Institutional Investment Advisors Limited

Strictly Private & Confidential

Briefing Note

Prime RMBS October 2012

This document is confidential and has been prepared for discussion purposes only. It

should not be transmitted in any form to any person outside the recipient’s organisation. It

is not, is not intended to be and should not be construed as investment advice. It has been

prepared on the basis of information believed to be reliable. IIA makes no warranty,

expressed or implied, as to the accuracy or completeness of any of the information or

opinions it contains. Please refer to the important notice at the end of this report.

© Institutional Investment Advisors Limited Authorised and regulated by the Financial Services Authority (Firm No. 475344)

Strictly Private & Confidential October 2012

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Introduction The largest single asset owned by most households is their house. Not surprisingly, bond issues backed by mortgages

form the second largest main sector in the European bond market after sovereign bonds. These bond issues are of

two types: Residential Mortgage Backed Securities ("RMBS") and Covered Bonds.

This briefing looks at the RMBS market and its main components – the senior secured tranches. With a focus on the

UK as the largest RMBS market in Europe, it compares its size, quality and performance with the corporate bond

market that is currently the preferred non-sovereign bond class for many institutional investors.

Chart 1: UK Market Relative Sizes

Total

Total

Total

Total

Total

AAA

AAA

AAA

AAA

AAA

0

100

200

300

400

500

600

UK RMBS BofA Merrill Fixed Rate UK

Covered

BofA Merrill Lynch Non Gilts

Of which BofA Merrill Lynch Sterling Corps

Sterling AAA Money Market

Funds

Relative Market Sizes - £ billions

Source: AFME, BAML and IMMFA. [BAML data 30Sep12. AFME RMBS data Q1 2012. IMMFA 17Aug12]

Summary The majority of the UK Prime RMBS market was and has consistently remained rated AAA.

Most issues are floating rate, currently yielding in the range 85 to 105 basis points over sterling LIBOR

As such, the UK RMBS market represents

the vast majority by value of AAA rated bonds available to sterling investors other than gilts and supranational

issues such as the EIB

the only substantial source of bonds that are not exposed to losses arising from a rise in the general level of

interest rates

an opportunity to obtain an excess spread of 40-60 basis points over AA rated non-financial fixed rate corporate

bonds [at 27 September 2012] for less credit risk and negligible interest rate risk.

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Residential Mortgage Backed Securities RMBS are securities issued by special purpose vehicles that own a large pool of mortgage loans. These vehicles are

typically put together by the banks that made the original mortgage loans and they are used as a source of funding

for that activity.

The liabilities of the SPV are secured on the underlying mortgages. The liabilities are "tranched", with the most

senior tranches having priority over the lower tranches. The lower, subordinated tranches protect the more senior

tranches from loss under all but the most extreme circumstances (e.g. for senior AAA tranches of Prime UK RMBS,

some losses would result if 1 in 3 houses were being repossessed following an unprecedented fall in house prices).

RMBS SPVs were among the very first types of securitisation vehicle and the vast majority retain their original basic

form and secure structure. Later developments in the securitisation markets involved stretching the model too far

and without sufficient control or care, resulting in failures in the period leading up to the credit crisis. The prime

RMBS structures that dominate the UK market survived the crisis unscathed, except for the collateral "brand"

damage caused largely by the US experience and reflected for a period in prices and spreads, but suffered by any

type of bond to which the term "securitisation" was attached.

Chart 2: Ratings Downgrades of US Non Agency RMBS by Vintage, to August 2009

0%

20%

40%

60%

80%

100%

2000 2001 2002 2003 2004 2005 2006 2007

Prime ARM Alt-A ARM

Subprime UK Master Trust RMBS

Source: Bank of America Merrill Lynch Research

Banks have used these high quality UK RMBS issues not only as a route for financing from the bond market, but also

via the Bank of England's repo facilities. Eligibility of the majority by value of UK RMBS as collateral for use in the

Bank of England's monetary operations1 reflects the importance of the RMBS market in the UK.

The main source of collateral for the Bank of England Special Liquidity Scheme was AAA UK RMBS.

Senior AAA-rated tranches of prime UK and Dutch RMBS are eligible collateral for the Indexed Long-Term Repo

scheme.

The most senior tranches of UK and EEA RMBS rated A3/A- or above provided they were rated AAA at issue are

eligible for Discount Window Facility (DWF) or Extended Collateral Term Repo (ECTR).

