Pre-crisis perspective. Now more than ever it has relevance with the emergence of "Vulture" Hedge Funds (VHF). The VHFs are an important part of the "ecosystem", to achieve a true market equilibrium, unhampered by 'subsidies'.

1. Event Driven Hedge Funds
“a

2. Event Driven Strategies
• Bankruptcy (in and out of…)
– High Yield/Distressed
– Credit Swaps
• Corporate reorganization; restructuring
• Fundamental change in business environment;
competition
• Lawsuits; legislation
• M&A
• Structured Bonds (Mortgage Backed Securities)

3. High Yield/Distressed Debt
Investing

4. Fixed Income Markets and Funds

5. Fixed Income Strategies
• Relative Value
– Long debt of one company and short debt of another in same industry; US and International
• Capital Structure Arbitrage
– Long municipal debt, short corporate debt
– Long senior debt, short subordinated
– Long high yield, short equity
– Long 1 year short 10 year of same company
• Event Driven
– Relies on catalyst to release value
• M&A arbitrage
• Bankruptcy or exit from bankruptcy
• Corporate restructuring, exchange offers, recapitalization, asset sales, debt buyback
• Ratings trigger downgrading from investment to high yield
• Credit/Distressed
– Relies on mispricing of security risk
• High yield
• Corporate credit arbitrage
• Distressed securities (debt and equity)
• Directional Long/Short
– Long
• Safer end of distressed (between high yield and distressed)
• Secured Financing
• Loan syndicated debt
– Short negative credit view of industry of issuer

6. Spectrum of Fixed Income
Investing
Asset Backed Securities CDO’s Commercial Real Estate Credit Derivatives Leveraged Credit
Equipment Middle Market Large Loans Correlation Trading Leveraged Loans
Commercial Loans Subordinated Classes Credit Default Swaps Distressed
Future Flow High Yield Bonds Direct Lending Baskets Mezzanine Debt
Consumer Real Estate Special Situations Indices Special Situations
Special Situations ABS Mezzanine Lending Direct Placement
Direct Portfolio Lending CDO High Yield Bonds
Mezzanine Lending High Grade Convertibles
Distressed PIPES
Derivatives ETC’s
Derivatives
Residential Mortgages High Grade Credit Governments Emerging Markets Municipals
Home Equity Agencies Agencies Sovereigns General Obligations
Alt-A US Treasuries US Treasuries Corporate Letters of Credit
Prime Non-Dollar Treasuries Non-Dollar Treasuries Asset-Backed Securities Healthcare
Whole Loans Repo Repo Direct Lending Moral Obligations
CMO’s Futures Futures Derivatives Project Finance
Mezzanine Lending Interest Rate Derivatives Interest Rate Derivatives Project Finance Revenue Bonds
Derivatives Structured Finance Distressed
Commercial Real Estate Derivatives

7. Trade Strategies and Risk
Trade Strategies Return Sources Risk Characteristics Typical Risk Allocation
HY Commercial Paper Carry Low 10-30%
Default Arbitrage Carry and Price Action Low 10-20
Short HY Basket, Long Carry and Price Action Low 20-30
HY Market Basket
Index Carry Trading Carry Low 10
Long HY Loan Market, Price Action and Carry Low 20
Short HY Loan Basket
HY Arbitrage Price Action and Carry Medium 0-30
Intracapital Price Action and Carry Medium 10-20
Long/Short Market Price Action Medium 10
Subsectors
New Issues Price Action Medium 5
L/S Specific Names Price Action High 30
Long Specific names Price Action, Carry High 10
Short Specific Names Price Action and Carry High 10
HY Municipals Price Action and Carry High 5
Cash/Derivatives Basis Price Action and Carry High 5
Trading
Single Name Volatility Price Action High 5

8. Global Fixed Income Market
Risk Sector Issues
Duration Treasuries; Global AAAs
Credit High Yield, Distressed, Emerging Market
Volatility Mortgages
Currency Non-dollar sovereigns; AAAs

9. Credit/Distressed/High Yield Sector
Opportunities
• Stable credit markets and economic
growth
• Lack of integration across credit spectrum
(inflection points)
– Investment to high yield
– High yield to distressed
– Across capital structure
– Across term structure of debt in a company

