

Given the prevalence of maturity date extensions, and the potential for large loan extensions to significantly impact returns for premium dollar price current-pay bondholders, we decided to focus on this modification and analyze the types of loans that are most, or least, likely to be extended.

By our estimates, within our earlier defined universe of $24 billion of modifications (excluding the GGP and Beacon modifications), about $13 billion of loans have been granted extensions. Around $7 billion of modified loans have been labeled maturity date extensions, while the remaining $6 billion fall in the ‘combination’ and ‘other’ modification buckets. Our universe for this exercise included 478 loans totaling $11 billion that have been granted maturity date extensions between January 2009 and September 2011. Note that we excluded about $2 billion (or about 15%) of loans that were classified as having been extended from this analysis since limited details were available on these extensions.

Chart 35: Combination modifications with extensions included

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Chart 36: Combination modifications without extensions

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Among all servicers, the average loan extension was 2.2 years. This number, however, masks the underlying distribution; in fact, only 5% of our universe was actually extended for between two and three years. A very different picture emerges when one considers the underlying distribution of extension lengths. Although the average extension length is greater than two years when weighted by balance, when we consider extension length by loan count we found that the majority of loans received extensions of about a year. All else equal, to us this implies that larger loans, on average, are receiving longer extension terms than smaller balance loans are. We detail the differences in extension times when measured by loan count or balance in Chart 37 and Chart 38, respectively.

When examined on the basis of loan balance rather than count, about 40% of loans were extended for a term of one year or less (Chart 11). On this basis, it appears that a large percentage of loans received three or five year extensions (27%). There were, however, only 13 loans that fell into the 5 year extension bucket. This highlights an important trend – shorter extensions were much more frequent among smaller loans while the larger loans were much more likely to be extended for an extended (pardon the pun) period of time. This trend is apparent by looking at the average loan size within each bucket. The average size of loans extended two years or less was about $18 million. For extensions between two and five years, the average loan size was $32 million. Finally, the average loan size for five-year extensions was $81 million. In fact, only four loans within our universe with balances less than $20 million were granted five-year extensions.

Over 70% of all extensions have been made by the top three special servicers. Despite LNR being the largest special servicer (37% market share), they have granted the fewest amount of extensions – only 57 versus over 120 each for both CW Capital and C-III (Table 36). LNR has also tended to grant extensions for much larger loans on average - $52 million versus the average of $23 million across all servicers. CW and C-III, on the other hand, have extended loans with an average balance of $26 and $15 million, respectively, which puts them fairly in line with the overall average. Note that the average loan size currently under the auspices of each of these special servicers is fairly similar – $20 million, $21 million, and $15 million, respectively, for LNR, CW and C-III.

Chart 37: On the basis of loan count, about half of all extensions between 2009 to today have been for one year or less

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Table 36: LNR has extended only about half as many loans as other large special servicers, as they have historically more readily liquidated loans LNR CW C-III Bucket # Loans Avg Size ($ mm) # Loans Avg Size ($ mm) # Loans Avg Size ($ mm)Less than 1 year 4 112.1 17 33.1 11 9.0 1 year 6 89.4 39 18.3 76 13.8 Between 1 and 2 years 6 7.0 26 14.0 6 7.3 2 years 19 25.8 16 25.7 10 14.2 Between 2 and 3 years 6 17.2 1 20.1 3 47.0 3 years 3 149.4 9 47.7 11 29.3 Between 3 and 5 years 8 59.5 9 11.3 6 9.4 5 years 3 99.4 2 196.2 2 5.7 Greater than 5 years 2 49.9 2 56.8 2 18.7 Average 57 51.6 121 25.7 127 15.0 Source: BofA Merrill Lynch Global Research, Trepp, Intex

We next examined these three special servicers – LNR, C-III, and CW Capital – to see what the distribution of extension lengths has been for each. For LNR, the weighted average extension length (by balance) was 2.5 yrs, with the greatest number of loans receiving two-year extensions. The distribution of extension lengths for LNR is shown in Chart 39.

For CW Capital, the weighted average extension length was 2.2 years. When measured by count, however, about one-third of all loans extended by CW received one-year extensions (39 of 123 loans). Extensions overall seemed on the shorter side for CW, with over 80% of loans by count having extensions of two years or less (65% by balance). Only 23 of 121 loans were modified for longer than two years, nine of which had three-year extensions. The two loans granted five year extensions were large, averaging $196 million (Chart 40).

