MBS - Lehman - Specified Pool Handbook

Fixed Income Research

The Specified Pool Handbook March 17, 2005

Sandeep Bordia 212-526-9325 [email protected] Prasanth Subramanian 212-526-8311 [email protected]

INTRODUCTION Specified collateral provided significant call protection during the 2003 refinance wave, and these stories are well documented. Specified collateral stories for extension protection, however, are relatively less understood. In this article, we take a closer look at discount prepayments for different collateral types. We draw our results primarily from agency discount prepayment data for 2003-2004 and non-agency loan level data for 1999-2000. The non-agency data was particularly useful in corroborating our analysis as agency discount prepayment data with expanded disclosures is relatively limited. We also review different collateral stories that provide call protection. Most of the results we present on the call side are based on agency data. It suffices to say that the results are very similar to what we find in non-agency loan level data.

PRIMARY CONCLUSIONS There is significant variation in prepayments across collateral types for both discounts and premiums. Prepayment differentials are mainly due to differences in credit, demographics, loan size and economic incentive to trade up or cashout. Our primary conclusions are as follows: •

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•

•

•

Low FICO, high LTV and non-owner-occupied pools provide significant call and extension protection. Low FICO pools in particular have always prepaid faster in a discount environment and slower during refinance waves. Prepayments on new high LTV pools are dependent on the strength of the housing market. However, high LTV conventional pools prepay very similarly to GNMA. The housing market notwithstanding, high LTV pools are a cheap substitute for GNMA-discount pools. Low loan balance refinancings are significantly slower than typical collateral. However, we do not have conclusive data on their behavior in a backup. At the margin, we believe that low-loan-balance collateral is likely to prepay faster in a serious backup. Pools with a higher share of refinancers season faster but to a similar turnover rate as purchase borrowers. Moreover, refinance borrowers are more more callable than purchase borrowers. States with higher transaction costs have consistently prepaid slower in a refinance environment. Discount prepayments by geography, however, seem to be driven largely by the economy and home price appreciation.

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

Lehman Brothers | MBS Research

The Specified Pool Handbook

SUMMARY OF SPECIFIED POOL STORIES

Low FICO

Refinance Behavior: Low FICO borrowers have lower opportunities to refinance. 0-12 month 700 FICO pools prepaid 12% CPR slower than a 750 FICO pool for a 100bp rate incentive. The differences decrease with age, 12-24 month pools prepaid only 6% CPR slower. 650 FICO pools prepaid 14% CPR and 4% CPR slower than 700 FICO pools within the 0-12 WALA category and 12-24 WALA categories respectively. Turnover Behavior: Due to defaults and credit curing, turnover on low FICO pools is higher. A typical 1218 months seasoned, 700 FICO agency pool prepaid about 1.5-2% CPR faster than a 750 FICO pool when 50bp out of the money. 650 FICO pools prepaid almost 5% CPR faster than an average 750 pool. Amount Outstanding in the Category: Category: Almost 50% of the total outstanding conventional 4.5s, 5s and 5.5s of the 2003 and 2004 vintage have an average FICO of 725 or below. Valuation and Relative Value: Current coupon medium FICO pools (average FICO 700) should trade at a payup of 15/32nds over TBAs. Currently there is no payup for this collateral.

High LTV

Refinance Behavior: Similar to weaker credit borrowers, high LTV borrowers have fewer refinancing opportunities. Newly issued high LTV pools prepaid almost 15%CPR slower than high LTV pools in the 2003-04 refinance episode. The differences decreased with seasoning as the high LTV loans accumulated equity and could qualify for lower rate loans. Turnover Behavior: The incentive to get rid of the mortgage insurance payment causes high LTV discounts to prepay faster. However, this is contingent on a strong housing market. Amount Outstanding in the Category: Almost 20% of the total outstanding conventional 4.5s, 5s and 5.5s of the 2003 and 2004 vintage have an original LTV > 75. Valuation and Relative Value: High LTV conventional discounts are an ideal substitute for GNMAs. Prepayments on these two collateral types have been on top of each other. The GNMA universe is primarily comprised of high LTV borrowers.

Non-Owner Properties

Refinance Behavior: Non-owners pay higher rates than owners and have fewer opportunities to refinance. A typical 12-24 WALA non-owner pool prepaid about 20% CPR slower than an owner pool for a 100bp rate incentive in 03-04. Turnover Behavior: Moving costs for non-owners are lower as they do not live in the house. Within nonagencies, discount investor properties have prepaid almost 2% CPR faster than owner properties. Amount Outstanding in the Category: Almost 7% of the total outstanding conventional 4.5s,5s and 5.5s of the 2003 and 2004 vintage have less than 75% owner occupied properties. Valuation and Relative Value: Current coupon 100% investor properties are trading at a 4+/32nd payup currently. Their fair value is close to 20/32nds. The value of these pools up 50 bp in rates is close to 28/32nds.

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SUMMARY OF SPECIFIED POOL STORIES Purchase Borrowers

Refinance Behavior: Refinance borrowers have demonstrated their efficiency in refinancings and are more callable than pools backed by purchase borrowers. Prepayment differences converge over time. Prepayment differences on pools with 25% and 75% share of refinancers (both 100 in-the-money) go from 22% CPR in the first 12 months to 7% CPR in the next 12 months. Turnover Behavior: Refinance borrowers benefit from a modest amount of pre-seasoning as they have been in the house longer. The extension properties are therefore worth as much as a moderately seasoned bond. Amount Outstanding in the Category: Purchase borrower, pools where % purchase is >50% comprise almost 30% of the 2003-04 vintage discounts. Valuation and Relative Value: Because of their worse callability refinance pools are worth less than purchase pools across coupons and even when the pool is almost 100bp in the money. We think the fair value of 50% purchase pools on current coupons is 6+/32nds over TBAs. This is a sector to pick up some cheap call protection.