10. Correlation of Monthly Returns
1991-2004
High Yield 10 year MBS (3) Three- High Stocks (6)
(1) Treasuries Month Grade
(2) Treasuries Corporates
(4) (5)
High Yield 1.00 0.06 0.295 0.0348 0.3123 0.5120
10 Year 1.00 0.83 0.72 0.93 (0.04)
Treasuries
MBS 1.00 0.29 0.09 0.23
3-mos 1.00 0.18 0.09
Treasuries
High Grade 1.00 0.12
Corporates
Stocks 1.00
Notes:
(1) ML High Yield Master Index
(2) ML 10 Year Treasury Index
(3) ML Mortgage-Backed Index
(4) ML three-month Treasury Index
(5) ML High Grade Index
(6) Wiltshire 5000 Stock Index

11. Benefits of High Yield and
Distressed Investing
• Capital appreciation Correlation to Treasuries
and Corporate Securities
and high current 1992-2004 US IT US LT LB
income Govt Govt Aggregate
Bond
• Diversified returns CSFB High 0.00 0.11 0.19
Yield Index
from various asset
classes CSFB Lev
Loan
-0.05 0.00 -0.01
• Market liquidity
Distressed
Index
• Lower volatility than
equities, other

12. High Yield Investment Thesis
• Record new capital inflows, migration from other
asset classes
• Interest rates near four decade lows
– Search for yield, income
– Rising rates hurt Treasury/Corporate debt
• Default rate in decline after 2002 peak
• New issue market biased to stronger credits
• Improving corporate balance sheets, corporate
governance, disclosure
• Increase presence of commercial banks in
underwriting and trading

13. High Yield Investment Thesis
(Continued)
• HY market remains inefficient
– Long only charter of majority of investor base
– Limited price transparency
– Price sensitivity to funds flows
– Dealer dominated market; liquidity “gaps”
– Market not integrated to other parts of the
capital structure

14. State of High Yield Distressed
Markets
• Historically low spreads
• Near record level of issuance
• Default rate in 2004 fell from 3.2% to 1.2%
– Long term average of 4.4%
– 1994-1998 average of 2.1%
• Credit quality of new issues deteriorated
by ratings, leverage and coverage ratio
– Maintain discipline in high lead; leads to
opportunities in distressed

15. Definition of Distressed Investing
• Undervalued, under followed, out of favor of
oversold securities
• Small to middle market companies
• “Distressed” segment
– Companies in or near reorganization and/or default
– Undervalued securities trading at deeply discounted
prices resulting from severe financial, operational or
economic problems
• “Stressed” segment
– Under followed or out of favor securities trading at
discounted prices resulting from cyclical or sector
downturns, financial stress and uncertainties

16. Distressed Debt Opportunities
• Low interest rates, thirst for yield Year Bonds B- Leveraged
and improving economy led to or Lower Loans B+
record issuance of junk bond and or Lower
leveraged loans in 2003-5 2002 3.4% 7.5%
• Combined with mortality rates will
2003 10.1% 20.8%
yield high supply of distressed
2004 20.6% 34.5%
(record) (record)
Years After Issuance Until Default
Rating
B Marginal 2.9% 6.9% 7.4%
Default Rate
Cumulative 2.9% 9.5% 16.2%
Default Rate
CCC Marginal DR 8.0% 15.6% 19.6%
Cumulative DR 8.0% 22.3% 37.5%

17. Credit Markets and Credit
Derivatives

18. Market Forces Change the
Rules of Credit Investing
• Equity declines drove re-allocations to fixed income
– Simultaneously government yields
decreased to all time lows
– Credit default rates neared all time highs
– Pension fund shortfalls (Focus on ALM)
• Credit markets are increasingly complex
– Universe of assets is expanding rapidly
– Spread products are becoming more complicated
– Limited headcount to cover expanding
number of issues

19. Currently Very Few Easy
Opportunities
• End of the bear credit
market in 2003
• Spreads have
tightened to extreme
levels
– Lowest since 1998
• Demand still high
– Non-traditional
Source: S&P
investors

20. Outperformance Is More
Demanding Than Ever
• Are we being correctly compensated?
– Risk premium close to zero
• How does a long-only investor
win/outperform?
– Spreads have nowhere to go
• Move to
– Lower-quality / higher-yielding
– Find names with value still

21. Discussion Outline
• Recent market environment
• New market-implied techniques to
manage credit risk
• Introduction to the BDP (Barra Default
Probability)
• Practical Examples
• Questions and answers

22. Market-Implied Measures
Provide Additional Insight
Market-implied measures from the:
 Equity Market – Barra Default Probabilities (BDP)
 Bond Market – Barra Implied Ratings (BIR)
 Derivatives Market – Credit Default Swaps (CDS)
Coming soon…
Crossover –Empirical Credit Risk (ECR)
Equity Risk Implied Spreads (ERIS)