C-III, the third largest special servicer, also most frequently granted extensions of one year (76 of 127 loans). In contrast to LNR and C-III, however, extension terms granted by C-III were not as widely distributed. The largest concentration of loans fell into the one year (55%) and three year (17%) buckets. Loans extended for three years had an average balance of around $30 million, whereas loans extended one year had an average balance of $14 million (Chart 41).

Chart 39: Deconstructing the extension terms granted by LNR

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Chart 40: CW Capital’s loan extensions were on the shorter side, with 65% of loans by balance given extensions lasting two years or less

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Chart 41: C-III extensions were distributed less widely relative to LNR and CW, with one year being the most frequent extension length by both balance and count

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BSource: BofA Merrill Lynch Global Research, Trepp, Intex

Although past performance is no guarantee of future performance, knowing which special servicer is responsible for a particular transaction and understanding their modus operandi can be a powerful aid when discerning relative value among legacy bonds.

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ABS Market View Preliminary excess returns show the auto ABS sector continues to perform relatively well (Chart 42). The sector has benefited from relatively strong credit performance, short and predictable cash flows, and steady issuance volume. Auto companies and their respective captives have proven to be resilient during the financial crisis, gas spikes and production distributions. Compare that to the student loan sector, which continues to see some stability in relatively high delinquency and default rates (see following section). As indicated in Table 38, a significant portion of the auto sector that was rated triple-A continues to be rated triple-A. In the student loan sector, FFELP deals have fared better than private loans but should have fared better since the underlying collateral is ultimately guaranteed by the Federal government and larger serviced by FFELP lenders with servicing contracts with the Department of Education. We are not alone in our thinking, as investors are increasing exposure to the sector and moving spreads to tighter levels (2-5 bps tighter this week).

Based upon the relative performance of the sectors, we are revising our new issue volume forecast by increasing auto ABS by $5 billion and decreasing student loans by $5 billion YTD new issue volume stands at $92 billion.

Spreads were unchanged for senior classes in the benchmark sectors, as the relatively strong demand for these products helps to offset the impact of the lack of conviction persisting in broader sectors. Volumes were light with most of the activity reflecting month- and quarter-end rebalancing. Spreads for subordinated auto ABS were wider by 5 bps, reflecting the demand for senior classes.

We maintain our overweight on the ABS sector, as the ability of the market to perform relatively well in volatile markets remains intact. Supply technicals favor credit card ABS over auto ABS, as new issue volume for credit cards has been well below autos for several years (see following section). Until the rating agencies come to some resolution on their respective ratings for FFELP ABS, autos and credit cards should continue to outperform the FFELP ABS sector.

We believe that on a selective basis some of the non-benchmark sectors/names offer value, as supply is expected to remain constrained and credit is expected to perform reasonably well. A number of factors should continue to help the FFELP ABS. The Department of Education continues to work with FFELP lenders, servicers and guarantors to ensure the integrity of the Federal student loan programs.

Table 38: Current ratings on ABS Sector Current Rating Fitch Moody's S&P Auto AAA 98% 92% 92% FFELP SL AAA 95% 77% 9% AAA/*- 2% 16% 89% Private SL AAA 44% 26% 19% AAA/*- 0% 9% 9% Source: Bloomberg, BofA Merrill Lynch Global Research. Current ratings of outstanding classes originally rated AAA (% of number).

Chris Flanagan MBS/ABS Strategist +1 646 855 6119 [email protected] Theresa O’Neill ABS Strategist +1 646 855 9285 theresa.o’[email protected] Matthew Carr ABS Strategist +1 646 855 9971 [email protected]

Chart 42: YTD Excess Returns

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Table 37: ABS Spreads

Sector Current Week

1-week Change

Credit Cards (vs. LIBOR) 3-year Class A 17 0 5-year Class B 73 0 Prime Auto (vs. Swaps) 3-year Class A 29 0 3-year Class B 130 5 Student loans (vs. LIBOR) 3-year Class A FFELP 45 -5 3-year Class A Private 175 0 Source: BofA Merrill Lynch Global Research

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Chart 43: 3-year Triple-A Spreads

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Chart 45: Spread Differential between Triple-A Cards and Triple-B Cards, Corporates and CMBS

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Revised & Actual Forecasted Volumes We are revising our forecast for new issuance volume for the year based upon year-to-date issuance volume, growth in receivables, utilization of alternative funding sources, and new issue pricing levels (Table 39). We expect gross volume of $120 billion and negative net volume of $45 billion for the full year. Relatively strong liquidity and attractive spreads have caused us to revise up our forecast for auto ABS (from $65 billion to $70 billion). Meanwhile, relatively weak liquidity and wide spreads, along with a challenging ratings environment, have caused us to revise down our forecast for student loan ABS (from $25 billion to $20 billion).

