Fixed Income Research

The Lehman Brothers U.S. Hybrid ARM Index

July 19, 2005 MBS Strategy 212-526-8311 Vikas Shilpiekandula Andrew Miller Index Strategy index@lehman.com 212-526-1000 Nick Gendron Brian Upbin, CFA Analytics Arun Kannambadi Jim Xue

OVERVIEW In light of the increasing relevance of the asset class and investor demand for a performance metric, we are launching the U.S. Hybrid Adjustable-Rate Mortgage (ARM) Index on August 1, 2005. This report provides an overview of the hybrid ARM market; outlines index inclusion rules and the development of hybrid ARM aggregates and sub-aggregates; discusses index pricing, settlement, and prepayment assumptions; and details key differences in prepayment and risk characteristics from the U.S. Fixed-Rate MBS Index.
The Need for a Hybrid Index There has been strong issuance in hybrid ARMs during 2001-2005, and the amount of agency hybrids outstanding is now approaching $300 billion. In addition, mortgage investors are increasingly using the product and need a benchmark to track the performance of the sector. Index Eligibility Rules The U.S. Hybrid ARM Index will encompass only agency issuers. Hybrid pool aggregates must have at least 12 months to floating coupon reset date and an outstanding balance greater than $250 million (consistent with the liquidity standard for our U.S. Aggregate Index). Structure and Size of the Index The structure of the hybrid index is similar to the agency fixed-rate index in most respects. The key difference is the existence of sub-aggregates based on the rate index, cap structure, and IO features, which are used for more accurate pricing. At inception, the index will have approximately 150 aggregates and 1,200 sub-aggregates and an estimated $275 billion amount outstanding, comparable in size to our CMBS and the GNMA MBS fixed-rate indices. Pricing and Return Calculations Trader quotes for unseasoned securities and pay-ups for seasoned securities are used to price the index at the sub-aggregate level. The return computation method for the hybrid Index is very similar to that used for the MBS fixed-rate index. Not Part of the U.S. Aggregate Index The U.S. Hybrid Index is currently a stand-alone index and is not a part of the U.S. Aggregate Index. As the index and its market acceptance seasons, it will be considered for inclusion. But at this time, we cannot predict whether or when hybrids will be a part of the U.S. Aggregate Index.

PLEASE SEE IMPORTANT ANALYST CERTIFICATION AT THE END OF THIS REPORT.

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Introducing the U.S. Hybrid ARM Index

TABLE OF CONTENTS
1. Introduction ..................................................................................................................... 2. Hybrid ARMs: Characteristics and Mechanics ............................................................... 3. Hybrid ARMs versus Fixed-Rate MBS: Prepayment and Risk Characteristics............... 4. The U.S. Hybrid ARM Index .......................................................................................... 3 4 5 7

5. Index Assumptions: Pricing, Coupon, and Prepayment Returns..................................... 11 6. Accessing Index Data on LehmanLive ........................................................................... 13

Appendix A: Lehman Brothers MBS Index Research Publications..................................... 16 Appendix B: Lehman Brothers Global Index Franchise and Methods............................... 17

The authors would like to express their gratitude to Peter Bulko, Don Choe, Donal Creed, Pak Eng, Leong Foong, Suet Lau, Anthony Marenghi , Mohit Mathur, Tatyana Perlina, Shashidhar Upadhyay, Guang Yu, and Amy Zhang for their analytics, systems, and development assistance in the creation of the U.S. Hybrid ARM Index.

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Introducing the U.S. Hybrid ARM Index

1. INTRODUCTION

The Lehman Brothers Global Family of Indices is the most comprehensive set of fixedincome benchmarks used by global investors. Since launching our first index in 1973, we have continually expanded our index offerings to new geographic regions and asset classes by anticipating the needs of index users and developing objective rules-based benchmarks to meet those needs. Lehman Brothers launched its first dollar-denominated fixed-rate mortgage backed securities (MBS) index in 1986, with historical data backfilled to 1976. The launch of this index spurred the creation of the U.S. Aggregate Index by adding the MBS asset class to our existing U.S. Government/Credit Index. Expansion of our securitized index offerings beyond agency passthroughs has resulted in benchmarks for asset backed securities (ABS), commercial mortgage backed securities (CMBS), pfandbriefes, Danish mortgage-backed securities, and other non-dollar mortgage bonds. Lehman Brothers adds new benchmarks to the Global Family of Indices based on three criteria: 1) relevance of an asset class; 2) investor demand for a performance metric; and 3) the availability of security level pricing and analytics to create an objective rules-based benchmark. Using these criteria, our newest index offering for MBS investors is the U.S. Hybrid Adjustable Rate Mortgage (ARM) Index.
Growth in Agency Hybrid ARM Issuance

