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Securitized Products Weekly US Fixed Income Strategy J.P. Morgan Securities Inc.

February 19, 2010


Brian YeAC (1-212) 834-3128

An Introduction to IOS Synthetic Agency MBS IO


IOS is a synthetic total return swap index referencing the interest component of agency mortgage pools On March 12th, three IOS indices are expected to launch based on the Fannie Mae 30-year 4%, 4.5% and 5% pools issued in 2009 An IOS contract is structured to synthetically replicate the economic value of owning IO assets financed at Libor We expect that servicers and hedge funds will be natural participants in this product. Total return investors with the freedom to own derivative assets could also play major roles in this market Fundamentally, IOS pricing should be dictated by rate, curve, volatility, and prepayment expectations. However, technical factors may overwhelm We anticipate that IOS pricing will initially be benchmarked off of Trust IO and excess servicing IO cash bonds Being balance-sheet light, embedded term financing, higher leverage, and pricing transparency are the key advantages of IOS over cash IOs With broad dealer participation at launch, we are cautiously optimistic that IOS may succeed while past innovations in the mortgage market did not

Chart 1: IOS is a synthetic Total Return Swap


A diagram showing the monthly exchange of IOS cashflows

Financing Payment

Long IOS

MTM P&L

Short IOS

IO Cashflow (Coupon)
Note: Long IOS investor is also known as the Floating Rate Payer Short IOS investor is also called a Fixed Rate Payer Source: JPMorgan

The dealer community voted in December to start trading IOS (Interest Only Synthetic) indices in Q1 20101. As of this writing, the anticipated launch date of the Index is February 24th. IOS provides investors with synthetic exposure to the interest flows of agency MBS, an alternative to cash IO instruments which is hitherto unavailable.
1 IOS is administered by MarkIt. For official documentation, please visit: http://markit.com/en/products/data/indices/structured-financeindices/ios/ios.page?

IOS provides several advantages over cash instruments such as Trust IO, excess servicing IO and structured IO. First, many investors, especially new investors, may not be comfortable dealing with the idiosyncrasies of individual cash securities. Second, an IOS contract locks in term financing for the duration of the contract. Third, IOS is a derivative, and as such, it requires no capital other than counterparty margin requirements. Thus, IOS potentially offers higher leverage and with it the potential for higher ROE (return on equity). On the flip side, being a pure synthetic instrument with no tie in to physical securities, i.e. its not possible to deliver cash securities to close out a short IOS position, and technicals may drive and dominate pricing such that market pricing may acutely deviate from fair value. Cash investors may be able to ride out price fluctuations due to unfavorable technicals. However, the IOS is marked to market on a monthly basis, and temporary pricing dislocations in IOS can cost real money. In the following section, we explain the basics of index construction, the mechanics of an IOS trade, as well as factors that can influence pricing.

Index Construction: reference securities


IOS is expected to be launched initially with three subindices: IOS.FN30.400.09, IOS.FN30.450.09 and

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Securitized Products Weekly US Fixed Income Strategy J.P. Morgan Securities Inc. February 19, 2010
Brian YeAC (1-212) 834-3128

IOS.FN.500.09. As implied by their names, they reference the cashflows derived from interest payments on the 2009 vintage Fannie Mae 30-year 4%, 4.5%, and 5% coupons, respectively2. The reference securities are designed to be as generic and inclusive as possible. Generally, all eligible Fannie 30-year pools are included and aggregated. Specifically, eligible pools are: 1) Fannie 30-year pools with the CL prefix that were issued in 2009 with the stated corresponding coupon. 2) For the three launch indices, each pool must have at least 90% of the balance originated in 2009. 3) For subsequent sub-indices thereafter (see a discussion below on Index roll conventional), pool loan age must be less than 15 months. Practically, these aggregates are the typical coupon/vintage generics used mortgage prepayment analysis. Technically, there is a small difference in that these are issue-year aggregates whereas the market convention for segregating cohorts uses origination year. This difference is negligible.
2

IOS Trading: periodic payments and date fixings


IOS contracts are structured as total return swaps with monthly cashflow exchanged between counterparties, after netting. An investor long the Index would receive the interest component (coupon) of the reference mortgage collateral. In turn, he would make a financing payment. The financing rate is fixed at flat to 1-month Libor. In addition, marked-to-market gain or loss on the Index price is exchanged monthly. Essentially, an investor long the IOS can synthetically replicate the economic value of a long position in cash IO instruments financed at Libor. The IOS indices follow several day count and calendar day fixing conventions. Monthly payment exchanges are anchored to the Period End Date, the12th of each month, as follows: 1. 2. Settlement payments are made T+3 , after Period End Date Reset Date is the day before Period End Date (T-1). On Reset Date, Index Factor and Period End Price are observed and fixed.

http://www.markit.com/en/products/data/indices/structured-financeindices/ios/ios-documentation.page

Chart 2: Cashflow diagram: monthly exchange of IOS cashflows


Period One Reset Date: T-1 from Period End Date. Index Price and Factor Set 1-mo LIBOR set: T-2 from Period One End Date Period One End Date: 12th Day of the Month. Accrual period starts (act/360 ). Period Tw o Reset Date: T-1 from Period Tw o End Date. Period End Price set for Index. Pay ment Date: T+3 from Period Tw o End Date.