Low loan Balance

Refinance Behavior: Because of the fixed costs of refinancings, low loan balance borrowers have less of a monetary incentive to refinance for the same rate incentive. Turnover Behavior: Primarily from empirical findings, 50 bp discount LLB collateral prepaid about 1.5%2% CPR faster than the average in both 1999-2000 and 1994-1995. There can be a case made for LLB borrowers to turnover faster primarily from the argument of a greater motivation to trade up. We believe LLB collateral discounts will prepay faster in a serious backup. Amount Outstanding in the Category: Almost 10% of the total outstanding conventional 4.5s, 5s and 5.5s of the 2003 and 2004 vintage have a loan size less than $100K. Valuation and Relative Value: Prepayments on the 2003 vintage 4.5s have shown a clear dependence on loan balance. Currently the market does not charge a premium for LLB 4.5s; we believe the fair value on these pools is around 20/32nds.

Geographies

Refinance Behavior: Transaction costs are very different across geographies and are a big determinant of a borrower’s callability. Turnover Behavior: On the turnover front, differences across geographies are driven primarily by the strength of the local economy and local home price appreciation. Valuation and Relative Value: It is very hard to take a view on regional differences in home price appreciation.

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LOWER FICO - SLOWER REFINANCING, FASTER TURNOVER •

•

Low FICO borrowers should have better convexity characteristics.

Low FICO pools have always prepaid faster in a discount environment and slower during a refinance wave. A typical 700 FICO pool should command a 15/32nds pay-up over TBA 5.5s; these pools are currently trading flat to TBAs. There is therefore substantial repricing potential in this sector.

Weaker Credit Borrowers - Better Convexity FICO is the most direct measure of credit available for agency pools. Like other credit impaired borrowers, opportunities available for a low FICO borrower to refinance are relatively limited. As a result, refinancings on low FICO pools are likely to be substantially lower than regular

pools. Moreover, as weaker credit pools season, there is a greater likelihood of both credit curing and default. As such, discount prepayments for low FICO pools are likely to be faster than high FICO pools. Weaker credit pools in the agency market have been valued for their better call protection so far. However, the better extension properties of this collateral have been more or less ignored and this is an area of potential significant repricing in the market.

On average, most pool characteristics are fairly uniform across FICO gradations.

The Outstanding Balance in Low FICO Pools Typical agency fixed-rate pools have FICO scores highly skewed to the high end of the range.

For instance, taking the example of the 2003 vintage 30-year conventional 5s (Figure 1 & Appendix A): Almost 70% of the vintage has a FICO score of 725-775 (Figure 1). The next rung is medium FICO pools, which have FICO scores of 675-725 and represent almost 25% of the outstanding balance in this cohort. The last rung of low FICO pools is, as would be expected, a small proportion of the agency universe. For instance, among conventional 5s, this category accounts for only 1.5% of the outstanding. On average, most other pool level characteristics are fairly uniform across FICO gradations. The only characteristic that stands out is the original loan to value (LTV). Average LTV increases by 5% on moving from 750 FICO pools to 650 FICO pools (Figure 1). Since other characteristics are fairly uniform on aggregate, it is possible to assign a value for lower FICO pools that is independent of other pool characteristics. • •

•

Figure 1. Other Characteristics Are Uniform across FICO Buckets

All Low FICO (625-675) Medium (675-725) High (725-775)

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Avg LTV

Avg FICO

% Refi

% Owner

70 74 72 69

728 652 717 733

76% 77% 75% 76%

95% 98% 95% 96%

Loan Size ($K) 168 180 169 167

% Bal 100.0% 1.5% 28% 70.5%

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Lower FICO pools refinance slower.


Low FICO Pools Refinance Slower In Figure 2, we show the refinance curves of agency pools in the 2003-2004 refinance episode.

The curves suggest that a borrower’s responsiveness to refinancing opportunities is highly correlated with his FICO score. Moreover, the effect of FICO on prepayments is visible for a wide range of credit scores, tapering off only for borrowers with FICOs north of 750. For example, a typical 0-12 month seasoned 700 FICO pool prepaid about 12% CPR slower than a 750 FICO pool for about 100bp rate incentive. 650 FICO pools prepaid another 14% CPR slower. While the differences in prepayments for FICO buckets reduce with seasoning (and burnout), the effect is fairly persistent. A 12-24 month seasoned 650 FICO pool in 2003-2004 prepaid 4% slower than a 700 FICO pool, which, in turn, prepaid another 6% CPR slower than a 750 FICO pool. These differences were higher for greater rate incentive buckets. In fact, given these differences in callability, the call protection on low FICO pools appears to be similar to low loan balance collateral.

Figure 2. Agency Refinance Curves 2003-2004, 0-12 WALA % CPR 75 FICO=650 FICO=700 FICO=750

60

45

30

15

0 0

50

100

150

200

Rate Incentive (bp)

Low FICO agency discounts prepaid faster in 03-04.

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Low FICO Pools Turn Over Faster As we noted earlier, there is greater likelihood of both credit curing and default in a low FICO pool. Discount prepayment data confirms this reasoning (Figure 3). A typical 12-18 months seasoned 700 FICO agency pool prepaid about 1.5%-2.0% CPR faster than a 750 FICO pool for -50bp rate incentive over the last two years. Moreover, the incremental prepayment effect of every 50 point move in FICO is even bigger as we moved down in FICO scores. 12 WALA 650 FICO pools prepaid almost 5% CPR faster than 750 FICO pools.

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Figure 3. Agency Seasoning Curves 2003-2004, 50 bp out-of-money % CPR 20 FICO=650 FICO=700 FICO=750

16

12

8

4

0 0

6

12

18

WALA (Months)

Non-agency discount data from 99-00 confirms the low FICO – high turnover behavior.

Clear Trends Seen in Non-Agency Prepayments Agency discount prepayment data in 2003-2004 was rather sparse, especially for high negative rate incentives given the premium nature of the MBS index in this period. To have more conviction for our analysis, we resorted to non-agency prepayment data from the 1999-2000 backup episode. Specifically, we compared deep out-of-money seasoning profiles of all nonconforming jumbo and jumbo Alt-A loans by FICO and found the behavior very similar to agencies (Figure 4). On average, >700 FICO (average FICO 750) borrowers consistently

prepaid about 1%-2% CPR slower than <700 FICO (average FICO 665) borrowers, despite similar WACs, LTV ratios, and loan sizes. Figure 4. Non-Agency Seasoning Curves 1999-2000, >50 bp out-of-money % CPR 12 FICO<700 FICO>=700

9

6

3

0 2

6

12

18

23

29

35

WALA (Months)

Sources: MIC, Lehman Brothers

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There is substantial value to be extracted from the better extension properties of low FICO.