We expect new issue volume of $28 billion for all sectors in 4Q11. The market should be able to absorb the foregoing supply without pressuring spreads due to overall favorable technical and fundamental conditions. Over the last few months, spreads have mostly been impacted by broader market volatility, although ratings actions have impacted the student loan ABS market.

Our equity research team is looking for US vehicle sales of 12.8 million units for 2011, 14.5 million for 2012 and 15.17 million for 2013, while our economics team is looking for 12.5 million units in 2011, 12.9 million in 2012 and 13.0 million in 2013. Vehicles sales for the 8ME 8/31/11 and 2010 equal 12.5 million units and 11.6 million units. YOY increases in vehicles sales have been supportive of new issuance volume in the auto ABS market.

Much of the remaining new issue supply in the FFELP ABS market is expected to come from lenders’ refinancing and restructuring needs. Although we continue to expect lenders to refinance FFELP loans currently being funded by Straight-A Funding7, today’s conditions have likely caused most lenders to push any refinancing plans into next year. At the end of 2Q11, the program funded about $35 billion of Stafford loans (87%) and PLUS loans (13%). These loans were originated between 10/1/03 and 7/1/09. At that time, 47% were in repayment, which should result in relatively short average lives for any related term ABS. Sallie Mae funds about $25 billion through the program, according to the company’s most recent 10Q.

The expectation of limited growth in receivables and utilization of alternative funding sources continue to limit new issuance volume in the credit card sector.

So far this year, $91 billion of new deals have been issued in the ABS market, which is slightly below the volume seen in last year’s comparable, as higher volumes in the auto, equipment and other sectors have been offset by lower volume in the credit card sector. New issue volume in the first half of last year included nearly $12 billion of TALF eligible ABS.

The prime auto loan ABS sector represents 29% of total volume, while the combined auto ABS sectors represent 60% of total volume. Not surprisingly, 10 of 15 of the top fifteen sponsors of ABS are auto lenders (Table 41). The student loan sector has captured 17% of the total loan volume.

7The ABCP program established by the Department of Education under The Ensuring Continued Access to Student Loans Act of 2008 (ECASLA)

Table 39: ABS Volume Forecasts

Sector YTD

Actual 2H 2011

Forecast Total Year

Auto $55.26 $14.74 $70.00 Credit Cards $7.10 $2.90 $10.00 Ed Loans $15.46 $4.54 $20.00 Equipment $7.19 $2.81 $10.00 Other $6.83 $3.17 $10.00 Total $91.83 $28.17 $120.00 Source: $ billions. BofA Merrill Lynch Global Research

Chart 46: Retail Deposits

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The expectation of steady new issuance volume in the auto sector and limited volume in the credit card sector, along with the relatively long maturity of student loans, means the ABS market will increasingly be dominated by auto and student loan ABS. As indicated in Table 43 to Table 45, the primary ABS sectors are dominated by a relatively few numbers of sponsors/issuers.

Table 40: Issuance Volume by Sub-Sector Broad ABS Sector Sub-Sector within the Broad ABS Sectors 2010 YTD 2011 Auto Auto - Fleet $2,883 $3,396 Auto - Floorplan $9,102 $5,844 Auto - Lease $8,460 $7,379 Auto - Non US $871 $1,883 Auto - Non-prime $8,373 $10,209 Auto - Prime Loans $32,761 $26,446 Auto - Trucks $1,209 $103 Auto Total $63,659 $55,259 Credit Card Credit Card - General Purpose $15,745 $3,800 Credit Card - Non US $1,250 $750 Credit Card - Private Label $3,031 $2,548 Credit Card Total $20,027 $7,098 Education Loans Education Loans - FFELP $16,623 $13,620 Education Loans - Private $6,260 $1,837 Education Loans Total $22,883 $15,457 Equipment Equipment - Ag & Construction $3,451 $2,981 Equipment - Floorplan $0 $620 Equipment - Multi $2,060 $3,584 Equipment - Trucks & Construction $666 $0 Equipment Total $6,177 $7,186 Other Other $2,007 $357 Other - Cell Tower $0 $940 Other - Container $197 $1,669 Other - Insurance Premiums $1,217 $100 Other - Rail $369 $1,714 Other - RRB $1,037 $207 Other - Small Business $189 $61 Other - Structured settlement $775 $247 Other - Tax Liens $486 $0 Other - Time Share $1,752 $788 Other - Whole Business $0 $745 Other Total $8,030 $6,829 Grand Total $120,776 $91,829 Source: IFR Markets, Bloomberg, BofA Merrill Lynch Global Research $ millions