1 http://www.bankofengland.co.uk/markets/money/publications/summary_collateral.pdf

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The Bank of England also provides a useful three part framework under the headings "Complexity,

Interconnectedness and Opacity". Or in simpler language: can the structures be understood; do they expose

investors to intricate chains of counterparty exposure; can investors see what assets underlie the liabilities initially

and over time. This framework distinguishes the main RMBS SPVs as very strong in comparison to the weaker later

developments in the securitisation market.

Complexity: Simpler than a corporate credit, well understood by leading asset managers

RMBS structures used in the majority of the market have been around for many years and are widely

understood. They are also not especially complex. Indeed, the Special Purpose Vehicles that issue RMBS are

considerably less complex and easier to analyse in terms of risks than most large corporations (and certainly

large banks and insurers) that issue bonds or in which investors hold equities. They are in a structural sense like

very simple banks that do nothing except hold mortgages, with buffers in place to protect holders of senior

liabilities. By absorbing losses, these buffers ensure that the economic character and risk faced by investors in

the senior liabilities are completely different from those involved in holding a pool of mortgage loans.

Interconnectedness: Very limited counterparty dependence, a diversification away from bank risk

RMBS are a method of diversifying away from general bank risk and thereby breaking chains of

interconnectedness of counterparty exposure. Granted, there are some residual exposures to banks involved in

RMBS, but these are not the main risks, are well understood and capable of being controlled. (E.g. swap

counterparties, where the risk is typically collateralised, and servicing obligations that could be taken over by

another party). This diversification feature is an investor benefit and has ensured that RMBS transactions

continued to be issued during the latter part of 2011 when the market for senior bank bond issues had all but

shut.

Opacity: More frequent, prompt and comprehensive reporting than any other major type of bond issue

High quality RMBS issuers such as UK Master Trusts have for many years reported comprehensive data, including

information on the status and performance of the underlying loans, with (1) greater granularity by type and

measurement band, (2) greater frequency (typically monthly) and (3) more promptly (e.g. December 2011

reports available mid January 2012) than any other type of bond issuer. In this respect, RMBS SPVs are among

the least opaque of issuers. As a result, it is no surprise that the ratings of these UK RMBS issues have proved

generally to be among the most stable of any AAA rated bonds.

Liquidity is provided by over 20 major investment bank market makers as well as several brokers. The highest credit

ratings, repo eligibility, a broad investor base and lack of interest rate risk (being floating rate bonds) all facilitate

secondary market liquidity in RMBS that is comparable to other non-government bonds. Even at the depths of

market disruption during 2008-9 there was always a bid, though prices were lower. Current typical bid/offer spread

is 2bps -10bps in £5m - £25m and larger trades are common. New PCS ("Prime Collateralised Securities") standards

will help to expand the investor base and deepen liquidity further.

Strictly Private & Confidential October 2012

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RMBS in a Global Context Chart 3: Bond Market Relative Sizes – US and Europe 31 March 2012 Euro Billions

4,350

1,184

5,486

1,064

126

1,504

1,580

374

3,056

795

355

4,760

569

169

1,850

965

18

67

- 1,000 2,000 3,000 4,000 5,000 6,000

Euro/Europe

£Stg/UK

USD/US

Covered Other Securitised RMBS Corporate Quasi & Foreign Govt Sovereign

Source2: BAML, AFME

Chart 4: European RMBS Market Relative Sizes - 31 March 2012 Euro Billions

0 50 100 150 200 250 300 350 400

Austria

Belgium

Finland

France

Germany

Greece

Ireland

Italy

Netherlands

Portugal

Russia

Spain

Turkey

UK

Source: AFME

2 Source: All data sourced from Banc of America Merrill Lynch fixed rate bond indices, except for Securitised. Securitised sourced from AFME Q1 2012 report.

Note: All data in Euro billions or equivalent. “Securitised” categorisation is by region of collateral not currency. All data other than Securitised are for fixed rate

index qualifying bond denominated in EUR, GBP or USD only. Index qualification criteria include minimum issue size of Euro250 million, GBP100 million and

USD250 million. Covered Bonds: Index data used as full data not available as at 31March2012. The currency selection excludes DKK, NOK, SEK and CHF bonds

among others from the index data used above. Total covered bonds outstanding globally in all currencies amounted to €2,501 billion equivalent at 31 Dec 2010

(Source: ECBC) of which €562 billion equivalent was floating rate and only €920 billion equivalent (47% of the fixed rate remainder) qualified for fixed rate index

inclusion. Of the full 2010 total, €1,700 billion was denominated in Euro of which only €870 billion (51%) qualified for fixed rate bond indices at that date.

