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Mortgage Market Insights

Revisiting US Bank Models

Institutional Considerations in the MBS

Markets Bank buying of MBS thus far in 2006 has occurred in the face of a flat yield

curve, a low carry environment, and a rise in holdings of commercial and

industrial loans, all factors that have challenged conventional wisdom.

With this being a major change in the institutional landscape for MBS thus far in

2006, we revisit US bank models and how these impact bank activity in the

MBS sector. Specifically, we examine long-term industry trends, structural

changes within the US banking industry, the interplay between deposit, loan,

and securities portfolios, and recent trends that have influenced bank

participation in the MBS sector.

Key takeaways from this report include: • Banks are structurally motivated to be more active today in the liquid Agency

pass-through sector than before.

• Consolidation in the US banking industry has resulted in a relatively high

concentration of MBS holdings across a handful of institutions. • Banks can no longer be considered collectively, as one group. Rather several

institution-specific models dictate bank participation in the MBS sector today. • Growth of the securities portfolio is the net result of relative growth of deposits

and loans (commercial and industrial, mortgage, consumer, commercial real estate), with the latter the preferred habitat for bank investments.

• Bank portfolio managers are more relative value-oriented today, but applying

relative value in the classic sense is secondary to duration, earnings, and net interest margin targets as set by the asset liability management committees.

• Relative value views are more commonly expressed in the choice of hedges

for servicing portfolios, which are an increasingly important component of total bank assets.

• Share buybacks, securities portfolio run-off, mergers and acquisitions, and

loan acquisitions are all viable options for banks to manage financial targets. Sales of MBS are weighed against these more manageable options.

17 May 2006

Fixed Income Research

http://www.credit-suisse.com/researchandanalytics

Contributors

Satish Mansukhani

+1 212 325 5985

[email protected]

Adama Kah

+1 212 325 0318

[email protected]

1

Table of Contents

I. Executive Summary 2

II. Long-term industry trends 6

III. Recent industry trends (last 3-5 years) 25

IV. Near-term industry trends (last 3-6 months) 35

V. A final review of bank models today and some closing thoughts 44

VI. Trends at the top 4 banks 50

Executive Summary

3

Executive Summary

� Banks are buyers, not sellers of MBS

– Banks have been buyers of US MBS rather than sellers

– This buying has coincided with a flat yield curve, low carry, and an uptick in commercial and industrial loan growth, all of which defy conventional wisdom

� Bank portfolio management practices have changed due to structural changes within the US banking industry

– Bank portfolio management practices have evolved rapidly over the last few years. This has resulted from rapid industry consolidation, a shift in investment bogeys, an enterprise rather than just a portfolio level view on assets, and greater portfolio manager sophistication

– Today, banks can no longer be considered collectively, as one group, with similar portfolio management techniques, but rather as individual institutions with often markedly varying practices

– Consolidation has resulted in larger institutions today, with portfolio models shifting from traditional asset/liability management to a mix of favoring liquidity and taking relative value views

� Growth of the securities portfolio is subject to the interplay between deposit and loan growth

– The preferred habitat for banks is to invest in high-yielding loans (mortgage, commercial and industrial, consumer, commercial real estate). Analysts view loan growth favorably, as it is generally assumed to be organic

– Some rules of thumb:

� Deposit growth exceeds loan growth -> Invest excess deposit liquidity in securities portfolio (2001, 2004, year-to-date 2006)

� Deposit growth lags loan growth -> Reduce portfolio through runoff or sale to invest in loans (1999 and 2000)

� Deposit and loan growth high -> Deploy excess liquidity in loans. No need for securities

� Deposit and loan growth low -> Growing securities portfolio may not be best economic choice (results in ballooning the balance sheet). Buy back shares or retire debt.

4

Executive Summary

� Advantageous funding of securities through low-yielding deposits is a myth

– The notion that banks can fund securities at deposit rates is a myth

– Loan holdings exceed deposits, making incremental securities purchases being funded at market borrowings

– Executives of the branch network want their franchise to be viewed as a profit center, not a subsidy to growth of the

securities portfolio. Internal funds transfer pricing ensures banks evaluate securities at market funding levels

� Recent considerations – Are banks entirely relative value oriented today?

– No. Net interest margin and earnings, duration targets set by the ALCO (Asset/Liability Committees) remain driving

criteria.

– Some large banks have shifted performance bogeys to track broadly followed market indices instituted to better

manage duration drift. Banks are structurally motivated to be active in the pass-through sector more than before

– Despite this, banks do NOT apply relative value in the classic sense as ALCO targets, absolute over relative

performance all supercede true relative value decisions dictated by traditional RV metrics (nominal, Z, option-

adjusted spreads, etc.)