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Table 41: New Issue Volume by Sponsors $ millions 2010 YTD 2011 Ally Bank (f.k.a.,GMAC Inc.) $9,702 $8,631 Ford Motor Credit Company $8,668 $6,464 Santander Consumer USA Inc. $4,887 $5,266 General Electric Capital Corporation $2,665 $4,624 AmeriCredit Financial Services, Inc. (General Motors Financial Company, Inc.) $3,150 $3,650 Hyundai Motor Finance Company $2,132 $3,534 Nissan Motors Acceptance Corp. $3,701 $3,098 SLM Corporation $5,537 $3,020 Brazos Student Finance Corporation $1,397 $2,968 Discover Financial Services $2,025 $2,800 Mercedes-Benz Financial Services USA LLC (f.k.a., DCFS USA LLC) $993 $2,640 Toyota Motor Credit Corporation $4,294 $2,501 American Honda Finance Corp $4,302 $2,445 BMW Financial Services NA, LLC $1,750 $2,250 CNH Capital America LLC $2,703 $2,096 Source: IFR Markets, Bloomberg, BofA Merrill Lynch Global Research.

Table 42: Outstanding by Sub-Sector Broad ABS Sector Sub-Sector within the Broad ABS Sectors Outstanding Auto Auto - Fleet $11,492 Auto - Floorplan $18,353 Auto - Lease $9,247 Auto - Non US NA Auto - Non-prime $16,864 Auto - Prime Loans $59,696 Auto - Trucks $618 Auto Total $116,270 Credit Card Credit Card - General Purpose $161,432 Credit Card - Non US NA Credit Card - Private Label $35,455 Credit Card Total $196,887 Education Loans Education Loans - FFELP $220,276 Education Loans - Private $46,461 Education Loans Total $266,738 Equipment Equipment Total $19,970 Source: Bloomberg, BofA Merrill Lynch Global Research

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Table 43: Auto ABS Outstanding by Sponsor Sponsor Total Ford Motor Credit Company $19,157 Ally Financial Inc. $17,308 Santander Consumer USA Inc. (Drive Financial Services) $7,142 General Motors Financial Company, Inc. (aka AmeriCredit Corp Financial Services, Inc.) $6,893 Nissan Motors Acceptance Corp. $6,579 American Honda Finance Corp $5,386 Hyundai Capital America $5,349 Avis Budget Group $4,678 Toyota Motor Credit Corporation $4,117 Bank of America, National Association $3,669 VW Credit Inc. $3,634 BMW Financial Services NA, LLC $3,607 CarMax Business Services, LLC $3,515 Mercedes-Benz Financial Services USA LLC/DCFS USA LLC $2,999 Hertz Corp. $2,732 All Others $22,089 Total $118,855 Source: Bloomberg, BofA Merrill Lynch Global Research

Table 44: Credit Card ABS Outstanding by Sponsor Sponsor Total Bank of America Corp. (FIA Card Services, NA) $38,986 Citigroup Inc. (Citibank (South Dakota), NA) $38,353 J.P. Morgan Chase & Co. (Chase Bank USA, NA) $35,495 American Express Company (American Express Travel Related Services Company Inc.) $16,794 Discover Financial Services $14,811 Capital One Financial Corp. (Capital One Bank) $14,507 Citi Holdings $20,196 General Electric Capital Corporation (GE Money Bank) $10,046 Alliance Data System Corporation (World Financial Network National Bank (includes Charming Shoppes) $2,562 Cabela’s Incorporated (World's Foremost Bank, NA) $1,850 All Others $3,287 Total $196,887 Source: Related Servicing reports, Bloomberg, BofA Merrill Lynch Global Research. Includes issued and retained subordinated classes.