The Valuation of Low FICO Pools 12-24 WALA Medium FICO pools when 100bp in the money have prepaid 6% CPR slower

than high FICO pools in 2003-2004. The market recognizes the value of weaker credits on the call side and 100bp premium low FICO pools currently command a 12/32nd premium over TBAs. The true value of the low FICO story derives, however, from its better extension protection properties. Fully seasoned medium FICO (700 FICO) pools turnover 1% CPR faster than TBAs. The turnover of low FICO pools (650 FICO) is almost 5% CPR faster. Figure 5 shows the fair value of lower FICO pools on an even OAS and even ZV basis. The even OAS payups fully reflect the shorter durations and better convexity of these pools, while the even ZV payups do not capture the better optionality in these pools. As one can see, the fair payup of current coupon low FICO pools is over a point, while medium FICO pools should command a payup of close to half a point. The fair value of 50 bp discount medium and low FICO pools is 14/32nds and 1-21/32nds, respectively.

Value in low FICO pools: With current coupon low FICO pools trading almost flat to TBAs, there is substantial value to be extracted from the better properties of low FICO pools. With almost 30% of agency pools in the medium FICO bucket, the effect of a repricing in this sector can be substantial.

Figure 5. Substantial Value in Low FICO Pools : 12-24 WALA Pools

Relative Coupon on Passthrough -50 CC +50 1 21/32 1 6/32 29/32 1 6/32 18/32 5/32

Low FICO Pool (625-675 FICO)

Even OAS Payup Even ZV Payup

-100 2 7/32 1 27/32

Medium FICO Pool (675-725 FICO)

Even OAS Payup Even ZV Payup

16/32

14/32 14/32

15/32 7/32

13/32 2/32

14/32 4/32

N/A

N/A

1/32

7/32

13/32

Current Market Payups for Low FICO

22/32

+100 28/32 4/32

Note: Valuations assume that in addition to better call protection, the base case turnover on low FICO pools is 5% CPR faster and is 1.5%CPR faster on medium FICO Pools

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HIGH LTVS: SLOWER REFINANCINGS, DISCOUNT SPEEDS LEVERAGED TO HOME PRICE APPRECIATION • •

High LTV borrowers have a better convexity profile due to their equity constraint.

High LTV borrowers prepay slower than typical pools in a refinance environment. Discount high LTV pools are a cheap substitute for GNMA pools.

Equity Constrained Borrowers: Better Convexity Original LTV is a proxy for borrower’s equity constraint. It acts primarily to separate low LTV (LTV<80) borrowers from high LTV (LTV>80) borrowers. High LTV borrowers pay an insurance premium for the higher amount of risk they carry. Similar to weaker credit borrowers, they have fewer refinancing opportunities. However, as housing prices rise, a drop in actual LTVs allows some of the >80 LTV borrowers to trade up or do a cashout. This also helps them get rid of their mortgage insurance payment. As a result, we would expect discount

prepayments for high LTV borrowers to be higher in a strong housing environment.

The characteristics of a <80 LTV borrower are very different from a >80 LTV borrower.

The Outstanding Balance in High LTV Pools Whereas almost 30% of the outstanding population is in the medium FICO bucket, the amount outstanding in higher LTV pools is more modest. For instance, within the 2003 vintage 30-year 5s, high LTV (>80%) pools represent only 3% of the total outstanding (Figure 6). Across coupons, the amounts outstanding are fairly substantial. Almost 20% of the total outstanding

conventional 4.5s, 5s and 5.5s of the 2003 and 2004 vintage have an original LTV > 75 (Appendix A). The characteristics of a high LTV borrower are also very different from a <80 LTV borrower (Figure 6). Most of these differences arise from the fact that higher LTV borrowers tend to be purchase borrowers and, possibly, first-time borrowers. The average WACs on higher LTV pools are around 8 bp higher than a lower LTV pool. The FICOs are comparable, though we see a minor decline, of around 15 points, on moving into higher LTVs. The share of refinance borrowers drops significantly, from 80% to 60%, on moving from <80 LTV pools to those greater than 80. Higher WACs, lower FICOs, and a higher share of investment properties are all characteristics that should enhance the discount prepayment behavior of high LTV pools.

Figure 6: Other Characteristics Are Uniform across FICO Buckets

All Low LTV (<80) High LTV (>80)

Newly issued high LTV premiums prepay significantly slower.

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WAC 5.49 5.48 5.56

Avg FICO 728 729 716

% Refi 76% 77% 61%

% Owner 95% 96% 94%

Loan Size ($K) 167 168 161

% Bal 100.0% 97% 3%

Newly Issued High LTV Pools Refinance Slower As expected, high LTV premium pools prepaid significantly slower than regular pools in 20032004 (Figure 7). However, the effect of original LTV on callability decreased rapidly with seasoning. We believe that the decay in this effect was driven primarily by the exceptionally strong housing market, which improved the refinancing opportunities for high LTV borrowers by lowering their actual LTVs (Figure 8). In a weaker housing market, we would expect the effect of high LTV on refinancings to decay at a slower rate.

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Figure 7. Agency Refinance Curves 2003-2004, 0-12 WALA % CPR 75 LTV=70 LTV=80 LTV=90 LTV=100

60

45

30

15

0 0

50

100

150

200

150

200

Rate Incentive (bp)

Figure 8. Agency Refinance Curves 2003-2004, 12-24 WALA % CPR 75 LTV=70 LTV=80 LTV=90 LTV=100

60

45

30

15

0 0

50

100 Rate Incentive (bp)

High LTV discount prepayments in 99-00 and 0304 were very much in line with intuition.

High LTV Turnover Faster in a Strong Housing Market There is relatively less prepayment variation for discounts within the LTV<80 group. However, prepayments of high LTV borrowers confirm our intuition. Borrowers with a >80 original LTV have prepaid significantly faster than the average loan in 2003-2004 (Figure 9). Given the strength of the housing market over the last couple of years, 85-95 LTV borrowers prepaid faster

than an average pool, even with a few months of seasoning. 95-105 LTV borrowers, however, had to season for a few extra months before some of the borrowers in the pool had their LTVs fall below 80. So while prepayments on 95-105 LTV pools were slightly slower than a typical borrower in the first few months, they turned out to be significantly faster when moderately seasoned. We find similar prepayment behavior in non-agencies in 1999-2000. However, one should note that strong home price appreciation occurred in both 1999-2000 and 2003-2004 . For newer collateral, high LTV discount prepayments are a function of the housing market. Still, we expect high LTV pools in cohorts with significant accumulated home price appreciation (e.g., 2003 vintage) to prepay faster than low LTV pools in the foreseeable future.