In the past few years, there has been a surge in the share of hybrids in originations and securitizations. Hybrids constituted 50% of all gross originations in 1H05, with almost all of the growth in the prime mortgage market in 2004 and 2005 coming from the hybrid sector (Figure 1). The amount outstanding in agency hybrids now approaches $300 billion, comparable to that of fixed-rate GNMA MBS.
Investor Demand for an Objective Performance Metric

Not only has the hybrid market grown in size, but it has also become increasingly important for mortgage investors as a relative value tool. The involvement of mortgage investors in the hybrid sector increased significantly in late 2003 and early 2004, when concentration in the fixed-rate MBS index was high. With over 60% of that index concentrated in two coupons, mortgage investors looked to the hybrid market for both diversification and potential alpha. With this, there is an increased need for a metric to track the performance of the hybrid sector.
Figure 1.
1,000 Hybrids 800 Fixed-Rates 600

Strong Growth in Hybrid ARMs, Net Cumulative Growth, $ billion

400

200

0 3/03 6/03 9/03 12/03 3/04 6/04 9/04 12/04

Estimates based on data from the MBA and the Federal Reserve; includes securities and whole loans.

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Introducing the U.S. Hybrid ARM Index

2. HYBRID ARMS: CHARACTERISTICS AND MECHANICS

A hybrid adjustable rate mortgage (ARM) is a mortgage in which the homeowner pays a fixed interest rate for a fixed period of time (typically 3, 5, 7, or 10 years) and a floating rate after that period, combining the features of fixed- and adjustable-rate mortgage securities. The most popular products are 5/1s and 3/1s, accounting for over 50% and 25% of the outstanding balance in the sector, respectively.
Rate Index and Margins (Gross and Net)

After the fixed period, the borrower pays a floating rate equal to the rate index (usually 1year CMT, 6-month LIBOR, or 1-year LIBOR) plus a spread, referred to as the gross margin. The gross margin is typically 225 bp for a LIBOR-based index and 275 bp for a CMT-based index. The investor in an ARM receives the net margin, which is the gross margin minus the servicing fee, typically 45-50 bp.
Cap Structure

The interest rate on the floating leg is subject to three caps: a first reset, a periodic reset, and a lifetime cap. The first reset cap limits the amount the coupon rate can change at the first reset date. The periodic cap limits the amount the rate can change at any subsequent reset date. The lifetime cap limits the amount the interest rate can increase over the lifetime of the security. 3/1s typically have a 2% first reset cap while longer resets like 7/1s and 10/1s have a 5% first reset cap. 5/1s have a mix of 2% and 5% first reset caps.
IO Feature

A feature more common to hybrid ARMs than fixed-rates is the presence of an interest only (IO) feature. In IO loans, the borrower pays no principal during the first few years of the loan and then makes larger payments including principal to amortize the loan over a shorter time. However, the IO period may or may not coincide with the fixed-rate period.
Quoting Conventions

Agency hybrid prices are quoted at a Z-spread at 15 CPB. Z-spread is a cash flow spread to the Treasury curve. CPB is comparable to CPR, but is derived from the balloon date rather than the maturity date and assumes that the floating leg is worth par on the first reset date.
Trading and Settlement

Hybrids trade and settle in a fashion very similar to fixed-rates. Agency hybrids settle with other class D securities such as fixed-rate balloons, usually between the 22nd and the 24th of the month. The delay on FNMA, FHLMC, and GNMA pools is 24, 44, and 19 days, respectively. There is no hybrid TBA market as of July 2005, so all hybrids trade as specified pools.
Figure 2.
Program 5/1 Caps 2/2/5 The first 2 stands for the first reset cap The next 2 is the subsequent period cap The 5 is the lifetime cap The first and lifetime caps are versus the initial rate Fixed-rate for 5-year; then it resets to 1-year rate

Hybrid Nomenclature and Typical Structures

Typical Cap Structures 3/1s 5/1s 7/1s GNs 2/2/6 2/2/6, 5/2/5, and 5/2/6 5/2/5, 6/2/6 1/1/5

Typical Margins, bp LIBOR CMT 180 (net) and 225 (gross) 225 (net) and 275 (gross)

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3. A COMPARISON OF HYBRID ARMS AND FIXED-RATE MBS PASSTHROUGHS: PREPAYMENT AND RISK CHARACTERISTICS

Self selection of borrowers with shorter horizons into hybrid ARMs.