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Table 45: Student Loan ABS Outstanding by Issuing Vehicle Sponsor Total SLM Student Loan Trust $110,370 Nelnet Student Loan Trust/Nelnet Education Loan Funding Inc. $22,235 SLC Student Loan Trust $19,705 National Collegiate Student Loan Trust $13,707 College Loan Corp Trust $10,667 Brazos Higher Education Authority/Brazos Student Finance Corp $9,114 Access Group Inc $7,023 GCO Education Loan Funding Trust $5,175 Collegiate Funding Services Education Loan Trust I $4,196 Pennsylvania Higher Education Assistance Agency $3,664 Northstar Education Finance Inc $3,557 Keycorp Student Loan Trust $3,359 Goal Capital Funding Trust $3,324 CIT Education Loan Trust $3,304 Missouri Higher Education Loan Authority $2,529 All Others $41,693 Total $263,621 Source: Bloomberg, BofA Merrill Lynch Global Research

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Private Student Loan ABS Credit Performance The levels of 90+ days delinquency rate and default rate have stabilized at relatively high levels, although there is variability from period to period. Credit trends in student loan ABS have been impacted by the unemployment situation. Today’s relatively high unemployment rate for 20-24 year olds (the likely age bracket for recent graduates) has offset the relatively low unemployment rate for segments of the population with higher levels of education. The earlier spikes in delinquency and defaults were the result of limited forbearance options and increasing percentage of obligors moving to repayment. The cumulative losses on more seasoned vintages appear to be leveling off. More recent vintages (2005-2007) continue to climb. The periodic default rates for the 2005 vintage have been declining, while they have recently increased for the 2007 vintage.

SLM Student Loan Trust (private only)

Chart 47: 90+ Days Delinquency versus Unemployment

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Chart 48: Forbearance versus Unemployment

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Chart 49: Defaults versus Unemployment

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Chart 51: Cumulative Gross Defaults by Vintage

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Table 46: ABS Spreads Current Week 1-wk 10 week Current Week 1-wk 10 week

09/29/11 change Min Max Avg 09/29/11 change Min Max Credit Cards (Fixed Rate-Swaps) Student Loan-FFELP (3 Mo. LIBOR) 1-yr 7 0 7 12 10 1-yr 30 -2 29 45 2-yr 11 0 11 16 14 2-yr 38 -4 38 60 3-yr 20 0 19 23 21 3-yr 45 -5 45 68 5-yr 38 0 30 42 38 5-yr 73 -2 69 85 7-yr 49 0 35 54 48 7-yr 88 -2 85 97 10-yr 60 0 40 65 56 10-yr 105 -5 100 113 Class B -5y, "A" 85 0 65 85 78 13-yr 135 0 117 140 Class C -5y, "BBB" 130 0 95 130 115 Class B ("A") 350 -10 295 360 Credit Cards (Floating Rate-1Mo. LIBOR) 1-yr 8 0 5 10 8 Student Loan-Private (3 Mo. LIBOR) 2-yr 12 0 9 14 12 3-yr 175 0 120 175 3-yr 17 0 14 19 17 5-yr 250 0 190 250 4-yr 20 0 17 22 20 7-yr 300 0 235 300 5-yr 23 0 20 25 23 10-yr 335 0 260 335 7-yr 31 0 28 33 31 15-yr 375 0 300 375 9-yr 37 0 34 39 37 Class B ("A/BBB") 1300 0 920 1300 10-yr 39 0 36 41 39 Class C ("BBB/BB") 1400 0 1020 1400 15-yr 43 0 40 45 43 Class B -5y, "A" 73 0 65 75 72 Class C -5y, "BBB" 128 0 95 128 111 Auto -Prime (Fixed-Swaps) Stranded Assets (Swaps) 1-yr 18 0 15 19 18 1-yr 6 0 6 12 2-yr 22 0 20 24 23 2-yr 12 0 12 17 3-yr 29 0 27 31 30 3-yr 18 0 18 22 Class B-3y ("AA") 130 5 85 130 108 5-yr 25 0 23 27 Class C-3y ("A") 235 5 160 235 193 7-yr 30 0 28 32 Auto -Prime (Floating Rate-1Mo. LIBOR) 10-yr 37 0 35 39 MMKT -1 0 -3 -1 -2 Equipment (Swaps) 1-yr 15 0 15 22 20 1-yr 35 0 35 42 2-yr 22 0 22 27 25 2-yr 40 0 40 53 3-yr 30 0 28 32 31 3-yr 50 0 50 61 Auto -Subprime (Fixed-Swaps) Swap Spreads 1-yr 65 0 54 69 64 2-yr 30 -2 22 32 2-yr 77 0 69 84 77 3-yr 30 2 25 33 3-yr 87 0 79 94 87 5-yr 28 -2 24 32 Auto -Subprime (Floating Rate-1Mo. LIBOR) 7-yr 27 -1 21 33 1 65 0 54 69 65 10-yr 18 -1 11 19 1-yr 77 0 69 84 79 2-yr 87 0 78 93 88 Source: BofA Merrill Lynch Global Research