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Figure 9. 03-04 Agency Seasoning Curves, -50 bp rate incentive (diff from overall, % CPR)

WALA 0 6 12 18

45-55 -0.2 -0.4 -3.3 -0.3

55-65 0.0 0.0 -0.8 0.0

Original LTV 65-75 75-85 0.0 0.1 0.0 0.2 -0.1 1.7 -0.1 1.4

85-95 0.4 0.3 3.2 4.5

95-105 -0.4 -0.5 6.4 4.9

The Relationship of Prepayments to GNMAs and Low FICO Pools Fast GNMA Speeds Are Primarily LTV Related

High LTV conventionals prepay very similar to GNMA.

Interestingly, high LTV conventional pools p repay very similar to GNMA collateral (Figure 10). For example, 95-100 LTV FNMA 03 5s prepaid on top of GNMA collateral for several months in a row. This is not surprising because high LTV FNMA borrowers also pay an insurance premium like GNMA borrowers. As home prices rise, they can potentially get rid of the insurance premium by refinancing into a regular <80 LTV loan. The GNMA population has very few less than 80 original LTV borrowers, which is the reason that aggregate discount speeds on GNs are much faster than conventionals.

Figure 10. High LTV Conventional Prepayments versus GNMA on 03 5s

GNMA

FNMA

Orig LTV 95-100 90-95 <=80

Sep 16 17

Oct 16 19

Nov 17 20

Dec 18 19

Jan 15 17

% Cur Bal 32.8% 61.9% 0.0%

95-100 90-95 <=80

17 16 11

18 15 12

15 18 13

16 16 13

17 17 11

0.3% 0.9% 97.4%

The Combined Effects of FICO and LTV

Low FICO pools prepaid faster than high FICO pools with each LTV gradation and vice versa.

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FICO and LTV are the most important determinants of a borrower’s credit profile and hence are important drivers of discount prepayments. Still, it is important to ascertain the level of interdependence between these two variables. Figure 11 shows that FICO and LTV seem to affect discount prepayments independently. Lower FICO pools have prepaid faster than higher FICO pools within each LTV bucket and vice versa. Moreover, most of the lower FICO pools have average LTVs. Similarly, most of the pools with high LTV have FICOs more in line with the aggregate average (Figure 12). Therefore FICO and LTV can be valued separately in a pool; it is unlikely that a low FICO delivered pool will have worse LTV characteristics.

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Figure 11. Jul04-Dec04 Prepayments on 03 5s by FICO/LTV, % CPR

Figure 12. % Balance Outstanding on 03 5s by FICO/LTV LTV

LTV

Discount LTV pools are cheap substitutes for GNMA.

FICO

60

600 650 700 750

16.9 9.5 10.3

70 19.1 15.4 12.0 10.8

80 25.3 21.8 14.7 10.9

90 40.9 29.4 18.1 11.7

FICO 600 650 700 750

60 0.1 1.2 6.8

70 0.1 1.0 23.4 58.6

80 0.1 0.2 4.7 2.6

90 0.0 0.1 0.5 0.1

Discount High LTV Pools: Cheap GNMA Substitutes The better call protection of high LTV pools is reasonably well appreciated by the market. We estimate that the better call convexity on higher LTV pools should be worth 19/32nds on a

100bp premium pool. Current market payups for these premium pools are around 6/32nds. Higher LTV pools have much more favorable properties on the turnover front. On average high LTV pools have prepaid 3-5% CPR faster than lower LTV pools. The discount prepayment behavior of higher LTV borrowers is however, significantly leveraged to home prices. The valuation of higher LTV pools is complicated because valuation would need to explicitly project home prices going forward. However, it is safe to say that in the absence of a very serious crash in the housing market, high LTV pools in seasoned vintages (2003s and earlier) should continue to prepay fast, reflecting the substantial built up equity in these vintages. Based on the base differences in prepayments, a 50bp discount high LTV discount pool should command a payup of 1-12/32nds a low LTV pool (Figure 13). Since higher LTV pools in the conventional space have prepaid as fast as GNs, an easier benchmark for valuation is to the prices on GN/FN swaps. Of course there are differences between the two strategies including the fact that unlike a GN pool, a high LTV pool will not be TBA eligible (the payup is lost if a high LTV pool is delivered, a GN pool retains its value) and cannot benefit from any special roll financing and the TBA liquidity. Also there are differences in payment delays on the two programs. Together, these factors should be worth around 10/32nds, or in other words the fair value for high LTV conventional pools is around 10/32nds lower than the corresponding GN payup. Value in high LTV Pools: Currently new issued current coupon high LTV pools are trading flat to TBAs. The GN/FN 5.5 swap is valued at 23/32nds. Given that there is almost no cost in buying high LTV pools, these are an ideal substitute for similar vintage GNMA pools.

Figure 13. Fair and Actual Payups on High LTV Pools, Create Cheap GNMA Substitutes

Even OAS Payups Even ZV Payups GN Payups Current Market Payups

Relative Coupon on Passthrough : CC i s Current Coupon -100 -50 CC +50 +100 1 28/32 1 12/32 30/32 21/32 19/32 1 18/32 1 16/32 4/32 2/32 28/32 29/32 23/32 19/32 22/32 N/A N/A 0 5/32 6/32

Note: Valuation assume that in addition to better call protection, the base case turnover is 4% CPR higher on high LTV pools.

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NON-OWNERS: LOWER REFINANCING, HIGHER TURNOVER Pools with higher share of non-owners are less callable. Lower transactions costs of moving also lead to faster speeds on discounts.

• •

Non-owner occupied borrowers have fewer opportunities to refinance and face lower moving costs.

Most of the outstanding is in higher coupon cohorts.