– Increased management of servicing assets by bank portfolio managers does provide some latitude for applying

relative value into their daily decision making

5

Executive Summary

� Recent considerations –Institution specific observations

– MBS growth has occurred mostly at large banks, not small banks. The top 4 banks, by MBS holdings, are Bank of America, Wachovia, Wells Fargo, and JPMorgan/Chase

– Bank purchases have been primarily in the form of Agency pass-throughs, not structured MBS

– Recent pick-up in purchases of MBS at one large institution has been as a catch up to incorrect calls on the market – Fed transparency and volatility - in Q4:05

– Recent pick-up in purchases of MBS at one large institution has been a repositioning of duration; sales of arms/hybrids in preference to 30-year pass-throughs

– Recent pick-up in purchases of MBS at one large institution was the result of a directive from the CEO to offset weak growth in other revenue lines

� Outlook

– Banks are expected to remain active in MBS. Strong deposit growth continues, outpacing loan growth (even with mild uptick in C and I loans, mortgage originations of preferred assets – arms, hybrids, prime quality fully amortizing fixed-rate – have declined, regulatory scrutiny on loan holdings has increased)

– Some banks are structurally motivated to favor pass-throughs for liquidity and changes to investment bogeys

– Some banks have raised exposure to credit (consumer or other) and pass-through holdings are viewed as a high credit quality offset to these holdings

– Some bank PMs manage servicing, which is hedged with pass-throughs

– Unrealized losses on AFS holdings are at record highs, turning any sales into a potential “earnings event”

Long-term industry trends

7

Investment portfolio guidelines direct banks to high credit quality assets

� Boards of directors generally prohibit banks from buying less than AAA, GSE, or US Treasury quality credit risk

� GSE credit quality

� High liquidity

� Offer yield spread relative to Treasuries and other highly rated assets

� Favorable risk-based capital

� Strong understanding of collateral, as banks are also large originators of mortgages

Mortgages and MBS are preferred assets at banks –Why do banks invest in mortgages and MBS?

8

Bank portfolios shift to higher quality assets, including mortgage loans and MBS

…. to residential mortgage-related loans and MBSShift from C&I and consumer loans ….

Asset Composition at 06/30/00

(Total assets = $3.3 trillion)

C&I

19%

Comm. Mort.

Loans

10%

Other Assets

30%

MBS

8%

Home Eq.

Loans

3%

Residential

Mortgage

Loans

14%

Credit Cards

and related

plans

3% Consumer

Loans

10%

Securitized

Consumer

Loans

3%

Asset Composition at 12/31/05

(Total assets = $4.5 trillion)

C&I

11%Comm. Mort.

Loans

9%

Other Assets

29%

Securitized

Consumer

Loans

4%

Consumer

Loans

9%

Credit Cards

and related

plans

3%

Home Eq.

Loans

7% Residential

Mortgage

Loans

16%

MBS

12%

Source: Credit Suisse (US Mortgage Strategy), Federal Reserve

Mortgage-related = 35%Mortgage-related = 25%

9

Banks are large originators of mortgages

2005 2004

2005 Volume Market Volume Market 2004

Rank Mortgage Originator ($B) Share (%) ($B) Share (% Rank

1 Countrywide Financial, CA 491 15.7% 363 12.9% 1

2 Wells Fargo Home Mortgage, IA 392 12.6% 298 10.6% 2

3 Washington Mutual 249 8.0% 255 9.1% 3

4 JP Morgan Chase 183 5.9% 197 7.0% 4

5 Bank of America Mtg. & Affiliate, NC 159 5.1% 144 5.1% 5

6 Citimortgage, Inc. MO 124 4.0% 103 3.7% 6

7 GMAC Residential Holding Corp, PA 92 2.9% 87 3.1% 7

8 Ameriquest Mortgage Co, CA 80 2.6% 83 2.9% 8

9 GMAC-RFC, MN 64 2.1% 51 1.8% 12

10 IndyMac, CA 61 1.9% 38 1.3% 17

Total for Top 10 1,895 60.7% 1,620 57.6%

Total for Top 30 Originations 2,739 87.8% 2,328 82.8%

Total Originations 3,120 100.0% 2,810 100.0%

Increased concentration of mortgage originations

by top 4 banks

0.6

1.0

2.1

2.7

3.8

2.83.1

8%

42%

34%

25%

40%43%

39%

0.0

1.0

2.0

3.0

4.0

5.0

1995 2000 2001 2002 2003 2004 2005

Origin

atio

n V

olu

me (

$ trilli

on)

0%

10%

20%

30%

40%

50%

Top 4

Origin

ato

rs S

hare

(%

, R

HS

)

1-4 Family Mortgage Origination Top 4

Source: Credit Suisse (US Mortgage Strategy), Inside MBS & ABS

10

Higher share of mortgage assets in bank portfolios has contributed to historically low credit losses currently

Source: Credit Suisse (US Mortgage Strategy), SNL

Net Charge-offs as % of loans

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

Ne

t C

ha

rge-o

ffs (

% o

f lo

an

s)

NCO/Loans Nonaccrual Loans% of Loans

11

Mortgage loans versus MBS – What are bank preferences between mortgages and MBS?

The view on mortgage loans

� Wall Street equity analysts reward loan growth, given that banks are in the lending

business

� Loans offer higher yields and spreads, as they are funded with deposits

� Loans, however, are demand driven, and final approval is subject to internal credit

policies and regulatory supervision

The view on MBS

� Securities are used to help banks maintain stable earnings growth and deploy excess

deposit liquidity

12

Local demand factors for MBS – How do banks, at any given point in time, decide between investing in loans versus MBS?