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Table 47: ABS Issuance by Asset Type ($ Million)

Total Auto Credit Cards Education Loans Equipment Other Jan-09 $5,474 $1,340 $3,850 $0 $0 $283Feb-09 $1,926 $1,145 $0 $547 $0 $235Mar-09 $16,490 $5,403 $8,743 $1,498 $528 $319Apr-09 $13,930 $3,362 $5,180 $5,051 $0 $337May-09 $19,910 $4,045 $11,602 $2,708 $1,032 $523Jun-09 $27,372 $7,180 $15,679 $1,432 $1,657 $1,424Jul-09 $20,421 $10,693 $6,376 $3,049 $0 $303Aug-09 $11,403 $990 $4,857 $3,977 $1,136 $443Sep-09 $25,586 $10,292 $13,500 $0 $618 $1,176Oct-09 $10,509 $6,890 $300 $1,024 $775 $1,520Nov-09 $17,742 $8,882 $3,117 $1,544 $2,486 $1,713Dec-09 $8,896 $1,552 $3,000 $2,786 $829 $729Jan-10 $16,841 $8,685 $6,075 $1,949 $0 $131Feb-10 $7,105 $5,942 $300 $783 $81 $0Mar-10 $12,757 $5,142 $1,163 $2,893 $1,741 $1,817Apr-10 $8,979 $5,333 $1,210 $1,454 $747 $234May-10 $14,924 $5,899 $6,722 $1,425 $879 $0Jun-10 $7,963 $4,505 $986 $1,935 $0 $537Jul-10 $10,878 $4,788 $1,125 $3,828 $0 $1,136Aug-10 $6,835 $4,236 $0 $1,140 $925 $534Sep-10 $12,220 $8,123 $950 $2,111 $726 $308 Oct-10 $7,347 $5,313 $0 $1,167 $0 $867 Nov-10 $10,309 $4,584 $1,250 $1,750 $876 $1,849 Dec-10 $5,271 $1,926 $80 $2,448 $202 $615 Jan-11 $8,446 $6,644 $744 $384 $471 $203 Feb-11 $10,127 $6,050 $1,000 $1,468 $1,364 $245 Mar-11 $9,711 $5,597 $500 $2,389 $0 $1,225 Apr-11 $10,075 $7,772 $0 $1,071 $1,106 $126 May-11 $10,004 $4,466 $1,000 $2,679 $1,000 $859 Jun-11 $17,442 $6,613 $2,125 $4,606 $692 $3,406 Jul-11 $6,869 $4,918 $0 $937 $755 $259 Aug-11 $3,481 $1,859 $0 $922 $400 $300 Sep-11 $15,674 $11,339 $1,730 $1,000 $1,398 $207 YTD Summary 2011 $91,829 $55,259 $7,098 $15,457 $7,186 $6,829 100% 60% 8% 17% 8% 7% 2010 $98,501 $52,653 $18,531 $17,518 $5,099 $4,699 100% 53% 19% 18% 5% 5% Full Year 2010 $121,428 $64,477 $19,861 $22,883 $6,177 $8,030 100% 53% 16% 19% 5% 7%Note: US Dollar, term ABS as of 9/30/11 and 9/30/10. 2010 full year numbers include about $10 billion of retained subordinated credit card notes. Source: BofA Merrill Lynch Global Research

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CLO Market View Flat to slightly wider spreads on very low volumes this week, as CLOs continue to adjust to the new levels in risky fixed income. We remain market weight but believe the re-alignment process has already gone a long way, and expect value to already be found at these levels. Equity continues to outperform, but going forward we are beginning to see equal value in high quality mezz tranches, which results in our flattening our CLO barbell somewhat.

After the noticeable pickup throughout the past couple of weeks, observable BWIC volumes in secondary trading were back on the light side. The same themes that have characterized CLO behavior recently remained valid: appetite for risk runs very low, and mezz spreads continue to leak wider, capping a September spent catching up with the re-pricing which took place in competing assets earlier in the summer.