Period Tw o End Date: 12th Day of the Month. Accrual period ends (act/360 ).

Mar. 10, 2010

Mar. 11, 2010

Mar. 12, 2010

Apr. 9, 2010 1 Month Transaction Period

Apr. 12, 2010

Apr. 15, 2010

Interest Pay ment = Coupon * (Day count 30/360) * Notional * Period One End Index Factor Financing Cost = LIBOR * Period One End Index Price * (Day count A/360) * Notional * Period One End Index Factor MTM Index Price Change = [(Period Tw o End Index Price * Period Tw o End Factor) - (Period One End Index Price * Period One End Index Factor)] * Notional
Source: JPMorgan

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Securitized Products Weekly US Fixed Income Strategy J.P. Morgan Securities Inc. February 19, 2010
Brian YeAC (1-212) 834-3128

3.

The one-month Libor rate observed on the day before Reset Date (i.e. T-2 from Period End Date) is used for computing Financing Payments for the month following. Index Factor is published on Reset Date, using the most recently published pool factors. Generally, pool factors are released by the agencies on or before the 5th business day of each month. The calculation agent, MarkIt, is committed to collect and collate this information and publish the official Index Factor by the 11th. Period End Price is the end of day (EOD) price observed on each Reset Date. This price becomes the Commencing Index Price for the next computing period. Marked to marked (MTM) gain/loss is the difference between Commencing Index Price and Period End Price (i.e. month over month change in index price fixings), multiplied by the respective Index Factor. Financing payment is calculated from the 12 of each month to the 12th in the month following (i.e. from one Period End Date to the next) based on an actual/360 day count. Interest cashflow (coupon payment) is computed using a 30/360 day count; this adheres to the mortgage payment convention.
th

Table 1: Major risk factors in being long a synthetic IO asset


Factor Effect on Pricing Comment IOs hav e negativ e duration; a forw ard rates Volatility Theoretically uncertain; Increased mortgage rates may empirically , higher v ol result from higher v ol, results in low er IO prices Prepay ment Increased refi risk decreases IO prices Financing Higher Libor/financing prices Technical Unknow n Sy nthetic-Cash basis is a function of demand/supply , credit risk, liquidity risk and other factors
Source: JPMorgan

Rates/Curv e Low er rates/flatter

4.

curv e low ers IO prices flatter curv e leads to low er

decreasing call risk; but ex treme v olatilty hurt can increase IO hedge cost Faster prepay ments decrease IO notional Increased financing reduces

5.

rates result in low er IO carry and lev erage

6.

7.

8.

Chart 2 shows a sample cashflow exchange timeline during a monthly payment cycle.

Financing Payment, paid by the long IOS investor3, is computed from the prior Period End Date to Trade Date. Coupon payment is made by the short IOS investor; this is also accrued from the prior Period End Date to Trade Date. Finally, MTM gain/loss is the difference between Commencing Index Price and Trade Price, multiplied by Index Factor. Essentially, these are true-up payments consisting of accrued interest net of financing and any MTM gain/loss between Commencing Index Price and Trade Price. On the next Period End Date, the full monthly coupon payment net of financing and the month over month change in MTM gain/loss are exchanged.

Index Trading: accrued interest, financing, and true-up payments


A special payment and settlement procedure applies during the initial period following each trade (Trade Date). Payments are settled T+3 following Trade Date.

Future Index roll mechanism


Periodically after the initial launch, we expect new IOS sub-indices created to reference the most recently issued agency pools at that time. According to documents circulated by MarkIt, IOS Index roll should occur semiannually, or at least annually, depending on the success
3 The long IOS investor makes periodic financing payment based on one month Libor; he is the Floating Rate Payer. The short IOS investor is the Fixed Rate Payer.

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Indicates certifying analyst. See last page for analyst certification and important disclosures.

Securitized Products Weekly US Fixed Income Strategy J.P. Morgan Securities Inc. February 19, 2010
Brian YeAC (1-212) 834-3128

of the initial launch. The planned rolling mechanism should be familiar to users of credit indices such as ABX and CMBX. For instance, in the 2nd half of 2010, a new IOS index called IOS.FN30.450.10-01 may be created to reference 4.5% coupon Fannie 30-year pools issued in H1 2010. Similar indices off of Gold or Ginnie collateral may be created in the future, depending on the success of the IOS.FN30 indices.