The prepayment and risk characteristics of hybrid ARMs are significantly different from those of fixed-rate MBS. The differences arise not only from the structure of the loan (the floating rate period after the first few years) but also due to the nature of the underlying borrowers. Borrowers with a shorter horizon are more likely to end up in a hybrid ARM pool and hence, the turnover on hybrids is faster than that of fixed-rate MBS. In addition, the credit characteristics of hybrid borrowers are typically worse than the comparable agency fixed-rate borrower, slowing the pace of refinancings.
Faster Turnover than Fixed-Rates

Faster turnover on hybrids, especially shorter resets like 3/1s.

Hybrid ARMs have faster speeds in a discount environment (turnover) due to the selfselection of shorter-horizon borrowers into the product. Base case turnover on 5/1s is approximately 20% CPR, compared with 11% CPR on 30-year fixed-rates (Figure 3). These faster speeds persist even in a deep discount environment. Fixed-rates that are 200 bp out of the money pay at about 6%-7% CPR, while 5/1 hybrids pay at about 12% CPR. The selfselection of shorter horizon borrowers is more prevalent in shorter hybrids; hence, turnover is much faster in 3/1s than longer reset hybrids. The turnover for 10/1s is not significantly different from that of fixed-rates.
Refinancings Similar to Fixed-Rates

Refinancings on agency hybrids are slightly slower than fixed-rates due to weaker credit characteristics.

Although base case speeds on hybrids are faster, premium speeds on hybrids are similar to or slightly slower than fixed-rates. Within agencies, hybrid borrowers typically have slightly worse credit characteristics than their fixed-rate counterparts, resulting in slightly slower refinancings. Hybrid pools with a 200 bp refinancing incentive pay about 4%-5% CPR slower than comparable fixed-rates.

Figure 3.

Prepayments on Hybrid ARMs and Fixed-Rates, % CPR b. Turnover

30 25 20 3/1 5/1 7/1 10/1 30 Year Fixed

a. Refinancings
80 5/1 Hybrids 30yr Fixed 60

40

15 10

20 5 0 0 50 100 150 200 0 0 -50 -100 -150 -200

Refinancing Incentive, bp

Refinancing Incentive, bp

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Shorter Duration and Better Convexity

The risk characteristics of hybrids are obviously different from fixed-rates, given the differences in prepayment speeds. To illustrate, we show how a 5/1 hybrid ARM differs from a fixed-rate MBS and then discuss how risk exposures change across hybrids. Shorter duration and lower convexity exposure in hybrid ARMs than fixed-rates. Shorter duration: A 5/1 hybrid has a shorter duration than a comparable 30-year fixedrate mortgage. This is understandable, given the floating-rate back-end cash flows on these securities, as well as the faster base case speeds and turnover of the underlying borrowers (Figure 5). More short-end exposure: Compared with 30-year fixed-rates, 5/1 hybrids have much more exposure to the front end of the yield curve, which is not surprising. Lower volatility exposure: 5/1 hybrid ARMs are short less convexity and volatility exposure than their fixed-rate counterparts. Spread sensitivity: The spread sensitivity of 5/1 hybrid ARMs is much lower than that of a fixed-rate mortgage.

Trends across ARM Products

Across products, hybrid ARMs look more and more like fixed-rates as the fixed period increases (Figure 4): Longer reset hybrids like 10/1s are similar to fixed-rates. The duration and curve exposure of 7/1s, for instance, is fairly similar to that of comparable 15-year TBAs. Shorter resets such as 3/1s, on the other end, are substantially shorter than fixed-rates and have more exposure to the front-end rates. The convexity and volatility exposure of hybrid ARMs increases from 3/1s to longer resets, which are very similar to 15-year TBAs. Shorter resets, on the other hand, have very low volatility exposure, both realized and implied. Finally, the spread sensitivity of longer-reset hybrids is similar to fixed-rates, while shorter resets have very limited exposure to spreads. Further, longer reset spreads are more correlated with fixed-rates. 3/1 spreads, on the other hand, have relatively lower correlation with fixed-rate spreads.

Overall, hybrids look more like fixed-rate mortgages because the fixed period increases from 3/1s into 10/1s.

Figure 4.

Risk Exposures Across Hybrids and in Comparison to Fixed-Rates

Coupon % Price $ 99-15 99-28 99-11 99-04 99-13 Curve Exposure, yrs 2yr 1.1 0.8 0.9 0.9 0.9 5yr 1.2 1.6 1.6 1.3 1.0 10yr -0.3 -0.1 0.3 1.2 1.9 OAD Yrs 2.1 2.3 2.8 3.4 3.8 Vega yrs -1.0 -2.2 -2.9 -4.2 -7.0 OAC Yrs -0.5 -0.8 -1.2 -1.3 -2.5

3/1 5/1 7/1 15Yr 30Yr

4.0 4.5 4.5 4.5 5.0

Current Coupons; Hybrid ARM valuations to maturity. As of 7/12/05

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Introducing the U.S. Hybrid ARM Index

4. THE U.S. HYBRID ARM INDEX

Refinancings on agency hybrids are slightly slower than fixed-rates due to weaker credit characteristics.