We have maintained a market weight throughout August/September on poor relative value metrics in the absence of trading visibility in CLO vs. the rest of the fixed income space. We believe the re-alignment process still has further to go but we are indeed getting much closer (Chart 52) and value can already be found at these levels – with spreads across the capital structure now wider year-on-year despite continued improvements on the fundamentals side.

We do not wish to ignore signals from the underlying market however, and believe credit quality may start to soften a little in the quarters ahead especially in light of the unfavorable growth outlook.

With this cautious stance in mind, we also note that issuers have managed their maturities very aggressively amid the liquidity wave of 2009/10, embedded corporate leverage has decreased versus pre-crisis levels, and we continue to believe that although defaults may rise, they are more likely to represent the echo of the 2007/08 default cycle than a renewed super spike.

We continue therefore to like equity – focusing on high quality, late vintage pieces – but given the steep rise in mezzanine yields, we flatten the barbell somewhat and now believe that solid high-quality bonds in mezzanine debt are likely to deliver very adequate returns for their risk.

Our outlook remains near term cautious, but long term constructive and despite choppy times ahead for risk assets as global growth continues to be repriced, corporate exposures are likely to remain a key outperformer – and CLOs provide such exposure at a cheap price relative to comparables. The gradual accretion of quality assets at current prices is therefore likely to prove to be the right strategy over the longer term.

Table 49: CLO liabilities estimated trading levels AAA AA A BBB BB 30-Sep-11 ~200 DM High 70s High 60s Low to Mid 60s High 50s to Low 60s

1w ago ~200 DM High 70s High 60s Low to Mid 60s High 50s to Low 60s 1m ago ~190 DM High 70s to Low 80s Low to Mid 70s High 60s to Low 70s 60s 12m ago ~200 DM $80 $70 $60 $50

Source: BofA Merrill Lynch Global Research estimates

Nicolas Gakwaya Research Analyst +44 20 7995 7212 [email protected]

Table 48: CLO DMs AAA AA A BBB BB

30-Sep-11 200 500 750 1050 1350 1m ago 190 400 625 900 1150 2m ago 180 325 550 775 1025


Chart 52: CLO single-A vs. loan spreads, catching up …

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Source: BofA Merrill Lynch Global Research, LCD

Chart 53: CLO AAA vs. CMBS

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Chart 56: Except for AAA, CLO DMs have retraced most of the post Jackson Hole ’10 advance

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Chart 54: CLO AAA vs. corporates

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Chart 55: CLO AAA vs. S&P LSTA discounted spreads

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Source: BofA Merrill Lynch Global Research, S&P LCD

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CLO equity the bright light in a dark quarter The quarter has been a very difficult one for risk assets, and CLOs were no exception, especially in the mezzanine segment where the confluence of 1°) low carry (inherited from the low current coupons from the pre-crisis era) and 2°) eroding NAV support (and associated markdowns of the principal optionality embedded in those bonds) have weighed on the price performance of the sector – leading to spread widening of approx 275/375/450bp for A/BBB/BB, with even the once more insulated double-Bs gapping ~200bp QoQ.

The one bright spot in this sea of red ink for CLO bonds was once again found in CLO equity, where the remarkable carry characteristics of the asset have two major positive effects. First, the high coupon in itself allows investors to soften the blow of potential MtM declines. Second, as expected, the ability to maintain large payments in a low yield environment (sub 1% US 5YR Treasuries) helped support the bid for CLO equity during this troubled summer – and while prices have backed up a little, the high-quality equity tranches have not suffered to the same extent as mezz debt, despite an evidently even worse NAV position.

The trailing performance of CLO equity can be seen in Chart 58, where cash-on-cash payments continue to make new highs, propelled by the same drivers as discussed many times in this space: low all-in funding costs, proliferation of LIBOR floors across the underlying product, and a steep OC/par regeneration which has led to an ever-increasing proportion of transactions switching payments to their shareholders back on.

In Chart 60 and Chart 61, we illustrate specific Q3 performance, both across the entire CLO space and differentiating by vintage – where the median quarterly cash payment was 6.7%, but when focusing on those tranches which are making distributions in the first place, payouts were most frequently seen in the 7-10% range (non-annualized). The vintage data also highlights the better cashflow performance (granted, at a higher purchase price too) of late vintages compared to seasoned deals. We continue to recommend investors position into high quality, solid par coverage and late vintage transactions, and believe paying up to stay up in quality is the right strategy at this stage.