Non-Owners: Lower Opportunities to Refinance and Lower Moving Costs As for credit impaired borrowers, refinancing opportunities for non-owner occupied properties are relatively lower. As such, their in-the-money prepayments are significantly lower than regular pools. When it comes to turnover, transaction costs are much lower for a non-owner occupied loan. This is due mainly to “lower hassle and moving costs” because the borrower is not living in the house. Moreover, discount prepayments for investor properties are likely to be higher in a strong housing environment because the housing market activity is high. The Outstanding Balance in Non-Owner Pools Investor properties tend to attract a 20-30 bp higher rate than owner-occupied properties. Therefore, the amount outstanding in investor property pools is fairly small in the lower coupons (Appendix A). Among 2003 5s, for instance, only 3% of all pools are less than 75% owner occupied. Their proportion within premium mortgages is larger: for instance. almost

55% of all outstanding pools in 6s today are less than 75% owner occupied (Figure 14).

Figure 14. Share of Non-owner Occupied Pools Is Higher in Premiums

Share of <75% Owner Occupied Pools

Non-owner premiums prepaid slower.

5s of 2003 3%

5.5s of 2003 12%

6s of 2002 23%

6s of 2003 54%

Non-Owner Premiums Are Slower As expected, refinancings on non-owner occupied properties are significantly slower than regular pools. A typical 12-24 WALA non-owner pool prepaid about 20% CPR slower than an owner pool for 100 bp rate incentive in 2003-2004 (Figure 15). The differences were even

bigger for newly issued collateral. Figure 15. Agency Refinance Curves 2003-2004, 12-24 WALA % CPR 75

Owner=0%

60

Owner=100%

45

30

15

0 0

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50

100 Rate Incentive (bp)

150

200

12


Non-owner discounts seem to be faster within agencies.


Non-Owner Discounts are Faster The concentration of non-owner properties is fairly small in lower coupon cohorts such as 4.5s

and 5s, which form the bulk of agency discount prepayment data over the last year. Therefore, agency discount prepayment data by occupancy do not reveal much information (Figure 16). However, from the little information we have, pools with a higher share of non-owner occupied propertied have prepaid faster within 4.5s. We would pay less attention to the prepayment behavior of 5s because their prepayments have been clouded by the many near money refinancings in the current environment. Please read our Mortgage Outlook 2005 for more details on this issue. Figure 16. Discount Agency Prepayments, % Owner Occupied, July 2004-December 2004 % CPR 25 03 4.5s 20

03 5.0s

15

10

5

0 0

25

50

75

100

% Owner Occupied

Non-agency non-owner properties prepaid faster in the 1999-2000 backup.

Non-Agency Prepayment Behavior of Discounts Concurs In the absence of any conclusive data within agencies, we resorted to non-agencies from the 1999-2000 backup episode. Specifically, we compared the deep out-of-money seasoning profiles of all non-conforming jumbo and jumbo Alt-A loans by occupancy type (Figure 17). On average, investor properties prepaid about 1% CPR faster than seconds, which prepaid another 1% CPR faster than owner occupied properties. Figure 17. Seasoning Curves by Occupancy, 1999-2000 Non-Agency, >50 bp out-of money % CPR 12

9

6 Owner Second Investor

3

0 6

12

18

24

30

36

WALA (Months)


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A non-owner 50bp discount pool should have a 19/32nds payup even after ignoring its better optionality.


Value in Discount Investor Properties Given that the lion’s share of investor property pools is within the higher coupons, the call

protection of these pools is well understood and priced by the market. Investor pools that are 100bp in the money prepay almost 20% CPR slower than owner occupied pools. While the fair payup for these pools is around 29/32nds, the market is currently assigning a 13/32nd premium over TBAs. However, investor properties are valuable for their extension protection as well. From the limited data available on agency prepayments and from data on non-agencies, discount investor properties can be expected to turnover 1%-2%CPR faster than owner occupied properties. The fair value of a 100bp discount investor property pool is around 28/32nds (Figure 18). Ignoring the better optionality and just focusing on the ZV valuations, these pools should trade at a 19/32nds payup over TBAs. Value in low Investor Properties: Current coupon investor property pools are trading at a 4+/32nd payup to TBA. At these valuations, we view these pools as a cheap put on the market. As the market sells off, the value of the pool should increase because of the lower extension on the collateral.

Figure 18. Fair Payups on Investor Properties (100% Investor Owned)

Even OAS Payup Even ZV Payup Current Payups

Relative Coupon on Passthrough : CC is Current Coupon -100 -50 CC +50 +100 31/32 28/32 20/32 19/32 29/32 24/32 19/32 7/32 3/32 20/32 N/A N/A 4+/32 10/32 13/32

Note: Valuations assume that in addition to superior call protection, the base case turnover is 2% CPR faster on investor properties

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REFINANCERS BENEFIT FROM PRE-SEASONING BUT REFINANCE FASTER • •

Borrowers who have refinanced earlier have revealed themselves to be more efficient refinancers.

Pools with greater share of refinance borrowers are more callable. Discount refinance borrowers season faster but not necessarily to a higher fully seasoned turnover rate.

Refinancers Are More Sophisticated Borrowers who have refinanced before have revealed themselves to be more efficient

refinancers and are likely to prepay faster, should another refinancing opportunity come by. On the turnover front, transaction costs of a home purchase are far higher than a refinance transaction. As a result, a purchase borrower with a short horizon is more likely to rent than purchase. In contrast, a refinance borrower, who also has a short horizon. may still benefit from refinancing and move after some time. The implication is that purchase borrowers, on average, have longer horizons than refinance borrowers and are likely to turn over slower, at least to begin with. Alternatively, one can also argue that refinancers have already been in their homes for some time (are seasoned to some extent) and will turnover faster. Refinancers Prepay Faster as Premiums A closer look at the agency data suggests that premium pools with greater share of refinancers have historically prepaid faster. However, 2003-2004 agency prepayment data indicate that

initial differences between purchase and refinance borrowers become much weaker as the pool seasons (Figure 19). For example, the prepayment difference between pools with 25% and 75% shares of refinancers (both 100 in-the-money) goes from 22% CPR in the first 12 months to only 7% CPR in the next 12. This behavior is due, at least in part, to the strong correlation between share of refinancers and LTV. As the pools season, the refinancer loses this advantage. Figure 19. Agency Prepayments by Purpose, 2003-2004

Refinancers are also pre-seasoned and turn over faster initially.