Like all Lehman Brothers indices, the U.S. Hybrid ARM Index is objective and rules-based, representing the universe of securities meeting published eligibility criteria. To build the index, it is necessary both to identify the universe of potentially eligible securities and to define index eligibility rules with which to screen these securities. In order to facilitate the construction of this index, Lehman Brothers has created hybrid ARM aggregates (used to determine index eligibility) and sub-aggregates (used to price the index) of hybrid ARM pools. A similar method is used to build our fixed-rate U.S. MBS Index.
Creation of Hybrid ARM Aggregates

Aggregates based on agency/program, coupon and origination year.

Instead of using specific pools for index construction, the U.S. Hybrid ARM Index uses pool aggregates to evaluate index eligibility. Aggregates are constructed based on the same attributes used for the fixed-rate index: agency/program, coupon, and origination year. Within each sector (FN 3/1s, 5/1s, etc.), pools are grouped first by coupon in increments of 0.25% (our fixed-rate MBS index currently uses 0.5% increments). Thus, the maximum pool coupon variation within each aggregate is limited to 0.125% around the aggregates coupon. Each coupon group is then segregated by origination year. A pool is mapped to an origination year based on the weighted average origination year of the underlying loans, not the year the loans were securitized to create the pool.
Creation of Hybrid ARM Sub-Aggregates

Sub-aggregates based on rate-index, cap structure and the IO feature.

One key difference between the fixed-rate and the hybrid indices is the necessity of subaggregates in order to price the latter accurately, given the greater pool diversity beyond coupon and origination year in the hybrid universe. Within a given hybrid ARM aggregate, sub-aggregates are further defined by the rate-index, cap structure, and the existence of an IO feature (Figure 5). This creates a universe of approximately 2,000 sub-aggregates in total. These sub-aggregates are then treated as individual securities for purposes of pricing.

Figure 5.

Attributes Defining of Aggregates and Sub-Aggregates

Values FN, FH, GN 3/1, 5/1, 7/1, 10/1 Quarter coupons 01, 02, 03, 04 etc. 1yLIBOR, 6m LIBOR, 1yCMT 2/2/6, 2/2/5, 5/2/5 Yes, no

Characteristic Aggregates Agency Program Coupon Origination Year Sub-aggregates Rate Index Cap Structure Interest Only

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Aggregate and Sub-Aggregate Nomenclature

The sub-aggregates are assigned 8-character identifiers called generic cusips. The naming convention reflects the seven dimensions along which pools are aggregated. The first two letters capture the agency and the program. Position three stands for the rate index-caps and the fourth spot represents interest only or not. The fifth and sixth indicate the coupon. The first one shows the whole part of the coupon; the second digit shows the number of eighths. The last two characters of the 8-character cusip show the origination year. Thus, F3AO4203 denotes a Fannie Mae 3/1 with a 2/2/5 cap structure off of 1-year LIBOR, with an interest only period, a 4.25% coupon, originated in 2003 (Figure 6).
Figure 6. Hybrid Sub-Aggregate Nomenclature

F 3 A O 42 03
Example Agency Program Rate Index - Caps Interest Only Coupon Origination Year F for FN, H for FH and G for GN 3 for 3/1, 5 for 5/1, 7 for 7/1 and A for 10/1 A to L depending on the rate index and cap structure (see table below)* O for IO and N for level pay 42 stands for 4.25; the second number stands for an 8 03 stands for 2003
th

* Rate Index Cap Nomenclature

Interest Rate Caps Rate Index 1-year LIBOR 1-year CMT 6-month LIBOR 225 A C I 525 B D J 226 E G K 526 F H L 115 M N O

Mapping Pools to Sub-Aggregates and Aggregates

Pools are mapped to aggregates and subaggregates; mapping could change over time.

For purposes of computing returns and other analytics, each hybrid ARM pool is mapped onto a generic security to which it contributes its outstanding balance. This mapping may change over time because every pool is backed by a large number of individual mortgage loans. While these loans will typically be fairly homogeneous, their origination dates are not necessarily all in the same calendar year. As the underlying loans prepay, each at its own rate, the average origination date for a given pool may migrate from one year to another. Pool mappings are recalculated each month based on the weighted average loan age (WALA) reported for each pool by the agencies. For example, a FHLMC pool of 5/1 hybrids issued in February 2005 with a WALA of 3 months will be put into a generic with a 2004 origination year. By December 2005, though, uneven prepayments might bring the WALA of this pool to 11, in which case the pool would be mapped into 2005 origination. Unlike in the fixed rate index where only the WAC of a pool might drift over time, in the Hybrid Index both the WAC and the coupon of a pool might drift. This could cause a change in the coupon to which the pool is mapped.