23. Merton’s Structural Model of
Default
• Default occurs at debt maturity if the firm
value
is below the liabilities value
• We thus need
– A model of firm value process
– Estimate of default point
• Merton identified equity as being long a call
option on the firm value
• Merton identified a bond as being short a
put option on the firm value

24. Merton’s Structural Model of
Default
No Default
V0
D
Default
Probability
of Default
T
0

25. Agenda
• The Credit Market
• Single name credit
• Correlation products
• Latest Innovation
• Risk Vision

26. Agenda
• The Credit Market
• Single name credit
• Correlation products
• Latest Innovation
• Risk Vision

27. The Market of Credit
• Size and sophistication of market has
grown enormously
- Notional exceed $2 trillion
- Single name (CDS, CLN) to full blown
portfolio based instruments (FtD, Synthetic
loss tranches, CDO squared)
• Initially used by bank loan managers to
hedge
• Now: insurance companies, hedge
funds, asset managers, etc

28. Credit Derivatives
• Instruments whose payoff is a function
of a reference assets credit
characteristics
• Transfer the ownership of credit risk
between buyers (of protection) and
sellers (of protection)
• Diversification, yield enhancement
• Credit risk is traded independently of
the instruments that generate the risk

29. Agenda
• The Credit Market
• Single name credit
• Correlation products
• Latest Innovation
• Risk Vision

30. Single Name Credit Modelling
• Structural approach: default when the company asset value
is less than its liabilities
• Spread relies on the internal structure of the company
• Can’t exactly fit a spread curve and can’t be used to price
complex credit derivatives
• Reduced-form approach: the credit process is directly
modelled via its probability of occurence
• Flexibility to fit a spread curve and extendable to price
complex credit derivatives

31. Credit Default Swaps
• Most common credit derivative (over
50% of the market)
• Provides protection against default of a
reference entity (isolates credit risk
component)
- Protection buyer retains market exposure
of reference entity
- Protection seller gets leveraged exposure
to reference entity

32. Agenda
• The Credit Market
• Single name credit
• Correlation products
• Latest Innovation
• Risk Vision

33. Correlation Products Modelling
• Contracts that reference the default of more than one obligor
• One of the fastest growing areas of credit derivatives
– nth-to-Default Baskets
– CDO’s (static, managed, synthetic etc)
• Methodologies used to price these instruments
– Default-time simulation (Normal, t, Archimedean copulas)
– Semi-analytical approach
• The normal copula is the “benchmark” model for multi-obligor
credit derivatives

34. Collateralised Debt Obligations
• Application of securitisation technology
– Synthetically transferring assets off balance sheet
via credit derivatives
• Asset pool is divided into tranches
– Tranches have different risk/return characteristics
– Payment to tranches is subordinated
• Risk on a CDO arises from the loss distribution
of the underlying asset pool
– Characteristics of individual underlying’s
– Joint correlated behaviour of underlying’s

35. Agenda
• The Credit Market
• Single name credit
• Correlation products
• Latest Innovation
• Risk Vision

36. Latest Innovation
• CDS options
• Default Swaptions
• Credit Default Swap Index (Trac-x,
iBoxx)
• CDO squared
• Option on CDO tranches
• Constant Maturity Default Swap
(CMDS)

37. Growth of Credit Default Swaps
2000 2001 2002 2003 2004
Global CDS 893 1,189 2,306 3,500 4,920
US 3,359 3,835 4,094 4,462 4,636
Corporate
(IG + HY)

38. Special Situations/Events
• Identify Drivers/Destroyers of Value
– Overcapacity
– Cyclical downturns
– Rising raw material costs
– Outsourcing manufacturing and service
– Elimination of trade/tariff barriers
– Aging populations in developed nations
• Extraordinary events
– Re-capitalization
– Restructurings
– Liquidations
– Spin-offs
– Management Changes
– Contests for Control; Proxy Contests
– Stock Repurchase; Special Dividend
– Business Repositioning
– Regulatory review/investigation

39. Credit Analysis
• Net income is not cash
– EBITDA
• EBITDA/Interest Expense
• Long Term Debt/EBITDA
• (EBITDA-Capital Expenditures)/Interest
• EBITDA/Revenues
– Interest Expense
– Capital Expenditures
– Free Cash Flow
– Long Term Debt
– Debt Repayment Requirements
• Qualitative Analysis
– Quality of management
– Equity sponsors
– Event Risk (Consolidation; IPO; Technology or Regulation issues; Refinancing
– Cyclical vs. Defensive industry
– Ranking and Capital Structure
– Bond Covenants

40. Examples of Multi-
Strategy/Event Funds

41. Examples of Multi-Strategy Funds
• Concordia
– 25% to distressed, 12% to credit relative value and 11% to
volatility arbitrage.
• Wexford
– 35% net long high yield against which they are carrying a 15%
duration weighted short in treasuries and a 25% long position in
the distressed book; 25% net long special situation equities.
• Deephaven
– 30% in relative value equity, 25% in convertible arbitrage, 20% in
event driven, 10% in distressed/ capital structure arbitrage, 5% in
global macro and 5% in credit opportunities.