WALA 0-12

Rate Incentive (bp) 50 100 150

0 20 28 40

25 20 32 46

12-24

50 100 150

34 46 60

31 46 62

Share of Refinancers 50 75 22 30 42 54 55 52 31 48 64

30 53 68

100 32 57 66 32 57 67

Refinancers: Are Pre-seasoned, Faster Turnover on New Pools We had argued earlier that transaction costs in a home purchase are higher and refinancers have already been in their homes for some time. In line with this reasoning, agency prepayment data suggest that discount pools with a greater share of refinance borrowers seasoned faster. However, the initial differences between purchase and refinance borrowers fade away with seasoning (Figure 20). Part of the reason is that purchase borrowers in general have higher average LTV ratios and ramp up as they accumulate equity in the house. Once they are fully

seasoned, there should be no difference between a purchase and refinance borrower in terms of mobility.

March 17, 2005

15



Figure 20. FNMA 03 5s by Purpose in 2003-2004, 50 bp out-of-money % CPR 16 Purchase Refinance

12

8

4

0 1

3

5

7

9

11

13

15

17

19

WALA (Months)

Source: Lehman Brothers

Fully seasoned turnover speeds for refinance borrowers are not different from purchase borrowers.

Non-Agency Refinancers Have Seasoned Faster We see similar behavior in non-agency collateral in 1999-2000. Figure 21 shows the seasoning profiles of 50 bp out-of-the-money non-agency collateral. Refinance borrowers seasoned faster than purchase borrowers but actually prepaid slower after about 20 months of seasoning. We do not see any reason for differences in fully seasoned turnover of refinancers versus purchase borrowers. However, given their longer stay in the house, refinancers should season faster.

Figure 21. Non-agency Refinance vs. Purchase Borrowers in 1999-2000, >50 bp out-of money % CPR 10 Purchase 8

Refinance

6

4

2

0 2

6

12

17

23

29

35

WALA (Months)


Preseasoning of refinancers is overwhelmed by their worse callability.

The Value Lies with Purchase Borrowers Most pools in the agency universe have a high share of refinancers. For instance, among 2003 5s, almost 90% of the pools have more than 75% refinancers. We find that the pre-seasoning of refinance borrowers is overwhelmed by their worse callability. Pools with a high share of

refinancers do benefit from the pre-seasoning of these borrowers. However, refinance borrowers are also more likely to refinance than purchase borrowers. We find that the better extension properties of refinancers are overwhelmed by their worse callability. We find that March 17, 2005

16



across coupons, purchase pools should command a payup over TBAs. On current coupons, the better call protection on purchase borrowers is worth 4/32nds. When 100 bp in the money, purchase pools should command a payup of almost 10/32nds (Figure 22). Value in Purchase Pools: The faster seasoning of refinancers is overwhelmed by their worse convexity on the call side. We think purchase borrower pools are worth more than refinance pools across coupons. The market does not currently assign any payup to purchase borrowers. Given their better convexity on the call side, these should be worth 6 and 10/32nds over TBA for 50 bp premiums and 100 bp premiums, respectively.

Figure 22. Fair Payups on Pools with Less than 75% Refinancers Relative Coupon on Passthrough : CC is Current Coupon -100 -50 CC +50 +100 Even OAS Payup 1/32 6/32 4/32 6/32 10/32 Even ZV Payup - 1/32 4/32 - 1/32 1/32 6/32 Note: Valuations assume that refinancers season 10 months faster but are 15% more efficient in refinancings.

March 17, 2005

17



LOW LOAN BALANCE: SOLID CONVEXITY STORY Low loan balance refinancings are significantly slower than typical collateral. At the margin, we believe that low loan balance collateral is likely to prepay faster in a serious backup.

• •

Low loan balance collateral refinances slower due to fixed costs of refinancing.

Low Loan Balance: Lower Monetary Benefits from Refinancing The basic premise behind better callability of low loan balance pools is fairly straightforward. Because of fixed refinancing costs (e.g., legal fees; application fees and add-ons; appraisal fees; and the “hassle costs” of searching for best rates, collecting documents, and closing), smaller loans tend to prepay slower than larger ones for a given level of rate incentive. A case can be made for lower loan balance collateral to turn over faster primarily from a low loan size

borrower’s having more of an incentive to trade up to a bigger house. While this is not a very compelling hypothesis, there is empirical evidence to suggest higher discount prepayments on LLBs. In any case, we view the better extension properties of LLB pools as an added bonus to the very established call protection of this collateral.

The refinancing story on low loan balance collateral is well understood.

Lower Loan Balance Collateral Is Less Callable Much has been written about the slower low loan balance premiums in the last few years. In fact, the market actively trades not only the low loan balance collateral (LLB, <85K max) but

also medium loan balances (MLB, <$110K max) and high loan balances (HLB, <$150K max). For the sake of completion, we show agency prepayments for different loan sizes for collateral roughly 50 bp and 100 bp in the money (Figure 23). As is evident, prepayments increase monotonically with loan size. Figure 23. Prepayments by Loan Size, 2003-2004 % CPR 75

60

45

30 Rate Incentive = 50 bp 15

Rate Incentive = 100 bp

0 50

100

150

200

250

300

Loan Size ($K)

LLB discount speeds were faster in 94-95 and 99-00.

LLB Discount Speeds Were Faster in 94-95 and 99-00 Low loan balance collateral has historically displayed higher discount prepayments than overall 30-year collateral, suggesting that it offers some level of extension protection during a backup

(Figures 24 and 25). However, discount prepayments by loan size have been inconsistent across sectors and time periods. We do not see a strong correlation between discount prepayments and loan size in the non-agency data from 1999-2000. And agency LLB near-money discounts have been slower than higher loan balance collateral in 2004.

March 17, 2005

18


The Specified Pool Handbook Figure 24. FNMA Seasoning Profiles in 1999-2000, 50 bp out–of-money % CPR 12 Size<=100K Size>100K

10

8

6

4 0

6

12

18

24

30

36

42

48

54

60

54

60

Loan Size ($K)

Figure 25. FNMA Seasoning Profiles in 1994-1995, 50 bp out–of-money % CPR 8

6

4

Size<=100K

2

Size>100K

0 0

6

12

18

24

30

36

42

48

Loan Size ($K)

Lower loan balances have prepaid faster within 03 4.5s.