� Start with deposit growth, examine loan growth relative to deposit growth

Strong deposit growth

� If deposit and loan growth are robust, loans remain the preferred asset and no need to

invest in securities

� If deposit growth exceeds loan growth, banks need to and can deploy excess liquidity

Weak deposit growth

� If deposit growth is lower than loan growth, potential for securities sales or portfolio run-

off to invest in loans

� If deposit growth and loan growth are low, evaluate option to buy back shares versus

growing securities portfolio to optimize financial targets

13

Drivers of Bank Portfolio Growth – A template

�Growing portfolio is dilutive to

net interest margin (NIM) and

return on assets (ROA)

�Best use of capital may be to

retire debt and buy back stock

�Actively reducing portfolio through

sale may be a better option than

increasing borrowings

BELOW TARGET

�Growing securities portfolio

maintains asset growth and

deploys excess deposit liquidity

�Deploy excess liquidity into loans.

Securities not needed to maintain

asset growth

�Securities portfolio may be

allowed to run off

AT/ABOVE TARGET

BELOW TARGETAT/ABOVE TARGETDEPOSIT GROWTH

ASSET/LOAN GROWTH

Source: Credit Suisse (US Mortgage Strategy)

14

Local demand factors for MBS – How do banks, at any given point in time, decide between investing in loans versus MBS?

� Historical scenarios – Low deposit growth/high loan growth – 1999 and 2000 – MBS

holdings declined at banks

� Historical scenarios – High deposit growth/low loan growth – 2001 and 2004 – MBS

holdings surged at banks

� Recent scenario - High deposit growth/slowing loan growth -> high securities growth

15

Strong growth in deposits and assets post-2000

Deposits and Assets (YOY change)

-5-25

258226

182 185220

160

337

240

22

115

4867

103

148 138

224

156

92

-50

0

50

100

150

200

250

300

350

400

1997 1998 1999 2000 2001 2002 2003 2004 2005 Q1:06

Ch

an

ge

($

B)

Deposits All Assets


16

Post-2000 growth concentrated in mortgage assets


MBS holdings (YOY change)

3244

-22

-4

8396

353647

35

-130

-80

-30

20

70

120

1997

1998

1999

2000

2001

2002

2003

2004

2005

Q1:06

Ch

an

ge (

$B

)

MBS

C&I loan holdings (YOY change)

5672

48

-71-57

-43

2

47

16

36

-130

-80

-30

20

70

120

1997

1998

1999

2000

2001

2002

2003

2004

2005

Q1:

06

Ch

an

ge (

$B

)

C&I

Residential mortgage loan holdings (YOY change)

3723

-10

96

12

82

8

-3 -6

14

86

-2

49

2414 17

54

41

2210

-130

-80

-30

20

70

120

1997

1998

1999

2000

2001

2002

2003

2004

2005

Q1:06

Change (

$B

)

Mortgage Loans HEL

Consumer and CRE loan holdings (YOY change)

-8

1

-21

-18

2333

-20

9134

35

142 2

292323

5

46

-130

-80

-30

20

70

120

1997

1998

1999

2000

2001

2002

2003

2004

2005

Q1:

06

Change (

$B

)

Consumer Loans CRE

17

Deposit growth and supply of assets for investment are key determinants of MBS holdings growth

� In recent years:In recent years:In recent years:In recent years: MBS holdings growth driven by need to deploy excess deposit liquidity

� In 1999/2000:In 1999/2000:In 1999/2000:In 1999/2000: Flat/decline in MBS holdings growth on slow deposit growth and strong growth in C&I and mortgage loan holdings

Source: Credit Suisse (US Mortgage Strategy), Fed

Cumulative change in Deposits and Assets

(1996-to-date)

-200

0

200

400

600

800

1000

1200

Dec-

96

Dec-

97

Dec-

98

Dec-

99

Dec-

00

Dec-

01

Dec-

02

Dec-

03

Dec-

04

Dec-

05

Cum

ula

tive C

hange in D

eposits

($B

)

(500)

-

500

1,000

1,500

2,000

2,500

Cum

ula

tive C

hange in A

ssets

($B

)

Deposits Assets (RHS)

Growth in

assets

and

deposits

Slow

deposit

growth

Cumulative change in MBS, Mortgage-

related Loans and C&I (1996-to-date)

-100

0

100

200

300

400

500

600

Dec-

96

Dec-

97

Dec-

98

Dec-

99

Dec-

00

Dec-

01

Dec-

02

Dec-

03

Dec-

04

Dec-

05

Cum

ula

tive C

hange (

$B

)

MBS Mortgage-related loans** C&I

Growth

in all

Growth in C&I

and loans;

MBS

declining/ flat

** Mortgage-related loans = raw mortgage loans +

HEL

18

Relative value views on MBS – Are banks more relative value oriented today?