42. Etolian Capital Credit Arbitrage

43. Kellner DiLeo Cohen & Co
• Investment Strategies (market neutral)
– Merger Arbitrage Fund
– Convertible Arbitrage Fund
– Distressed and High Yield Securities Fund
– Special Situations Fund
– Multi-Strategy Fund
• 40% Distressed/high yield
• 23% Convertible Arbitrage
• 27% Merger Arbitrage
• 10% Special Situations
• Investment Professionals
– CIO
– Three Portfolio Managers
– Four analysts Distressed Analyst
• $600 mm under management

44. Pinewood Capital Partners
• Long, short and long/short positions in high yield
& investment grade debt, commercial and
industrial loans, municipal bonds and exchange
traded and OTC derivatives
• Staffing
– CIO
– Director of Reseach + 3 analysts
– Head Trader
– Risk Manager

45. Dickstein Partners
• Event Driven Situations
– Merger Arbitrage
– Distressed/High Yield Securities
– Event Driven Strategies
• $450 Capital
• Six Investment Professionals

46. Dickstein Partners

47. Canyon Capital

48. Canyon Organization

49. Canyon Credit Culture

50. Canyon Capital

51. Canyon Capital Direct Debt
Investments

52. Canyon Capital

53. Angelo Gordon Alpha Credit Fund
• $8.5 billion in assets
– 116 staff
• 56 investment professionals
• 22 accounting/operations
• 6 client service professional
• Percent of assets by strategy
– Distressed securities – 30%
– Leveraged loans (CLO) – 18%
– Real estate – 18%
– Convertible arbitrage – 12%
– Merger Arbitrage – 4%
– Cash – 10%
– Other (Credit arbitrage, private equity, etc) – 18%

54. Angelo Gordon Alpha Credit Fund
• Intra-Company Credit Arbitrage
– Senior vs. Subordinated
– Parent vs. subsidiary
– Short vs. long maturities
– Bond vs. credit default swap
– Bond vs. equity
• Inter-Company Arbitrage
– Relative value within industry of credit rating
– Individual credits vs. credit indices
• Outright Longs/Shorts
– Longs/Shorts based on fundamental research
• Structured Transactions
– Long/Short CDO hedging
– Exploiting differences in instrument characteristics
– Options on default swaps

55. Taconic Event Investing
• Portfolio Composition
– Merger Arbitrage – 23%
– Distressed/Stressed – 49%
– Capital Structure Arbitrage – 32%
• Distressed/Stressed
– Invest at the senior level (secured or senior); turns
into cash and/or credit worthy senior debt
• Capital Structure Arbitrage
– Mispricing of different levels of stressed company’s
capital structure
• Bonds underpriced because of bondholder fear and equity
overpriced because of equity investors greed
– Long senior bond and short junior bond or equity

56. Sagamore Hill Multi-Strategy
Market Neutral Investment Fund
• Net Return Target = Risk
Free + 5-8% Strategy Current Allocation
• Areas of Focus Event 16%
– Event Driven Distressed 16%
• Distressed, Special Merger Arbitrage 15%
Situations, Merger Arb. Capital Structure 14%
– Relative Value Long-Short Credit 7%
• Capital Structure, Equity
Equity Market 7%
Neutral, Long/Short Credit
Neutral
– Volatility Capture Convertible 16%
• Convertibles, Volatility Arbitrage
Trading Volatility Arbitrage 9%

57. Sagamore Hill Strategies:
Event Driven
• Distressed
– Fundamental-driven research of securities in, near or recently
emerged from bankruptcy
– Domestic and European allocation
– Deal sourcing; on the run; private opportunities
• Event Driven – Special Situations
– Mispriced securities with clear valuation catalysts including
litigation, regulatory actions, spin-offs, refinancing
– Excess returns from superior due diligence to capture excess
risk premiums created by risk averse investors
• Merger Arbitrage
– Quantitative, fundamental and regulatory concerns
– Use of options to mitigate risk and add value
– Domestic and European focus