Chart 57: Loan prices vs. the inverted CLO capital structure

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65

70

75

80

85

90

95

100

Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11

AAA AA A BBB BB Equity Loan prices

Source: BofA Merrill Lynch Global Research, LCD

Chart 58: Historical quarterly cash-on-cash returns for CLO equity (4 period moving avg)

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5%

10%

15%

20%

25%

30%

Jan-05 Sep-05 May -06 Jan-07 Sep-07 May -08 Jan-09 Sep-09 May -10 Jan-11 Sep-11

Source: BofA Merrill Lynch Global Research, Intex

Chart 59: Distribution of CLO equity market value coverage

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10%

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30%

40%

50%

60%

70%

80%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 110% 120% More

End June Aug 5th Aug 11th Sep 15th


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As we have discussed in the previous weekly, we also take note of the rapidly increasing yields offered in mezz debt, and believe these are now starting to compete against equity IRR targets. As argued in the Market View section, we would like to see firmer behavior in competing asset classes (and a restoration of the relative value argument in favor of CLOs) but on resumption of our medium-term overweight stance on the CLO product, we are unlikely to have such a marked preference for the AAA/barbell as has been the case over the past year and a half – given the extent of the underperformance of mezzanine and the subsequent realignment of the risk reward equation.

We are not there yet, in our view, but the time for mezz to shine is closing in – and as we alluded to in our most recent Global CLO Weekly (see “PIKs and pans in Junior CLOs”) we expect selective forays into high quality bonds in mezz should deliver good results over the medium term.

Chart 60: Distribution of Q3 equity payments across US CLOs

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% More

All Vintages

Source: BofA Merrill Lynch Global Research, Intex

Chart 61: Distribution of Q3 equity payments, per vintage

0%

5%

10%

15%

20%

25%

30%

35%

40%

0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% More

2007 2006 2005 2004 2003 Source: BofA Merrill Lynch Global Research, Intex

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Link to Definitions Credit Click here for definitions of commonly used terms.

Analyst Certification I, Chris Flanagan, hereby certify that the views expressed in this research report accurately reflect my personal views about the subject securities and issuers. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or view expressed in this research report.

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Important Disclosures BofA Merrill Lynch Credit Opinion Key The BofA Merrill Lynch Global Research Credit Opinion Key is designed to allow BofA Merrill Lynch Global Credit Research to provide recommendations on an issuer’s bonds, capital securities, equity preferreds and CDS as described below. An issuer level recommendation may also be provided in respect of an issuer as explained below. BofA Merrill Lynch Global Research credit recommendations are assigned using a three-month time horizon. Issuer Recommendations: If an issuer credit recommendation is provided, it is applicable to all bonds of the issuer except bonds specifically referenced in the report with a different credit recommendation. Where there is no issuer credit recommendation, only individual bonds with specific recommendations are covered. Issuer credit recommendations do not cover equity preferreds or CDS related to the issuer. Issuer credit recommendations do not cover capital securities of the issuer unless a statement to that effect is provided in the relevant research report. CDS Recommendations: CDS are recommended on an individual basis under the Credit Opinion Key. Issuer credit recommendations do not apply to CDS. Capital Securities: Capital securities are recommended individually unless the research report specifically states that the issuer credit recommendation applies to such securities. In cases where the issuer credit recommendation applies to capital securities of the issuers, it is not applicable to capital securities that we classify as equity preferreds. Equity Preferreds: Equity preferreds are recommended on an individual basis under the Credit Opinion Key. Issuer credit recommendations do not apply to equity preferreds.

Recommendation Investor Action Points (Cash and/or CDS) Primary Investment Return Driver Overweight-100% Up to 100% Overweight of investor's guidelines Compelling spread tightening potential Overweight-70% Up to 70% Overweight of investor's guidelines Carry, plus some spread tightening expected Overweight-30% Up to 30% Overweight of investor's guidelines Good carry, but little spread tightening expected Underweight-30% Down to 30% Underweight of investor's guidelines Unattractive carry, but spreads unlikely to widen Underweight-70% Down to 70% Underweight of investor's guidelines Expected spread underperformance Underweight-100% Down to 100% Underweight of investor's guidelines Material spread widening expected Time horizon – our recommendations have a 3 month trade horizon

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