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Index Rules and Eligibility

The U.S. Hybrid ARM Index has three inclusion rules to evaluate hybrid ARM aggregates: 1. Liquidity: To be included in the index, the size of a hybrid ARM aggregate must be at least $250 million. A sub-aggregate whose size is less than $250 million would still be part of the MBS index, as long as the size of the aggregate is over $250 million. Time to reset date: All pools/aggregates included should have at least 12 months to the floating coupon reset date. Agency affiliation: The U.S. Hybrid ARM Index includes only agency issuers. Within the Lehman Brothers sector classification scheme, this index will be classified as Securitized>MBS Passthrough>Agency>Hybrid ARM.

2. 3.

There are approximately 150 index eligible aggregates, representing 1200 index eligible subaggregates in the hybrid ARM universe. The index is initially a stand-alone benchmark and is not part of the U.S. Aggregate Index. As the index and its market acceptance seasons, it will be considered for inclusion. But at this time, we cannot predict whether or when hybrids will be a part of the U.S. Aggregate Index.
Index Composition at Inception

The size of the hybrid index at inception is currently just over $275 billion (Figure 7). The following are noteworthy trends across different dimensions: Agency: FNMA and FHLMC account for $170 billion and $94 billion of the total outstanding balance, respectively. GNMAs hybrid ARM program is relatively new and has about $12 billion. Program: 5/1s are the largest component of the index, with $161 billion outstanding. 3/1s are the second-largest program, with $58 billion outstanding in the index, followed by 7/1s and 10/1s. Origination year: Most of the index was originated in 2003 and 2004, but obviously the share that was originated in 2005 is continuing to grow. Rate index: The share of LIBOR-based indices is about 60% of the total. Cap structure: The most common cap structures in the hybrid index are 5/2/5, 5/2/6, and 2/2/6. Each of these three cap structures constitutes 25%-35% of the index. 3/1s typically have a 2% first reset cap, while longer resets such as 7/1s and 10/1s have a 5% first reset cap. 5/1s have a mix of 2% and 5% first reset caps. IO loans: Approximately 30% of the index is made up of interest only loans, but this fraction is likely to grow because the share of interest only loans in agency hybrid originations has increased to over 50%.

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Introducing the U.S. Hybrid ARM Index

Figure 7.
a. Program

Current Distribution of Hybrid Index, $ billion

b. Coupon Distribution FH 15 57 16 6 94 GN 12 0 0 0 12 Total 58 161 47 10 276 % 21% 58% 17% 4% 100% 3/1 5/1 7/1 10/1 Total <=3.5 15 5 0 0 20 3.75 9 12 0 0 22 4.0 9 24 4 0 37 4.25 9 34 7 0 50 4.5 9 35 10 1 55 4.75 3 32 15 2 51 5.0 3 14 9 5 31 5.25 0 3 2 2 8 >=5.5 Total 0 2 0 0 2 58 161 47 10 276

FN 3/1 5/1 7/1 10/1 Total 31 104 31 4 170

c. Rate Indices CMT 6m L 3/1 5/1 7/1 10/1 Total 28 60 24 6 118 3 15 2 1 21 1yr L 27 86 21 3 137 Total 58 161 47 10 276

d. Origination Year 2002 3/1 5/1 7/1 10/1 Total 0 10 2 0 13 2003 8 49 19 3 79 2004 38 71 19 5 133 2005 12 30 6 2 51 Total 58 161 47 10 276

e. IO Loans IO 3/1 5/1 7/1 10/1 Total 17 52 12 2 84 LP 41 109 35 8 192 Total 58 161 47 10 276

f. Cap Structure 5/2/6 3/1 5/1 7/1 10/1 Total 3 38 20 6 66 2/2/6 43 33 0 0 76 5/2/5 0 74 27 4 105 2/2/5 12 17 0 0 29 Total 58 161 47 10 276

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5. INDEX ASSUMPTIONS: PRICING, COUPON, AND PREPAYMENT RETURNS

There are many similarities in the pricing and return calculation methods of the fixed-rate U.S. MBS Index and U.S. Hybrid ARM Index.1 The best source for detailed return calculations is in the Quantitative Portfolio Strategies paper, Managing Against the Lehman Brothers MBS Index: Prices and Returns, B. Phelps, J. Mann, Lehman Brothers, November 2003. Here are some key points:
Same Day Settlement Pricing versus PSA Settlement Pricing