� Net interest margins, earnings targets, search for yield and carry are primary driving

factors feeding into decisions to invest into MBS

� Relative value, in the classic sense as applies to a money manager or total-return

oriented investor, is a secondary consideration

� Accounting practices – FAS 115 – allow banks to maximize current yield and be less

concerned about any mark-to-market impact (1) or relative value

� MBS holdings have grown irrespective of trends in spreads (nominal, Z-spread,

OAS)

� MBS holdings have grown despite reduction in carry and flat yield curve

� MBS holdings have grown despite recent uptick in commercial and industrial

loans

� MBS holdings have grown as deposit growth has outpaced loan growth – banks

indeed face a challenging environment for asset growth

(1) FAS 115 – Securities holdings are classified under three categories – trading, available for sale (AFS), held to maturity (HTM). MBSholdings are primarily held under the AFS category. Gains and losses on AFS holdings flow through to the balance sheet, impacting equity capital. In comparison, any gains and losses on the trading account flow through to the income statement, potentially imparting volatility to earnings, and the relatively restrictive HTM classification is limiting in terms of optimal portfolio management.

19

MBS valuation metrics are not the sole determining factor …

� Loose relationship between bank MBS holdings growth and spread levels

Change in MBS holdings vs. Nominal basis

0

100

200

300

400

500

Dec-

96

Dec-

97

Dec-

98

Dec-

99

Dec-

00

Dec-

01

Dec-

02

Dec-

03

Dec-

04

Dec-

05

Cu

m.

Ch

g.

in M

BS

Ho

ldin

gs (

$B

)

0

20

40

60

80

100

120

30

-Yr

CC

No

m.

Sp

rea

d (

bp

)

Large Banks MBS Holdings (RHS)

30-Yr CC Nominal Basis (RHS)


20

Flat curve and low carry are not a sufficient condition for bank selling of MBS

Carry vs. Cum. change in MBS holdings

0

3

6

9

12

15

Dec-9

6D

ec-9

7D

ec-9

8D

ec-9

9D

ec-0

0D

ec-0

1D

ec-0

2D

ec-0

3D

ec-0

4D

ec-0

5

Curr

ent C

oupon Y

ld S

pre

ad to

3-m

onth

LIB

OR

(%

)

0

100

200

300

400

500

Chg. in

MB

S H

old

ings (

$B

)

Raw Carry (ticks/month)

Large Banks MBS Holdings (RHS)

Small Banks MBS Holdings (RHS)

Low Carry

Flat/slight

decline in

MBS holdings

Low Carry

Increase in Large

bank MBS

Yield curve shape vs. rate levels

3.00

3.75

4.50

5.25

6.00

6.75

7.50

Dec-

96

Dec-

97

Dec-

98

Dec-

99

Dec-

00

Dec-

01

Dec-

02

Dec-

03

Dec-

04

Dec-

05

10-Y

r S

wap r

ate

(%

)

0

50

100

150

200

250

300

10s/2

s S

wap C

urv

e (

bp)

10-Yr Swaps 10s/2s Swap Spread (bp) -- RHS

Flat curve

environment

Flat curve

environment


21

Majority of bank securities holdings are classified as AFS

AFS Securities % of Total Securities Holdings

40%

60%

80%

100%

2000Q

120

00Q

320

01Q

120

01Q

320

02Q

120

02Q

320

03Q

120

03Q

320

04Q

120

04Q

320

05Q

120

05Q

3AF

S C

lassif

ied

Secu

riti

es

Sh

are

(%

)Bank of America Wachovia

JP Morgan Chase Wells Fargo


22

Funding advantages at banks – Don’t banks have an advantage as they can fund at deposit rates?

� The notion that banks can fund at deposit rates is largely a myth

� As loan holdings exceed deposits, incremental securities purchases are funded at

market borrowings rather than through deposits

� Executives responsible for the branch franchises want these to be viewed as profit

centers, not just subsidizing a securities portfolio

� Internal funds transfer pricing (FTP) policies also force banks to evaluate securities

relative to duration-matched market funding levels

� So, while the banking institution benefits from inelastic deposit funding sources, these do

not directly influence the portfolio manager’s decision to buy

23

Strong growth in mortgage assets despite an increase in bank cost of funds, driving NIM to historical tights


Bank Cost of Funds vs. 1-month LIBOR

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Rate

(%

)

Cost of Funds 1-month LIBOR

Net Interest Margin

3.50

3.75

4.00

4.25

4.50

1996

1997

1998

1999

2000

2001

2003

2004

2005

NIM

(%

)

24

Share of CDs has surged, as rates are more attractive


CD Share of Total Deposits

20%

25%

30%

35%

40%

45%

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

CD

Share

of

Tota

l D

eposits (

%)

Yields on CDs

1.0

2.0

3.0

4.0

5.0

6.0

7.0

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

CD

Rate

(%

)

Recent industry trends (last 3-5 years)

26

Bank portfolio manager sophistication – Given industry consolidation, aren’t bank portfolio managers and their practices far more sophisticated today? � Portfolio managers at some of the nation’s large banks are indeed far more sophisticated

today than 10 to 15 years ago

� The performance bogeys at some of the large banks are now broadly followed market indices. This developed as a way for banks to manage duration drift, especially extension

� Because of this trend, some banks are now more structurally motivated to be active in the pass-through sector

� However, the primary considerations remain net interest margin and earnings, duration targets as set by the Asset/Liability Committees (ALCO)

� Moreover, absolute performance supercedes relative performance

� Within the above constraints, portfolio managers at banks do make coupon, yield/convexity plays in their active day-to-day management

� Banks may be buyers of MBS even if traditional relative value metrics – nominal spreads, adjusted spreads, Z-spreads, OAS, price regressions – point to MBS being rich. This may not be the case for traditional relative value managers.