Strictly Private & Confidential October 2012

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Rating Performance The two largest RMBS markets in Europe are in the UK and Netherlands. AAA tranches of both exhibit rating stability

through the post Lehman crisis and the more recent Eurozone crisis, exceptionally so in the case of the UK.

Chart 5 Proportion of issues retaining AAA rating from May 2007 to May 2011 – Moody's

0% 20% 40% 60% 80% 100%

UK Prime RMBS

UK Credit Card ABS

Dutch RMBS

Italian RMBS

Italian Consumer Loan ABS

German Auto ABS

Spanish RMBS

Spanish Consumer Loan ABS

UK Non-Conforming RMBS

Irish RMBS

Portugese RMBS

Greek RMBS

Source: Moody's Investors Service July 12, 2011 Special Report: “European ABS And RMBS Rating Performance During The Crisis: Major Markets Prove Resilient, While Periphery Weakens”

European AAA RMBS had more stable ratings than other European or US structured products or corporate bonds

(mid 2007 to Q1 2011)

Chart 6: Proportion of rating downgrades in the period mid 2007 to Q1 2011

0%10%20%30%40%50%60%70%80%90%

100%

AAA

AA

A

BBB

BB

B

Source: S&P

Strictly Private & Confidential October 2012

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Spreads and Relative Value The following chart compares AAA UK RMBS spreads with non-financial corporate bonds from the resumption of

issuance after the post Lehman crisis to date. Since the onset of the Eurozone crisis in the Autumn of 2011, UK RMBS

spreads have been less volatile than non financial corporate spreads. While they have performed better, narrowing

significantly during 2012, they continue to provide better value than AA or A non-financial corporates.

Chart 7: UK RMBS spreads over LIBOR/EURIBOR Vs Non-Financial Corps

0

50

100

150

200

250

300

UK RMBS AAA 5y EUR EMU Corp Non-Financial AA UK RMBS AAA 5y GBP

Euro Corp Non-Financial A Euro Corp Non-Financial BBB

Source: BAML, JP Morgan weekly data

Similarly, AAA UK RMBS spreads have been less volatile than senior bank bonds and the generality of covered bonds.

These latter two sectors have experienced a general widening. Bank senior only began to retreat in late 2011 after

the ECB's LTRO operation. Meanwhile, the very strongest German pfandbriefe, – the original covered bonds, now

yield less than EURIBOR.

Chart 8: UK RMBS spreads over LIBOR/EURIBOR Vs Banks, Covered Bonds and AAA Pfandbriefe

-50

0

50

100

150

200

250

300

UK RMBS AAA 5y EUR EUR Corporates Banking Type-Senior

EMU Pfandbriefe 1-3 Yr AAA Rated UK RMBS AAA 5y GBP

EMU Covered Bonds Index 3-5 Yrs GBP AAA Covered 3-5 (monthly)

Source: BAML, JP Morgan. Weekly data except for GBP AAA Covered 3-5

Strictly Private & Confidential October 2012

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Prime UK RMBS in 2007/08 and in the current Eurozone crisis

2007/08 and the period until Autumn 2011

The long period prior to the crisis of

very low spreads on the highest

quality ABS was largely due to the

impact of the leveraged section of

the buyer base and especially highly

leveraged SIVs and ABCP conduits.

(See Chart 9 for RMBS).

This was particularly the case for

floating rate issues since they could

be financed readily via borrowing or

repo on a floating rate basis without

requiring a swap to extinguish

interest rate risk.

During the first seven years of this

century, the market was in effect

overbought as regards an

unleveraged investor who therefore

did not buy this paper.

Meanwhile, 10bps to a 15X leveraged investor was worth 150bps gross.

When the crisis occurred, the SIVs and ABCP conduits were forced to liquidate when their funding ran dry or they

were absorbed by their parent banks. The demise of the ABCP conduits alone is reflected in the fall in total USD and

Euro outstandings for all ABCP borrowers from $ 1,400 billion equivalent in 2006 to around $400 billion in 2010 and

at mid 2011.

During the 2007/08 crisis and at the extremes, the raw spread data in Chart 9 for RMBS reflected non-binding broker

marks in the context of disrupted secondary market activity, the vast majority of which involved forced transactions

many of which were not at arm's length. The overwhelming overhang of RMBS as the leveraged investors withdrew

ensured that spreads reflected demand falling off a cliff rather than fundamental credit concerns.

Control is being re-established by central banks and regulators to ensure that the SIVs and ABCP conduits do not

return. As a result, spreads for highest quality ABS – RMBS, Auto loans and Credit cards –had settled at levels around

150bps by late 2011, delivering a good running yield for a non-leveraged buyer. Since then, holders have benefited

from substantial spread narrowing. However, spreads are highly unlikely to revisit the previous very narrow levels.