The U.S. Hybrid ARM Index uses same day settlement pricing assumptions to calculate index returns (similar to the fixed-rate MBS index). Once a price quote is obtained for a subaggregate, it must be adjusted for the difference between index and market settlement conventions. A single standard settlement day each month is used by the Bond Market Association (formerly Public Securities Association, or PSA) for agency hybrids. Quoted prices for sub-aggregates are always for this standard PSA settlement. The Hybrid Index, however, uses a same day settlement convention to reflect the current market value of securities held by the index. The discrepancy between the settlement convention used for quotes and for pricing the index necessitates price adjustments of two types. First, a pure adjustment of forward prices to spot prices reflects the cost of carry. More important, when the index and PSA settlement dates are in different months, the index price includes one more payment of principal and interest.
Two Types of Price Adjustments

If the index and PSA settlement dates are in the same month, the index adjusts the PSA settlement quote for the cost of carry until settlement. This is sufficient because a purchase that settles on April 3, for example, will entitle the buyer to the identical set of cash flows as a purchase that settles on April 24 since each monthly cash flow belongs to the owner of record at the end of the month. The situation at or near the end of the month is different. The trader quote on April 28 is for May PSA settlement. Such a purchase will entitle the buyer to receive cash flows from this security starting in June.
Adjusting Quote for Additional Cash Flows

However, a purchase for immediate settlement (or an existing position) would entitle the owner to an additional payment of principal and interest in May. In this case, the index settlement price is backed out to match the sum of the present values of the following two quantities. The first principal and interest cash flow (which would be received in May) is discounted from the payment date back to the present. The position remaining after this paydown is valued by discounting the quoted price and the appropriate accrued interest from the PSA settlement date back to the present. This calculation is complicated by the May cash flow, which is the subject of this adjustment and is not yet known. Rather than projecting it using our proprietary (and subjective) prepayment model, we use the simple approximation that next months single monthly mortality (SMM), or percentage of outstanding prepaid, will be equal to the most recently observed one.

Several papers on the mechanics and pricing dynamics of the U.S. MBS Index have been published by the Quantitative Portfolio Strategies team at Lehman Brothers and are available on LehmanLive. A specific list of relevant research papers is listed in Appendix A.

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Returns on Individual Generics

Because hybrid passthroughs are amortizing securities, their realized return always consists of two parts: the return on the portion of the initial investment that is still in securitized form and the return on the portion paid out as cash. Thus, all return calculations will be affected by the remaining balance and paid down amount numbers, which in turn depend on the current month prepayment estimate.
All Factor Information Updated on 16th Business Day

While all events that affect the U.S. Hybrid ARM Index are essentially monthly in nature, they occur throughout the month. The agencies issue monthly pool factor reports on different days for different types of hybrids. There may also be one or more updates following the initial factor release. To simplify index calculations, our convention is to address each of these monthly events simultaneously for all securities in the index. Pool factor updates are not applied to the index database in a piecemeal fashion as they come in. Instead, factors are updated all at once after the last factor update is received. Currently, the last factor update for the previous month is received on the 15th business day of each month. Starting on the next business day, the SMM computed from the previous months factors begins to serve as the estimate for the current months prepayment. This convention ensures that all securities progress through the same sequence of calculations in the course of a month, regardless of their individual characteristics.
Paydown Return Realized on First Day of the Month

For purposes of the Lehman Brothers Hybrid ARM Index, both interest and principal components of the received cash flow contribute to the paydown return, while coupon return is based on only the surviving portion. Because the beginning or base value for all return calculations is the last day of the previous month, on the very first day of the current month the mortgage security sheds one cash flow. Thus, the full paydown return for the month is realized on the first day of the month. Advancement into a month determines which months prepayment is used as an estimate in computing month-to-date returns. At the beginning of April, the March factors are not yet available for some securities in the index, so the February prepayment is used as an estimate for all securities in the index. When on the 16th business day the factors are updated for the index, the March prepayment begin to serve as the estimate. These switches in prepayment estimates may lead to discontinuities in the daily sequence of month-to-date returns. If prepayments change little from one month to the next, the effect is negligible. When there is a significant change in prepayments, this discontinuity can become noticeable (particularly in the paydown return). Investors who closely monitor month-to-date returns need to be aware of this potential discontinuity.
Coupon Returns Based on 30/360 Convention

The coupon return calculation for the Hybrid Index reflects the 30/360 day count convention and makes monthly coupon flows independent of the actual number of days in a particular month. In the end-of-month return calculation, accrued interest is brought up to the full monthly coupon (30 days accrual), regardless of the actual number of days in the month. For end-of-month calculations, the U.S. Hybrid Index is assumed always to settle on the last day of the month, whether it is a business day or not. So if the last business day happens to be the 27th, the accrued interest on that day will jump from 26 days worth up to the full monthly coupon. For a 4.5% passthrough, for example, the accrued interest will go from 4.5x26/360 (+0.325%) directly to 4.5x30/360 (+0.375%) instead of to 8x27/360 (+0.338%).