27

Pass-throughs represent a higher share of bank MBS holdings today

Growth in MBS holdings at banks

0

150

300

450

600

750

Dec-

96

Dec-

97

Dec-

98

Dec-

99

Dec-

00

Dec-

01

Dec-

02

Dec-

03

Dec-

04

Dec-

05

All

MB

S H

old

ings (

$B

)

0

100

200

300

400

500

Pass-t

hro

ughs (

$B

)

MBS Passthrus (Agy + Non-Agy)

c

Rising share of pass-throughs at banks

0

150

300

450

600

750

Dec-

96

Dec-

97

Dec-

98

Dec-

99

Dec-

00

Dec-

01

Dec-

02

Dec-

03

Dec-

04

Dec-

05

All

MB

S H

old

ings (

$B

)65%

70%

75%

80%

Pass-t

hro

ughs S

hare

(%

)

MBS Pass-throughs share (%, RHS)


28

High capital ratios – How have high capital ratios helped position banks vis-à-vis MBS?

� Capital ratios at banks are high today due to pressure from the rating agencies and the

Federal Reserve to establish enough of a cushion against a downturn in the credit cycle

� With a strong credit environment, banks are finding themselves more than adequately

capitalized

� This contrasts to the scenario during the late 1980s through the early- to mid-1990s

when banks were forced to de-lever and shrink their balance sheets as they were

relatively undercapitalized

� Today’s high capital ratios position banks to be more opportunistic

29

Adequate capital is not a limiting factor impacting bank asset selection decisions


Bank Tier 1 capital ratios are at high end of historical range

4

5

6

7

8

9

10

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Tie

r 1 C

apital R

atio (

%)

B of A Wachovia JP Morgan Chase

30

Earnings management – Aren’t net interest margins at banks declining? What are banks doing to improve earnings?

� Net interest margins at banks have indeed been on the decline

� Banks have been following a variety of strategies today

� One strategy is to buy back their own shares to manage earnings per share figures to

Wall Street equity analyst targets

� In an environment of strong deposit relative to loan growth, investing in securities has

been a more attractive option than buying back shares

� In an environment of weak deposit growth, buying back shares may be a more attractive

option and securities portfolio growth likely slows

� We have observed a combination of factors – high deposit growth, escalation in volume

of share buybacks, increased M&A activity, growth in commercial and industrial loans,

growth in MBS holdings, heavy demand for mortgage loans – all reflecting the flexibility

of options available to banks today to grow assets and manage earnings, net interest

margins, etc.

31

Bank appetite for assets – How does this compare to past environments?

� Our view has been that on the heels of the above factors – strong capital ratios, high

deposit growth – that banks have been challenged to find enough income-earning assets

� This is evidenced through the asset accumulation that has occurred – acquisitions of

credit card and home equity lenders, purchases of auto loans, mortgage loans and MBS

� The rules remain – favor loan growth (mortgages, home equity, commercial and

industrial), but if deposit growth continues, deploy into MBS

32

Escalated pace of share buybacks and dividend payouts


Bank

Avg. Purchase

Price of 2005

Buybacks 2005 2004 2003 2002 2001 2000

Bank of America 45.61$ 126 148 259 218 164 135

Wachovia 51.76$ 52 48 60 15 30 19

JPMorgan Chase 33.50$ 102 25 0 0 22 NA

Wells Fargo 59.80$ 53 38 31 43 39 79

U.S. Bancorp 70.77$ 3 94 15 45 20 33

SunTrust Bank 29.37$ 61 0 3 6 8 13

Natcity 34.31$ 45 42 11 1 9 3

Total Repurchases: NA 442 395 379 328 293 281

Change: 48 16 51 36 11

2005 2004 2003 2002 2001 2000

Bank of America 47 46 40 41 55 46

Wachovia 46 44 39 38 66 NM

JPMorgan Chase 57 88 42 170 170 45

Wells Fargo 44 45 41 35 51 39

U.S. Bancorp 40 47 44 46 85 49

SunTrust Bank 51 39 38 37 34 34

Natcity 47 31 36 46 51 40

High share buybacks (shares in millions) Stable to high dividend payout ratios

33

High equity market valuations

Bank Stocks Index: Valuations trending higher

100

200

300

400

500

Dec

-96

Dec

-97

Dec

-98

Dec

-99

Dec

-00

Dec

-01

Dec

-02

Dec

-03

Dec

-04

Dec

-05

Index L

evel

BIX Index

Source: Credit Suisse (US Mortgage Strategy

34

Rise in M&A activity, resulting in greater exposure to the consumer, search for income-generating assets

Acquired

Institution Date Deal

Bank or Portfolio Announced Industry Value

Bank of America GM auto loans Jul-05 Auto finance $55B over 5-yrs

Bank of America MBNA Jun-05 Credit card $35.7B

Wachovia Westcorp Sep-05 Thrift/Auto finance $3.4B

U.S Bancorp Aviation card business Feb-05 Credit card NA

HSBC Metris Aug-05 Credit card NA

Washington Mutual Providian Jun-05 Credit card NA


Near-term industry trends (last 3-6 months)