The Current Eurozone Crisis

In the current crisis, the investor base for high quality ABS is much more stable. The SIVs and ABCP conduits have

gone. Holders include many more unleveraged "real" money investors such as insurance companies and pension

funds. Concerns abound for both the asset (sovereign, corporate and retail lending) and liability (funding and capital)

sides of bank balance sheets, and bank senior debt spreads have risen significantly. This has been exacerbated by the

EU Commission "bail-in" proposals of June 2012 for senior unsecured bank bondholders. European banks have

resorted to covered bonds as an alternative funding tool, placing more pressure on senior bondholders as assets are

tied up for collateral. In this context, senior Prime AAA RMBS and other high quality senior ABS spreads have shown

much lower volatility. We believe this is an appropriate response to their strong credit fundamentals, being secured,

underpinned by junior tranches and bankruptcy remote from their bank originators.

Chart 9: UK Prime AAA RMBS versus Euro Corps – Spreads to EURIBOR – basis points

0

50

100

150

200

250

300

350

400

450

Dec-99 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09 Dec-11

UK Prime AAA RMBS Secondary Markets RMBS New Issues

Euro 3-5 Yr AA Corps

Source: JP Morgan, Bank of America Merrill Lynch, 24AM

Strictly Private & Confidential October 2012

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UK Prime RMBS Credit Fundamentals The Table below shows fundamental data for UK Prime RMBS Master Trusts from September 2012. This data is

derived from the regular detailed reports provided monthly by the Trusts.

With one exception (Granite), net loss rates are amply covered by “Excess spread” (net residual margin). In Granite's

case, the level of Excess spread cover is lower, but the level of AAA credit enhancement is significantly higher than

for any other Trust listed below.

UK Prime RMBS

Master Trusts Originator £bn

Weighted

Average

LTV

(indexed)

Net loss

rate Seller share Excess spread Credit enhancement:

AAA AA A

Arkle Lloyds 21.2 64.86% 0.04% 38% 0.73% 17.8% 15.9% 15.5%

Fosse Santander 19.0 64.98% 0.00% 13% 1.03% 21.3% 19.7% 19.5%

Gracechurch Barclays 10.6 58.57% 0.01% 34% 0.86% 15.9%

Granite N Rock 18.6 85.56% 0.58% 22% 0.82% 33.5% 24.9% 16.4%

Holmes Santander 14.2 67.59% 0.03% 18% 1.32% 20.1% 19.1%

Lanark Yorks and Clyds 3.7 62.21% 0.00% 39% 2.03% 17.9%

Permanent HBOS 29.4 64.84% 0.08% 31% 0.96% 19.0%

Silverstone Nationwide 25.5 60.20% 0.02% 17% 0.81% 16.7%

Source: JP Morgan, 24 Sep 2012

Size: These Master Trusts are large. The smallest is well over £3 billion, the largest is £30 billion

LTV = Loan to Value: With the exception of Granite, these seasoned Trusts contain loans with LTVS under 70%.

Net Loss Rate: Except for Granite, the net loss rates are all in single digit basis points and amply covered by

Excess Spread.

Seller Share: This is the "Skin in the Game", the economic risk in the structure retained by the originating

bank. In all cases, it is significant and well above the 5% requirement for issues after 1 Jan

2011 under the new Capital Requirements Directive for Banks and Solvency II for Insurers.

Excess Spread This is the first element of the structure available to absorb losses, being the excess of the

interest receivable from borrowers over the interest costs of the SPV's liabilities and

representing the originating lenders profit margin.

Credit Enhancement The proportion of the capital structure that ranks respectively behind the AAA, AA and A

senior tranches and acts as a loss absorbing cushion. This is broadly comparable with, and in

all cases substantially in excess of, the minimum 10%Tier 1 Capital or loss absorbing cushion

of a bank that investors would expect to be maintained.

Important Notice

Neither the information nor any opinion expressed constitutes an offer or an invitation to make an offer, to buy or sell any securities or other financial

instrument or any derivative related to such securities or instruments (e.g., options, futures, warrants, and contracts for differences). This report is not intended

to provide personal investment advice and it does not take into account the specific investment objectives, financial situation and the particular needs of any

specific person or institutional investor. Investors should seek financial advice regarding the appropriateness of investing in financial instruments and

implementing investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be

realised. Any decision to purchase or subscribe for securities or loans in any offering must be based solely on existing public information on such security or loan

or the information in the prospectus or other offering document or information memorandum issued in connection with such offering, and not on this report.

October 2012