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6. ACCESSING THE INDEX THROUGH LEHMANLIVE

As with other Lehman indices, there will be three sources to monitor index performance: LehmanLive (Index Website), POINT, and Bloomberg. LehmanLive: Investors may retrieve index returns and statistics from the Fixed Income Indices section on LehmanLive. This site allows entitled users to access and download historical index returns and statistics of the entire Global Family of Fixed Income Indices back to each indexs inception date. Go to the Fixed Income page and click on Fixed Income Indices. The U.S. Hybrid ARM Index link will be listed as a separate page under Other Americas. POINT: For investors with access to POINT, Lehmans risk management and portfolio analysis tool, the index returns and statistics will be retrievable by loading the U.S. Hybrid ARM Index. Bloomberg: Type LEHM <GO> to take you to the index selection screen for Lehmans Global Family of Indices. Select Other from the U.S. & Canada column, then select U.S. Hybrid ARM Index. This will provide the monthly and daily index returns and statistics. Here are some example reports and data that can be found on LehmanLive.

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EXCESS AND PERIODIC RETURNS SCREEN FOR HYBRID ARMS

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BASIC STATISTICS SCREEN FOR HYBRID ARMS

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APPENDIX A: LEHMAN BROTHERS U.S. MBS INDEX RESEARCH PUBLICATIONS

Managing Against the Lehman Brothers MBS Index: Evaluating Measures of Duration, L. Dynkin, B. Phelps, J. Mann, Lehman Brothers, April 2005. Managing Against the Lehman Brothers MBS Index: Pools vs. Annual Aggregates, B. Phelps, Lehman Brothers, June 2004. Managing Against the Lehman Brothers MBS Index: Prices and Returns, B. Phelps, J. Mann, Lehman Brothers, November 2003. Managing Against the Lehman Brothers MBS Index: Returns versus Statistics Duration, B. Phelps, J. Mann, Lehman Brothers, August 2003. MBS Index Returns: A Detailed Look, L. Dynkin, J. Hyman, V. Konstantinovsky, N. Roth, Lehman Brothers, August 1998.

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APPENDIX B: LEHMAN BROTHERS GLOBAL INDEX FRANCHISE AND METHODS

Lehman Brothers introduced the first total rate of return bond index in 1973 and has since become the global leader fixed income benchmarks. The Lehman Brothers Global Family of Indices has expanded rapidly in our quest to provide investors with a complete map of the global fixed income markets. While there are still some new fields to conquer, we are drawing closer to completing coverage of the investable fixed-income world. As of July 1, 2005, our indices contained over 55,000 bonds with a market value of $28.0 trillion. The value and analytics for each bond is calculated daily, and we maintain over 400 data fields per security. In addition to the main indices shown below (each with numerous sub-indices), we maintain approximately 3,000 customized indices for investors. Our indices are used by over 90% of U.S. institutional investors, a majority of European investors, and a growing share of Asian investors. Institutional investors have become increasingly sophisticated and require more advanced analytical support for their benchmarks. Thus, the expansion in the Global Family of Indices has been matched by our analytics platforms. Since its launch in 2000, our POINT (Portfolio and Index Tool) platform has grown rapidly in its capabilities. POINT has provided clients the ability to customize standard indices, create their own benchmarks, and perform in-depth portfolio risk and performance analytics versus standard or user-defined global benchmarks. All of Lehman Brothers indices adhere to the same set of underlying principles: Rules-based: To be included in a Lehman Brothers index, a security or issuer must meet all published eligibility requirements. This removes any subjectivity regarding the issues or names in the different indices. Each security (in the cash indices) can contribute to one or more indices, depending on their inclusion rules. Maintenance of statistics and returns universes: All Lehman Brothers indices consist of two universes. The returns universe is fixed at the beginning of each return period (one month for the cash indices). Holding the returns universe constant throughout the month means that a fund manager avoids having to hit a moving target and is able to rebalance at the end of each return period. The statistics universe is a dynamic set of bonds that changes daily to reflect the latest composition of the market. Changes due to new issuance, calls, or partial redemptions occur as of the settlement dates. Statistics such as market values and sector weightings are updated and reported daily. At the end of each reporting period, the latest statistics universe becomes the returns universe for the next reporting period. The statistics universe allows a manager to monitor changes in the market during the reporting period and thereby anticipate changes when the next returns universe is set at month-end. Data Quality: The Lehman Brothers Global Family of Indices is priced predominantly by traders, with vendor and matrix pricing used to fill the gaps and verify Lehman trader pricing. Cash indices are priced on the bid side, with the exception of new issues. These are initially priced on the offer side. Credit default swaps are priced at mid-market. To ensure that the statistics universe is up to date, Lehman Brothers maintains an extensive database of call/put features and refunding and sinking schedules on outstanding bonds, and it continuously monitors the market for retirement, new issuance, and rating change activity. Settlement: For index purposes, securities are assumed to settle on the next calendar day, except for mortgages, which are priced for PSA settlement in the following month and then discounted back to same day settlement at the mortgage repurchase date to match the other indices. At the end of the month, the settlement date is assumed to be the first day of the following month, even if the last business day is not the last day of the month. This procedure allows for one full month of accrued interest to be calculated.
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Lehman Brothers | Fixed Income