36

Regulatory scrutiny of mortgage loans and commercial real estate, declines in mortgage origination volumes –What has been and is the expected impact of these factors? � Banks have a preference for prime quality, fully amortizing ARMs and fixed-rate

mortgages

� Origination volumes of both are on the decline as a result of a flat yield curve (impacting

share of ARM originations) and higher rates (resulting in decline of fixed-rate mortgage

originations)

� The growing share of innovative mortgage products – interest-only, option ARMs – has

increased regulatory scrutiny of mortgage loan holdings at banks

� As stated before, the loan side of the asset mix is demand driven. Overlaying this with

declining origination volumes, increased regulatory scrutiny, and strict adherence to

credit policies dampens the outlook for significant growth in mortgage loan holdings.

(The appetite for mortgage loans remains considerable, driving securitized issuance

volumes of prime MBS lower and the non-Agency/Agency basis tighter)

37

Securities versus whole loan – How do practical factors impact a bank’s view on buying mortgage loans versus securities?

� Liquidity – lower on mortgage loans than on MBS

� Credit exposure – higher on mortgage loans than on Agency pass-throughs, CMOs, or

structured, AAA-rated non-Agency pass-throughs and CMOs

� Regulatory capital – 50% on mortgage loans, 20% on Agency pass-throughs, CMOs and

on AAA- or AA-rated non-Agency MBS

� Factors favoring loans include – higher yield, held-to-maturity (HTM) classification,

limiting mark-to-market impact, and favorable view by Wall Street equity analysts

� Factors favoring MBS include – operational ease in trading, settlement practices, fewer

hurdles to cross as they relate to credit quality and approvals

38

Current risk-based capital weightings on asset classes


Regulatory risk-based capital weightings

Security Rating Risk Weight

Minimum Total

RBC Charge

Securities

AAA- and AA-rated (including 20% 1.6%

Agency MBS)

A-rated 50% 4.0%

BBB 100% 8.0%

BB 200% 16.0%

Loans

first-lien mortgage loans 50% 4.0%

39

Do banks have greater appetite for credit risk today?

� Banks have displayed comfort in increasing exposure to the consumer sector. This has

been evident in their purchases of home equity and credit card lenders, acquisitions of

auto loans, etc.

� Some banks have also displayed appetite for lower credit quality products, either through

acquisition of lower than prime quality secured mortgages or through the addition of

lower-rated securities

� This has gone in tandem with the bank bid for high credit quality Agency pass-throughs

40

Mortgage servicing – How has this resulted in bank appetite for MBS?

� The largest banks, comprising the largest holders of MBS, also happen to be amongst

the largest servicers of mortgages

� Some banks take an “enterprise” level view, combining their need for MBS as it fits into

their portfolio as well as hedging mortgage servicing rights

� These hedging activities are often more relative value oriented given the active

management required of these assets

41

The largest banks are also amongst the largest servicers of mortgages…..


2005 2004

2005 Volume Market Volume Market 2004

Rank Servicer ($B) Share (%) ($B) Share (%) Rank

1 Countrywide Financial 1,111 12.1% 838 10.5% 1

2 Wells Fargo Home Mortgage 1,005 11.0% 782 9.8% 2

3 Washington Mutual 747 8.2% 728 9.1% 3

4 JP Morgan Chase 604 6.6% 563 7.0% 4

5 CitiMortgage Inc. 403 4.4% 364 4.5% 5

6 Bank of America Mtg. & Affiliates 368 4.0% 332 4.1% 6

7 GMAC Mortgage Corp. 289 3.2% 232 2.9% 7

8 ABN Amro Mortgage Group 206 2.3% 201 2.5% 8

9 National City Mortgage Co. 170 1.9% 165 2.1% 9

10 PHH Mortgage (Cendant) 155 1.7% 146 1.8% 10

Total for Top 10 5,058 55.3% 4,351 54.3%

Total for Top 30 Servicers 6,491 70.9% 5,747 71.7%

1-4 Family Mortgages Outstanding 9,152 100.0% 8,014 100.0%

42

…with these banks applying TRR strategies


Servicing assets outstanding have surged, increased

concentration of holdings

3.5

9.2

5.1

6.6%

24.9%

37.9%

0.0

2.0

4.0

6.0

8.0

10.0

1995 2000 2005

Serv

icin

g A

ssets

($ t

rilli

on)

0%

10%

20%

30%

40%

Top 4

Se

rvic

ers

Share

(%)

All Servicers Top 4 Servicers Share of Total (%, RHS)

43

Mortgage servicing – Does FAS 156 change the way banks have hedged mortgage servicing rights?