Table 2: IOS collateral characteristics and indicative valuation metrics


Loan Coupon WAC Age FN Trust IO FNS 400 FNS 397 IOS 4.5 5.0 4.0 4.5 5.0 4.94 5.48 4.57 4.94 5.41 10 9 8 8 7 258 241 245 233 199 313 457 263 313 457 25.92 23.63 25.21 25.83 24.55 Size (k) L-OAS Price

Trust IO pricing and collateral characteristics; indicative IOS pricing, modeled priced to even OAS to comparable Trust IO benchmark as of 2/18/2010

IOS: asset pricing and risk factors


Just like cash IO instruments, IOS valuation is a function of interest rates, yield curve, volatility, mortgage rates and prepayments, plus factors such as financing and market technicals. IO valuation is the most sensitive to mortgage rates and prepayments. Higher mortgage rates (all else being equal) entail lower prepayments (i.e. lower call risk), longer IO cashflows streams and higher valuation. IOs have negative duration, because mortgages are continuously callable and the shortening in the IO cashflow stream in lower rates overwhelms the benefits of lower discount factors. IOs also lose value when the curve flattens because of lower forward rates (Table 1). IO prices exhibit negative convexity, similar to mortgage pass-throughs. As a result, volatility can hurt IOs. There is also a partially offsetting effect. Higher vol puts pressure on TBA prices, increases mortgage rates, and reduces prepayments which can benefit IOs. This secondary vol/mortgage rate effect is somewhat theoretical and model dependent. Empirically, higher realized vol increases IO delta hedging costs and can lead to widening in IO spreads and thus lower prices. Sure, inside the computer, mortgage basis widening reduces call risk and makes IOs look cheaper. In reality, the first order effect of IO negative convexity dominates pricing. IOS valuation should closely track Trust IO pricing, which has been the benchmark for two decades. Both the excess servicing and structured IO markets are priced off of Trusts. Typically, excess servicing IOs are traded at certain percentage discount to Trust IOs. Structured IOs are more nuanced and they are often model priced to a market OAS (again model dependent). This is because CMO deals often use collateral with better convexity than the cheapest-to-deliver TBA collateral backing

IOS 4.0 IOS 4.5 IOS 5.0

Source: JPMorgan, MarkIt

Trusts. Both asset classes generally trade at wider spreads relative to Trust IO. IOS reference pools are vintage cohort aggregates which are better than Trust IO collateral from a convexity standpoint. In Table 2, we display IOS collateral characteristics, based on our current understanding of the eligibility rules, to several recently issued Trust IOs (FNS 400 and 397). In our example, IOS prices are model priced at equal OAS to comparable coupon Trusts. Since a 4% coupon Trust IO doesnt exist, we are pricing it 50bp tighter to the 4.5 Trust (accounting for better convexity and the potential for less model error). The model priced IOS have comparable prices and valuation metrics relative to Trust IOs. We believe that initially IOS will likely trade cheap to Trust IO. One reason is the lack of familiarity with the product. A second reason is that dealers and other investor classes may fear the potential for massive servicer flows if IOS trades rich relative to Trust IO and excess servicing valuations. Servicers are the potential 800 pound gorillas in the market (see the discussion below on servicer participation). Since excess servicing trades cheap relative to Trust IO, dealers may handicap IOS pricing relative to Trust IO for fear of being run over by servicers if their pricing is too aggressive.

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Indicates certifying analyst. See last page for analyst certification and important disclosures.

Securitized Products Weekly US Fixed Income Strategy J.P. Morgan Securities Inc. February 19, 2010
Brian YeAC (1-212) 834-3128