But Haven’t LLBs Discounts Prepaid Slower in 03-04? This may appear to be true based on prepayments on 03 5s. There is no doubt that higher loan balance 03 5s prepaid faster than LLBs in 2003-2004. However, prepayments on more out-of-

the-money collateral paint a different story (Figure 26). In particular, within 03 4.5s, 150K balance collateral has prepaid faster than 200K, which, in turn, has prepaid faster than 250K collateral. We believe that faster prepayments for higher loan balance on 03 5s are an indication of near-money refinancings in the current environment (fixed to ARM, cash-out, etc.) and will die down in a big sell-off. Please see our Mortgage Outlook 2005 for more details.

March 17, 2005

19



Figure 26. Conventional Prepayments by Loan Size, July 2004-December 2004 % CPR 12

10

8

6

03 4.5s 03 5.0s

4 50

100

150

200

250

300

Loan Size ($K)

If anything, we expect LLB discounts to prepay faster in a serious backup.

Faster turnover on LLB pools is worth 23 ticks on current coupon, double the current market payup.

LLBs Should Prepay Faster in a Large Backup Based on the above analysis, we do not expect low loan balance collateral to prepay below high loan balance in a serious backup. At the margin, we expect low loan balance collateral to prepay faster than high loan balance collateral. Given that the market currently does not recognize the fast turnover on this collateral, we view this as an added bonus. Valuation of LLB Pools Low loan balance collateral forms a sizeable chunk of the 30-year universe. For instance, among 2003 5s, pools with a loan size less than 100K comprise almost 10% of the vintage. Like most

call protection stories, the call protection of lower loan balances is very well priced by the market. We estimate than low loan balance, 100 bp premium pools should trade at a payup of 25/32nds to TBAs; current market payups are around 23/32nds. If we assume that the trends seen on LLB turnover in 1999-2000 and 1994-1995 are likely to repeat, there is substantial value in this story on the extension side. 50 bp discount low loan balance pools currently have no payup in the market. In past discount episodes, low loan balance pools have prepaid 1%-2% CPR faster when 50 bp out of the money. The faster turnover is worth close to a point on discount low loan balance collateral (Figure 27). Value in LLB 4.5s: Prepayments on 2003 vintage 4.5s have shown a clear dependence on loan balance. Lower loan balances have consistently prepaid faster in 2004. Currently, the market does not demand any premium for LLB 4.5s. We believe this is cheap optionality waiting to be monetized. The fair value on these pools is close to 29/32nds.

Figure 27. Fair Payups on LLB Pools (<100K Loansize) Relative Coupon on Passthrough : CC is Current Coupon -100 -50 CC +50 +100 Even OAS Payup 29/32 29/32 23/32 24/32 25/32 Even ZV Payup 20/32 17/32 6/32 5/32 17/32 Current Payup 0 1/32 11/32 21/32 23/32 Note: Valuations assume that in addition to superior call protection, LLB borrowers turnover 1% CPR faster than HLBs

March 17, 2005

20



GEOGRAPHIES: INHERENTLY FAST AND SLOW STATES •

•

Differences in transaction costs and economic conditions cause regions to prepay differently.

States with higher transaction costs have refinanced slower.

States with lower transactions costs have consistently prepaid slower in a refinance environment. Discount prepayments by geography, however, seem to be driven largely by economy and home price appreciation.

Geographical Variation: Economic Conditions and Transaction Costs Transactions costs are a big determinant of collateral callability because borrowers compare these costs to the benefits from refinancing. Given how widely title insurance and mortgage taxes wary across states, we would expect some regions consistently to prepay slower or faster than others. On the turnover front, regional variations in economy and home price appreciation can cause collateral to prepay differently. Transaction costs should have a minor effect on turnover because the costs of moving are usually much higher than these costs. Refinancing Are Very Different across Regions Figure 28 shows the actual prepayment differences for a high-cost region (Mid-Atlantic) and a low-cost one (New England) versus the U.S. average over the last two years. It is worth noting that the same regions have prepaid faster or slower in every refinancing episode over the last decade, even after controlling for loan size and credit differences. Mid-Atlantic, East South Central, and West South Central have higher-than-average transaction costs, while New England and East North Central have lower than average transaction costs. Figure 28. Prepayments across Geographies, 2003-2004

There is significant variation in discount prepayments across geographies.

March 17, 2005

Diff from US Average, % CPR MAT (Slow) NEG (Fast)

WALA

Rate Incentive (bp)

0-12

50 100 150

-7 -14 -16

7 15 10

12-24

50 100 150

-1 -4 -6

13 10 9

Discount Prepayments across Regions Also Vary There is significant variation in discount prepayments across geographies. Figure 29 shows the differences in prepayments on 2003 5s from the average across states. A large number of states prepaid 2%-4% CPR slower than the average for 03 5s. On the other hand, California prepaid about 4% CPR faster than the average (taking the average up by 1% CPR due to its share being about 25% share in total outstanding). However, most of the differentials across states are driven primarily by home price appreciation and the economy. For example, the two fastest prepaying states in Figure 32 (California and Nevada) had 21% and 25% annualized home price appreciation at the end of June 2004. In contrast, some of the slower prepaying states (Texas and North Carolina) had very modest home price appreciation of 3%-4%.

21



Figure 29. July 2004-December 2004 Prepayments on FN 03 5s by States, difference from average (% CPR) % CPR 10 8 6 4 2 0 -2 -4 -6

Regional differences in turnover are primarily home price and economy driven.

Differences in Turnover are Primarily Home Price/Economy Driven Figure 30 shows prepayments on FN 03 5s for different US states against their 1-year home price appreciation at the end of June 04. There is a strong correlation between the two and there are few outliers. This analysis is rather simplistic but shows that most of the regional differences can be explained by differences in home price appreciation. A few states that appear to be slower after adjusting for differences in home price appreciation look familiar as states with higher transaction costs (NY, NJ, PA etc.). That said, we are less comfortable with trades involving discount prepayment differences across geographies. Home price appreciation has varied significantly across regions and time periods and it is anybody’s guess what it will be in future across regions. Moreover, unlike other specified pool stories that have similar or better call characteristics, regions with lower transaction costs are also likely to prepay faster in a rally.