� FAS 156 is a new alternative to FAS 140 (also colloquially referred to as lower-of-cost-

or-market, LOCOM, accounting) and FAS 133 (also colloquially referred to as hedge

accounting)

� FAS 156 better aligns accounting treatment to economic reality of servicing assets and

hedges by moving to mark-to-market accounting for assets and hedges. FAS 140 often

resulted in a mis-alignment, with servicing assets recorded at LOCOM, but hedges

recorded at mark-to-market or available-for-sale

� Adoption of FAS 156, especially by banks that used FAS 140, we believe, has

resulted in an increase in one large bank’s recent purchases of Agency pass-throughs

� Adoption of FAS 156, by banks that used FAS 133, is expected to have limited impact

on their activities in the Agency pass-through sector

� Adoption of FAS 156 by smaller servicers that may not have used FAS 133 due to its

relative complexity and difficulty of implementation is expected to result in limited change

in their use of Agency pass-throughs for hedging purposes

A final review of bank models and some closing thoughts

45

No single model, but multiple models exist

� No single model dictates the portfolio management practices at banks. Rather multiple

models exist spanning across:

– Asset/liability management

� The norm at small- and mid- sized banks

� Pocket carry, position portfolio to take advantage of a “call” on the market, extract value through allocation into

specific coupons, sectors, structure

– Benchmark total rate of return

� Initially instituted as a means to manage duration drift in rising rate environments

� Relative performance, to a benchmark, counts for little if absolute performance is negative

– “Enterprise” level view on MBS

� Role of a bank portfolio manager, especially at any of the large money centre banks, has changed materially

over the last few years.

� Duration drift, which paralyzed banks in the past, is now minimized on an “enterprise” level, with some viewing

servicing assets as an offset to duration extension on their portfolio

46

Outlook for continued demand for MBS, as deposit growth is strong thus far in Q2:06

MBS holdings growing, mortgage loans slowing

2

24

(2)

35

8

(2)

22

8

1

(10)

-

10

20

30

40

MBS Residential Mortgage

Loans

Home Eq. Loans

Change (

$B

)

Q4:05 Q1:06 Q2:06-to-date (thru 04/19/06)


MBS holdings growth concentrated in pass-throughs

(4)

6

40

(6)

22

(0)

(10)

-

10

20

30

40

50

Pass-throughs (Agy + Non-Agy) CMOs (Agy + Non-Agy)

Change (

$B

)

Q4:05 Q1:06 Q2:06-to-date (thru 04/19/06)

C&I holdings growth continues, but lags deposit growth

17

7

(3)

16

5

99

42

(10)

(5)

-

5

10

15

20

C&I Comm. Mort. Loans Consumer Loans

Ch

an

ge

($

B)

Q4:05 Q1:06 Q2:06-to-date (thru 04/19/06)

Strong deposit and asset growth continues

115

95

(25)

22

6981

(50)

(25)

-

25

50

75

100

125

Deposits Assets

Change (

$B

)

Q4:05 Q1:06 Q2:06-to-date (thru 04/19/06)

47

Outlook for limited bank selling of securities given negative P&L currently on AFS holdings

Unrealized P&L of bank AFS securities: Near historical lows

-20

-15

-10

-5

0

5

10

15

Dec-

96

Dec-

97

Dec-

98

Dec-

99

Dec-

00

Dec-

01

Dec-

02

Dec-

03

Dec-

04

Dec-

05

P&

L o

f A

FS

Securities (

$B

)

2.0

3.0

4.0

5.0

6.0

7.0

8.0

10-Y

r S

wap Y

ield

(%

)

Net Unrealized Gains (Losses) on AFS Securities 10-Yr Swap Yield (%, RHS)

Source: Credit Suisse (US Mortgage Strategy), FDIC (at 12/31/05)

48

Declining origination volumes for mortgages

Source: Credit Suisse (US Mortgage Strategy), Inside Mortgage Finance (through 2005), MBA (2006 forecast)

0.91.0

0.8 0.7 0.8 0.9

1.51.3

1.0

2.1

2.7

3.8

2.8

3.1

2.2

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

1992

1994

1996

1998

2000

2002

2004

2006 Est

.

Mort

gage O

rigin

atio

ns (

$T

)

49

Increased regulatory scrutiny, a concern for mortgage loan holdings growth at large banks

Primarily

small banks,

where CRE

loans

compromise

25% of

assets, in

aggregate

� Concerned that proposal

limits CRE activity

� Recommend that regulators

should take into consideration

geographical regions with

less cyclical

economies/property

valuations

� Regulators’ concerns center around risk of credit losses

at banks with high concentrations of CRE loans in an

economic downturn

Key proposals

� Requires banks with certain threshold CRE

concentrations to hold higher capital

� CRE concentrations of 300% or more of total capital is

considered high

� Comment period ended April 2006

Commercial

real estate

loans

CRE

concentrations

01/10/06

All banks, in

general

� Underwriting to a “worst

case” deemed too

conservative for IO loans

� Need for differentiation

between IO and neg-am

loans, given substantially

different risks.

