MBS Research US Fixed Income Strategy J.P. Morgan Securities Inc.

July 29, 2008 Amy HsiAC (1-212) 834-3123 Matt Jozoff (1-212) 834-3121

An Introduction to U.S. Covered Bonds

Covered bonds are bank-issued debt with security interest in a pool of collateral, i.e., high quality mortgages. Unlike MBS, they are not a securitization of assets. We view covered bonds as another financing tool for banks, allowing them a new avenue to access the capital markets, rather than a means of capital relief. Treasury issued best practice guidelines, which include criteria on eligible collateral and basic structure of the securities to achieve some uniformity in the issues.

Treasuries, or 140 bp over swaps. We estimate that covered bonds issued by this corporation would trade around swaps + 50-90 bp, assuming prime loans as collateral. These are approximations, however, and actual clearing levels are yet to be determined. Finally, another positive for issuers: assets being funded are not markedto-market and up to 10% of collateral pool can be pledged with AAA mortgage securities. On the negative side for issuers, the biggest hurdle is that mortgage loans backing covered bonds remain on banks balance sheets and do not offer issuers any risk mitigation or capital relief, as securitization does. Furthermore, covered bond issuance is currently limited to 4% of the issuing institutions total liabilities, and we therefore estimate total issuance will be no more than $500bn. This limit could be raised as the market develops. However, another constraint to the size of this market would be the amount of eligible collateral outstanding. The initial size of the market will likely be small and dwarfed by the agency pass-through market, which is roughly $4.5 trillion in size, among other major differences in the structure and collateral. In addition, issuance of covered bonds to fund mortgages will create a mismatch of vol and duration between assets and liabilities. As discussed in more detail later, the principal of covered bonds are paid at maturity, and are structured in a way where the investors are protected from prepayments, but the underlying assets would be mortgages with prepayment risk. Finally, we dont expect mortgage rates to be significantly impacted by funding via covered bonds. Currently, banks already have relatively cheap sources of funding, such as deposits. Consider the following scenario: We could see covered bonds backed by agency eligible collateral trading as tight as swaps + 25 (depending on the issuer). With mortgages currently trading around LIBOR + 50 bp OAS (in our model), it would be attractive to issue covered bonds at swaps + 25 and buy mortgages. But we could see mortgages potentially tightening through the covered bond funding level because banks will rely on other funding sources (FHLB advances, deposits, etc.). From investors perspective, covered bonds will receive favorable treatment from a capital standpoint, as their credit risk is mitigated by their first recourse to the pool in addition to an unsecured claim against the issuer for any shortfall. However, they will not be as liquid as the TBA market, and even though there are general
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Following Treasury Secretary Henry Paulsons recommendations of covered bond issuance in the U.S. and yesterdays release of best practice guidelines, we explain the fundamentals of covered bonds, their potential effect on the U.S. MBS market and describe the established covered bond market that already exists in Europe. We view covered bonds as another financing tool for banks, allowing them a new avenue to access the capital markets, rather than a means of capital relief. Furthermore, liquidity in the U.S. covered bond market will not be comparable to the TBA market. Nevertheless, banks should get favorable funding via the covered bond market relative to issuing senior unsecured debt.

Effect on the U.S. MBS market

There are certainly pros and cons of the program for an issuer. On a positive note for issuers, covered bonds should trade tighter in spread than their unsecured debt. As a comparison, in the U.K. markets, we find that a 5-yr covered bond trades around swaps + 80bp, while AAA RMBS trades at Libor + 170bp, and senior unsecured debt at LIBOR + 150bp. Evidence suggest covered bonds could trade as tight as 50-75 bp tighter than the unsecured debt. However, this will depend heavily on the issuer and collateral, of course. We expect interest for these bonds to be mainly from corporate investors, who may not give as much credit to the underlying collateral. Here in the U.S., assume a bank issues AA- unsecured 5-year senior debt at 230 bp over

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MBS Research US Fixed Income Strategy J.P. Morgan Securities Inc.

July 29, 2008 Amy HsiAC (1-212) 834-3123 Matt Jozoff (1-212) 834-3121

guidelines, there will less uniformity of issuer credit and collateral used. We anticipate that the development of a covered bond market in the U.S. will not have a large impact on the MBS market, per se. It is not meant to replace or fix the current securitization market, but instead offers another source of funding for banks.