IOS: market participants


The synthetic market should complement the existing cash IO markets. It offers advantages to cash such as being balance sheet light, having better pricing transparency, and increased leverage. Naturally, IOS are well suited to investors already involved in cash IO assets. Relative value trades involving IOS may include: 1) cash versus synthetic 2) IOS versus TBA coupon swaps and 3) IOS versus rates and vol. IOS offers a relatively easy way for investors to go long or short IO assets, potentially without limitation. Thus, IOS can be an important hedging as well as relative value tools. We discuss how IOS may be viewed by different investor classes (Table 3) and summarize them below: 1. Dealers can short IOS to hedge long cash IOs positions. Dealers can also go long/short IOS to offset down in coupon/up in coupon positions. However, combining IOS positions with cash positions may involve significant cash/synthetic basis risks. Hedge funds and money managers can be long/short IOS versus TBA coupon swaps or versus rates. The decision is mainly driven by relative value. IOS may also appeal to traditional mortgage investors seeking to shed portfolio duration without giving up carry. Long IOS together with TBA pass-throughs synthetically creates an up-in-coupon exposure while maintaining or adding to carry. The downside is added negative convexity. This can also be accomplished with traditional cash IO bonds. The advantage of IOS is that it avoids bond specific idiosyncrasies Servicers may find that IOS could be the perfect market value hedging tool for servicing assets (MSR). Servicers are natural IOS sellers. Since IOS cashflows are referenced off of generic vintage cohorts, theoretically its valuation should closely mirror servicing valuations. IOS avoids the idiosyncratic nature of Trust IOs and may have better pricing transparency than structured IOs. Shorting IOS is akin to selling excessive servicing. The main difference is that selling excessive servicing affords balance sheet

Table 3: A summary of major IOS investor classes


Investors Position Comment hedge PO positions Dealer/Pass- Long/Short Relativ e v alue v ersus TBA coupon stack through Hedge Funds Money Managers Long/Short Relativ e v alue v ersus TBA coupon stack; Basis trade Long/Short R/V v ersus TBAs; Long IOS can reduce duration w /o selling carry ; increase negativ e conv ex ity ; Many can not directlly ow n deriv ativ es. Serv icers Short Natural market v alue hedge for serv icing assets
Source: JPMorgan

Dealer/CMO Long/Short Short IOS to hedge cash IO bonds; Long IOS to

2.

relief but shorting IOS does not. On the other hand, bringing an excess servicing deal to market can be time consuming and is rarely employed as a hedging tool. It is often a balance sheet management tool. In theory, servicers could arbitrage IOS and excess servicing pricing difference by selling excess servicing and buying back the IO exposure through synthetic IOS or vice versa. In reality, they are different and each has its purpose.

IOS: limitations and drawbacks


While mortgage servicers are natural sellers of IOS, natural buyers of IOS are hard to pinpoint. Macro hedge funds may be key players in IOS. IOS offers a leveraged vehicle for hedge funds express views in volatility, rates, and curve while potentially boosting carry. The pricing transparency of IOS also should help these nontraditional mortgage investors Many traditional mortgage investors can not directly invest in derivatives but can own cash bonds with embedded derivatives. This is a potential drawback of IOS and it places limitations on investor participation. IOS also has counterparty risks to worry about as well as heightened liquidity risk during times of extreme market volatility. The credit crisis of the past two years has taught a valuable lesson in managing liquidity in dislocated markets. However, the performance of ABX,

3.

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Indicates certifying analyst. See last page for analyst certification and important disclosures.

Securitized Products Weekly US Fixed Income Strategy J.P. Morgan Securities Inc. February 19, 2010
Brian YeAC (1-212) 834-3128

CMBX, and other indices during the crisis has shown that derivative instruments with pricing transparency could be more liquid than cash bonds. IOS is scheduled for launch on March 12th with initially 8-10 dealers participating and contributing daily pricing. The reaction from the investor community has so far been mixed. The role of ABX and its supposed impact on cash bond prices is still being debated. Some argue that the excessive shorting of ABX indices had contributed to the collapse of subprime markets in 2007/2008 and fear that IOS could do the same at the most inopportune time. There is concern that IOS may be the tail that wags the dog, contributing to further volatility in IO asset pricing. Servicers are natural sellers in IOS and when the going gets tough, as the saying goes, who will take the other side? While the debate between cash versus synthetics rages on, many investors will approach IOS cautiously. This may limit its, at least initially.

Conclusion
While were cautiously optimistic, the history of innovation in the synthetic mortgage market has not been particularly encouraging. The mortgage index total return swap market has had a checkered history. CMM has done better, but to this day, dealer participation is still limited. The RPX (a housing price derivative) is an exchange traded derivative that has failed to catch on. IOS may avoid a similar fate. Unlike CMM which prices off of mortgage nominal basis, arguably an artificial construct, or RPX, a relative novelty, the mortgage market has been actively pricing IO assets for two decades. The 2009 prepayment experience has yielded a deeper and richer understanding of borrower prepayment behavior which ultimately determines IO asset pricing. With broad dealer participation at launch, IOS may have a better chance of success than synthetic mortgage products of the past.

AC

Indicates certifying analyst. See last page for analyst certification and important disclosures.

Securitized Products Weekly US Fixed Income Strategy J.P. Morgan Securities Inc. February 19, 2010
Brian YeAC (1-212) 834-3128

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Securitized Products Weekly US Fixed Income Strategy J.P. Morgan Securities Inc. February 19, 2010
Brian YeAC (1-212) 834-3128

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