Figure 30. July 2004-September 2004 Prepayment Rate on FN 03 5s vs. HPA % CPR 20

16

12

8

4 0

5

10

15

20

25

% HPA

Sources: Lehman Brothers, Freddie Mac

March 17, 2005

22



Summary Before we finish, let us recapitulate the main results. There is significant variation in prepayments across collateral types for both discounts and premiums. Prepayment differentials are due mainly to differences in credit, demographics, loan size, and economic incentive to trade up or cash out. We can briefly summarize the findings as follows: •

•

•

•

•

March 17, 2005

Low FICO, high LTV, and non-owner occupied pools provide significant call and extension protection. Low FICO pools, in particular, have always prepaid faster in a discount environment and slower during refinance waves. Prepayments on new high LTV pools are dependent on the strength of the housing market. However, high LTV conventional pools prepay very similarly to GNMA. The housing market notwithstanding, high LTV pools are a cheap substitute for GNMA discount pools. Low loan balance refinancings are significantly slower than typical collateral. However, we do not have conclusive data on their behavior in a backup. At the margin, we believe that low loan balance collateral is likely to prepay faster in a serious backup. Pools with higher shares of refinancers season faster to a similar turnover rate as purchase borrowers. Moreover, refinance borrowers are more callable than purchase borrowers. States with lower transactions costs have consistently prepaid slower in a refinance environment. Discount prepayments by geography, however, seem to be driven largely by economy and home price appreciation.

23



APPENDIX A: OUTSTANDING & AVG. CPRs of 2003-04 LOWER COUPONS 1. AMOUNT OUTSTANDING AND CPRs BY FICO 2003 Vintage Average FICO

4.5s

5.0s

2004 Vintage 5.5s

4.5s

5.0s

5.5s

1 42 60 0 104

4 77 30 0 111

Amount Outstanding ($B) 625-675 675-725 725-775 >775 Total

0 5 45 0 50

4 90 206 0 300

7 200 120 0 328

0 1 5 0 6

Average CPR (Jul-Dec 2004) 625-675 675-725 725-775 >775 Total

17.1 10.5 6.1 8.1 7.0

21.2 13.3 11.1 6.5 11.0

26.2 18.2 15.6 13.0 18.0

10.5 7.2 3.4 0.4 3.0

8.3 5.5 4.9 0.7 6.0

16.1 11.1 10.8 18.6 11.0

2. AMOUNT OUTSTANDING AND CPRs BY LTV 2003 Vintage Original LTV (%)

4.5s

5.0s

2004 Vintage 5.5s

4.5s

5.0s

5.5s

10 82 11 1 0 104

5 64 39 2 1 111

6.1 6.0 6.9 9.2 5.7 6.0

10.2 11.3 11.3 14.7 12.9 11.0

Amount Outstanding ($B) <=65 65-75 75-85 85-95 >95 Total

4 44 2 0 0 50

24 250 23 2 1 300

20 222 80 4 2 328

1 5 0 0 0 6

Average CPR (Jul-Dec 2004) <=65 65-75 75-85 85-95 >95 Total

March 17, 2005

7.1 7.2 8.8 12.7 12.3 7.0

10.2 11.2 13.7 18.4 17.0 11.0

15.7 16.9 19.0 26.6 26.0 18.0

2.7 3.2 4.0 11.8 7.8 3.0

24



3. AMOUNT OUTSTANDING AND CPRs BY % REFINANCERs 2003 Vintage % Refi

4.5s

5.0s

2004 Vintage 5.5s

4.5s

5.0s

5.5s

1 4 37 56 5 104

2 18 51 37 3 111

5.6 5.1 5.8 6.2 7.5 6.0

11.8 10.6 10.7 12.3 12.5 11.0

Amount Outstanding ($B) 0-12.5 12.5-37.5 37.5-62.5 62.5-87.5 >87.5 Total

0 1 5 39 5 50

1 3 30 221 45 300

3 10 90 191 35 328

0 0 1 4 0 6

Average CPR (Jul-Dec 2004) 0-12.5 12.5-37.5 37.5-62.5 62.5-87.5 >87.5 Total

9.0 8.7 7.5 7.1 8.0 7.0

15.2 12.5 11.1 11.4 11.3 11.0

24.3 17.4 17.0 17.6 18.0 18.0

4.8 3.5 3.3 3.2 3.2 3.0

4. AMOUNT OUTSTANDING AND CPRs BY % OWNER OCCUPIED 2003 Vintage % Owner

4.5s

5.0s

37.5-62.5 62.5-87.5 >87.5 Total

0 0 49 50

0 8 292 300

2004 Vintage 5.5s

4.5s

5.0s

5.5s

Amount Outstanding ($B) 1 37 290 328

0 0

2

6

101

6

104

0 14 97 111

5.6 5.1 5.8 6.0

12.9 12.1 11.2 11.0

0

Average CPR (Jul-Dec 2004) 37.5-62.5 62.5-87.5 >87.5 Total

March 17, 2005

19.8 9.4 7.3 7.0

14.2 14.3 11.3 11.0

19.4 19.7 17.2 18.0

18.8 6.4 6.1 3.0

25



5. AMOUNT OUTSTANDING AND PREPAYMENTS BY AVERAGE LOAN SIZE 2003 Vintage Loan Size ($’000s)

4.5s

5.0s

2004 Vintage 5.5s

4.5s

5.0s

5.5s

2 4 20 54 23 104

5 9 34 44 18 111

5.5 5.2 5.5 6.2 6.7 6.0

6.6 7.3 10.3 12.8 12.9 11.0

Amount Outstanding ($B) <75 75-125 125-175 175-225 >225 Total

0 2 13 29 5 50

7 23 91 149 30 300

16 37 114 142 19 328

0 0 1 4 1 6

Average CPR (Jul-Dec 2004) <75 75-125 125-175 175-225 >225 Total

March 17, 2005

6.7 7.6 7.7 7.3 6.3 7.0

9.6 10.0 11.4 11.7 10.8 11.0

11.9 14.1 17.9 18.8 16.9 18.0

0.5 5.2 3.5 3.1 3.5 3.0

26

The views expressed in this report accurately reflect the personal views of Sandeep Bordia & Prasanth Subramanian, 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 ex pressed 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 ([email protected]; 212-526-6268) or Valerie Monchi ([email protected]; 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 firm’s 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, T. Wan, 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. 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.

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