U.S. covered bonds to be backed by high quality mortgages

As a result of strict collateral requirements based on U.S. Treasury guidelines, the credit worthiness of covered bonds is quite high, with highest ratings expected for most issuances, potentially allowing banks a cheaper form of financing compared to senior unsecured debt. How much cheaper will depend ultimately on the liquidity and demand it receives from investors. Some eligible collateral pool criteria as per Treasurys Best Practices for Residential Covered Bonds are as follows: o Performing mortgages on one-to-four family residential properties. o Mortgages underwritten at the fully indexed rate. o Mortgages income. underwritten with documented

Overview of covered bonds

Covered bonds are bank-issued debt with security interest in a pool of collateral, e.g. high quality mortgages. To be clear, principal and interest are paid by the issuer and the pool of mortgages simply serves as collateral in case the issuer becomes involved. In the event that the issuing bank defaults, the underlying assets in the collateral pool are used to pay the covered bond investors. If there is a shortfall between collateral recovery and principal owed, the investor then becomes an unsecured creditor. To jumpstart the market in the U.S., the Treasury issued best practice guidelines, which include criteria on eligible collateral and basic structure of the securities to achieve some uniformity in the issues. Unlike MBS or ABS, covered bonds remain on-balance sheet. The bonds remain obligations of the bank, and the underlying loans remain risks to the bond issuers. Furthermore, the collateral supporting the bond is dynamic where non-performing or prepaying assets have to be substituted. Pools collateralizing MBS remain static until maturity. In the event that the issuing institution defaults, swap and deposit agreements are in place to ensure that there are no prepayments prior to maturity. In the event of default, the FDIC would act as conservator for outstanding covered bonds of insured depository institutions. If possible, the FDIC administers the covered bond under the original terms. Otherwise, it can either pay off the covered bond in cash up to the value of the pledged collateral or allow for the liquidation of the pledged collateral to pay off the covered bonds. To be clear, there are no guarantees from the FDIC or the government for any repayment of principal.

o Mortgages that comply with existing supervisory guidance governing the underwriting of residential mortgages, including the Interagency Guidance on Nontraditional Mortgages and the Interagency Statement on Subprime Mortgage Lending. o Cash, Treasuries, and agency securities, as necessary, to prudently manage the cover pool. o Mortgages that are current when added. Any mortgage that become more than 60 days delinquent must be replaced. o Mortgages with LTVs of 80% or less when included. In the event that the LTV of a mortgage within the cover pool exceeds 80%, only the portion that is 80% or less counts towards the value of the cover pool. o No more than 20% of cover pool mortgages can be within a single MSA. o Negative eligible. amortization mortgages are not

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MBS Research US Fixed Income Strategy J.P. Morgan Securities Inc.

July 29, 2008 Amy HsiAC (1-212) 834-3123 Matt Jozoff (1-212) 834-3121

o Cover pools must be overcollateralized by at least 5% at all times.

Covered bonds in Europe

At the end of 2007, there were 2.1 trillion of covered bonds outstanding in Europe, which are backed by mortgages or by public sector debt. The covered bond market grew quickly in Europe since 1995, where there arent any government agencies such as Fannie Mae, Freddie Mac, and Ginnie Mae to facilitate funding for the housing market. In the U.S., only Washington Mutual and Bank of America have issued covered bonds so far. Covered bond laws vary slightly by country, but in Germany, where more than half of outstanding covered bond are issued and where Pfandbriefe have a more than two hundred year history, there are similar strict cover pool requirements. These requirements have kept Pfandbriefe relatively safe investments, with no cases in which creditors have failed to receive their obligations.

Final thoughts
Looking ahead, we expect banks will see additional sources of funding through covered bonds, and although we expect pricing to be cheaper than unsecured debt, it will take some time to reach the efficiency of the European markets. More importantly, although this diversifies bank liabilities and potentially offers cheaper funding, it does not solve the current balance sheet pressures that banks are experiencing. Nevertheless, covered bonds provide a different source of mortgage funding for U.S. banks and could be a valuable tool for some institutions.

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Securitized Products Weekly US Fixed Income Strategy J.P. Morgan Securities Inc.
July 29, 2008 Amy HsiAC (1-212) 834-3123

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