� Guidance should apply to

all originators of these

loans; not only to federally

regulated institutions

� Regulators are concerned that nontraditional mortgages

are being offered to borrowers that might not otherwise

be qualified

Key proposals

� Underwrite nontraditional mortgages to a “worst case”

(Fully indexed, fully amortizing) assumption

� Proposal applies to all nontraditional mortgage

originations, irrespective of whether loans are retained in

portfolio or securitized

� Addresses appropriateness of high LTV and low doc

loans on nontraditional loans

� Extended comment period ended March 2006. Final

guidance expected summer 2006

� IO

mortgages

� Neg-am

mortgages

Underwriting

standards for non-

traditional

mortgages

12/19/05

Banks

impacted

Bank an other stakeholders

concerns and commentsRegulators’ concerns and key proposals

Products

impacted

Guidance focuses

onDate Issued


Bank Regulatory Scrutiny

Trends at the top 4 banks

51

Substantial proportion of bank MBS and mortgage loan holdings held by a few large banks


Top banks' share of all bank holdings: By mortgage loans and MBS

35% 36%

53%

48%

0%

10%

20%

30%

40%

50%

60%

Mortgage Loans All MBS

Share

of

Tota

l (%

)

Subtotal for Top 4 banks Subtotal for Top 10 banks

52

Top 4 banks by mortgage holdings


Share of all bank mortgage holdings

Top 4 banks by mortgage assets

All

mortgage

holdings

Mortgage

Loans All MBS

Agency

Pass-

throughs

Agency

CMOs

Non-

Agency

Pass-

throughs

Non-

Agency

CMOs

1 Bank of America 18% 15% 21% 31% 0% 18% 4%

2 Wachovia 7% 5% 9% 12% 0% 0% 10%

3 Well Fargo 6% 8% 3% 4% 0% 0% 5%

4 JP Morgan Chase 5% 7% 2% 3% 0% 0% 0%

Subtotal for Top 4 banks 36% 35% 36% 51% 0% 18% 19%

Subtotal for Top 10 banks 51% 53% 48% 60% 23% 33% 29%

53

MBS holdings at these banks is concentrated in pass-throughs


Top banks' share of all bank holdings: By MBS type

51%

0%

18% 19%

60%

23%

33%29%

0%

10%

20%

30%

40%

50%

60%

70%

Agency Pass-throughs Agency CMOs Non-Agency Pass-

throughs

Non-Agency CMOs

Share

of

Tota

l (%

)

Subtotal for Top 4 banks Subtotal for Top 10 banks

54

Strong relationship between deposit growth and MBS holdings growth

**Residential mortgage loans + HEL


Wells Fargo

55

14 11 22

195

3410

-11

12 15

-26-9 -8

25 253 9 4 10

60

14

-10-8

11

-50

0

50

100

150

200

250

2000*

2001

2002

2003

2004

2005

Yearl

y C

han

ge (

$B

)

Deposits MBS C&I Residential Mort. Loans**

JP Morgan Chase

2317

30 31 27

40

4 4

-12

4 185

-1 -1

2 4 68

32

42

2520

8

-30

-15

0

15

30

45

2000*

2001

2002

2003

2004

2005

Yearl

y C

han

ge (

$B

)


Wachovia

-2

45

4

32

72

29

-6

714 17 13 12

-2

6

-6 -2

15

3

-6

6 410

2315

-20

0

20

40

60

80

2000*

2001

2002

2003

2004

2005

Yearl

y C

han

ge (

$B

)


Bank of America

8 9 1328

206

15

-4

36

-2

116

-7

24 18

-10

4227

6530

-15 -14-19-23

15

-32-50

0

50

100

150

200

250

2000*

2001

2002

2003

2004

2005

Yearl

y C

han

ge (

$B

)

Deposits MBS C&I Unsecuritzed Resid. Mort. Loans**

STRUCTURED PRODUCTS RESEARCH

Gail Lee, Managing Director Global Head of Structured Products Research

+1 212 325 1214

Bunt Ghosh, Managing Director Global Head of Fixed Income Research

+44 20 7888 3042

NORTH AMERICA Eleven Madison Avenue, New York, NY 10010

Asset-Backed Securities (ABS)

Rod Dubitsky, Managing Director Rajat Bhu, Vice President Jay Guo, Vice President Sergei Ivanov, Vice President

Senior Strategist, Group Head +1 212 325 4740 [email protected]

+1 212 325 5410 [email protected]



Larry Yang, Associate Thomas Suehr, Analyst



Collateralized Debt Obligations (CDO)

David Yan, Vice President Stephen Chow, Associate Willie Green




Commercial Mortgage Backed Securities (CMBS)

Gail Lee, Managing Director Paul Fitzsimmons, Vice President Manish Rajguru, Vice President Serif Ustun, Vice President

Senior Strategist, Group Head +1 212 325 1214 [email protected]




Mortgage Backed Securities — Residential (MBS)

Satish Mansukhani, Managing Director Mahesh Swaminathan, Director Adama Kah, Vice President Chandrajit Bhattacharya, Vice President

Senior Strategist, Group Head +1 212 325 5985

[email protected]




Mu’taz Qubbaj, Associate


EUROPE – Structured Products (All) One Cabot Square, London E14 4QJ, United Kingdom

Recai Güneşdoğdu, Director Tim Francis, Associate European Head +44 20 7883 7978 [email protected]


JAPAN – Structured Products (All) Izumi Garden Tower, 1-6 Roppongi 1-Chome, Minato-ku, Tokyo 106-6024

Kenji Toukaku, Director Kaoru Kondo, Associate Japan Head + 81 3 4550 7172 [email protected]

[email protected] +81 3 4550 7171

For general inquiries or to be added to a distribution list, please contact:

Angela Chuang ([email protected]) or Werner Pauliks ([email protected])

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