Introducing the U.S. Hybrid ARM Index

Total Returns: All Lehman Brothers index results are reported on daily, monthly, annual, and since-inception bases. Returns are cumulative for the entire period. Intramonth cash flows (coupon, calls, redemptions, and paydowns) generated by an index remain un-invested in the benchmark until month-end. For further details, please see Guide to the Lehman Brothers Global Family of Indices.

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The views expressed in this report accurately reflect the personal views of Nick Gendron, the primary analyst(s) responsible for this report, about the subject securities or issuers referred to herein, and no part of such analyst(s) compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed herein. Any reports referenced herein published after 14 April 2003 have been certified in accordance with Regulation AC. To obtain copies of these reports and their certifications, please contact Larry Pindyck (lpindyck@lehman.com; 212-526-6268) or Valerie Monchi (vmonchi@lehman.com; 44-(0)207-102-8035). Lehman Brothers Inc. and any affiliate may have a position in the instruments or the companies discussed in this report. The firms interests may conflict with the interests of an investor in those instruments. The research analysts responsible for preparing this report receive compensation based upon various factors, including, among other things, the quality of their work, firm revenues, including trading, competitive factors and client feedback. Lehman Brothers usually makes a market in the securities mentioned in this report. These companies are current investment banking clients of Lehman Brothers or companies for which Lehman Brothers would like to perform investment banking services.
Publications-L. Pindyck, B. Davenport, W. Lee, D. Kramer, R. Madison, A. Acevedo, M. Graham, V. Monchi, K. Banham, G. Garnham, Z. Talbot This material has been prepared and/or issued by Lehman Brothers Inc., member SIPC, and/or one of its affiliates (Lehman Brothers) and has been approved by Lehman Brothers International (Europe), authorised and regulated by the Financial Services Authority, in connection with its distribution in the European Economic Area. This material is distributed in Japan by Lehman Brothers Japan Inc., and in Hong Kong by Lehman Brothers Asia Limited. This material is distributed in Australia by Lehman Brothers Australia Pty Limited, and in Singapore by Lehman Brothers Inc., Singapore Branch (LBIS). Where this material is distributed by LBIS, please note that it is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. An investor should consult his Lehman Brothers representative regarding the suitability of the product and take into account his specific investment objectives, financial situation or particular needs before he makes a commitment to purchase the investment product. This material is distributed in Korea by Lehman Brothers International (Europe) Seoul Branch. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy the securities or other instruments mentioned in it. No part of this document may be reproduced in any manner without the written permission of Lehman Brothers. We do not represent that this information, including any third party information, is accurate or complete and it should not be relied upon as such. It is provided with the understanding that Lehman Brothers is not acting in a fiduciary capacity. Opinions expressed herein reflect the opinion of Lehman Brothers and are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, and they may not be suitable for all types of investors. If an investor has any doubts about product suitability, he should consult his Lehman Brothers representative. The value of and the income produced by products may fluctuate, so that an investor may get back less than he invested. Value and income may be adversely affected by exchange rates, interest rates, or other factors. Past performance is not necessarily indicative of future results. If a product is income producing, part of the capital invested may be used to pay that income. Lehman Brothers may, from time to time, perform investment banking or other services for, or solicit investment banking or other business from any company mentioned in this document. 2005 Lehman Brothers. All rights reserved. Additional information is available on request. Please contact a Lehman Brothers entity in your home jurisdiction.