58. Sagamore Hill Strategies:
Relative Value
• Capital Structure Arbitrage
– Intra-company relative value among securities and derivatives
within a capital structure
• Debt-equity, debt-option, senior-subordinated, structural arbitrage
and pari-passu
• Balanced portfolio has minimal risk exposures
• Long-Short Credit
– Fundamental credit research
• Asset values, business fundamentals, legal considerations and
capital structure
– Domestic and European allocation
– Isolate mispriced credit risk
• Equity Market Neutral
– Equity Long/Short
– Statistical quantitative equity portfolio construction

59. Sagamore Hill Strategy:
Volatility Capture
• Convertible Arbitrage
– Global portfolio
– Mispriced volatility, credit risk, event risk
– Quantitative and fundamental valuation techniques
– Integration of convertible with other strategies within
the firm
• Volatility Arbitrage
– Relative value trading (time spreads, skew and
dispersion trades)
– Relative value between derivatives of related
securities
– Focus on equity and foreign exchange markets

60. Structured Credit Programs

61. Mortgage Backed Securities
• Value Proposition
– Mortgage market is large, liquid but not entirely efficient
– Preferred Habitat by major players indifferent to relative value
• Banks buy to yield; shorter-duration mortgages
• Homeowners borrow to buy/refinance; must pay current coupon
• Mortgage servicers driven by hedging needs
• Mortgage Backed Securities and Related Instruments
– Mortgage pools; adjustable rate loans; interest only loans;
balloon payment loans; non-performing loans; Commercial MBS;
Private Label Mortgage Securities; CMOs, Mortgage derivatives,
etc.
• Position Analysis
– Risk/cheapness; Carry; Duration; Convexity
– Identify shifts in investor preferences

62. JP Morgan Asset Management
• Program Details
– Leverage of 10-15 times net assets
– Return objective 8-12% over full market cycle (3-5
years)
– $30 bln in long and long/short
• Organization
– Three senior mortgage portfolio managers
– Three quantitative research and risk management
analysts
– Support from head of fixed income

63. Mortgage Backed Securities
Common Types of Trades
• Coupon Swap: Long one coupon vs. duration-neutral short
position in another coupon
– Buy FNMA 6%, Sell FNMA 5.5%
• Trading Rolls: Long coupon in one settlement month vs. short
same coupon in different month
– Buy Sep GNMA 6%; Sell Oct GNMA 6%
• Butterfly: Long “center” short “wings”
– Buy FNMA 6%, Sell FNMA 5.5% and 6.6%
• Agency-to-Agency: Long/short agencies in same coupon
– Buy FNMA 5.5%, sell GNMA 5.5%
• 30-year vs. 15-year: Buy FNMA 20 year 5%, Sell FNMA 15 year
4.5%
• Mortgage vs. Treasuries or Swaps: Long (or Short) mortgage
basis with expectation of spread compression (or widening) vs.
Treasuries or swaps

64. Basis Yield Alpha Fund
• Diversified Global Structured Credit Securities and Derivatives
– Asset Backed Securities (ABS)
– Mortgage Backed Securities (MBS)
– Collateralized Debt Obligations (CDO)
– Collateralized Loan Obligations (CLO)
• Market Opportunities
– Diversification benefits of pool of assets and high recovery rates
– Lower default risk and credit migration
– Uncorrelated to other asset classes
– Premium from Illiquidity and complexity and because traditional fund
manager investment mandates stop at investment grade
– Issuance in 2004 of $160 billion
• Personnel
– Three portfolio managers
– Four analysts

65. Concordia Advisors
• Concordia Advisors hired Christopher Dillon and
James Wise, former co-heads of JPMorgan’s
tax-exempt structured product group to manage
a new fund, The Concordia Municipal
Opportunities Fund, which will launch Oct. 1.
• Fixed income, interest rate neutral relative value
fund will invest exclusively in the U.S. municipal
bond market.
• Concordia has $1.2 billion in assets under
management in eight other hedge funds.

66. Introduction to Asset Securitization
• “What is a Mortgage”
• Mortgages as a Fixed Income investment
• What else can you securitize?

67. Tradable Fixed Income Supply
U.S. Dollar Denominated Debt Market
US Treasuries
25%
Mortgages
43%
US Agency
15%
Corporates
ABS
Sov/Supers 13%
2%
2%
(2002 Information)

68. What are Mortgage Backed “Pass-Through”
Securities?
+ + = Securitized
Mortgage Pool
or Pass-throughs
• A number of similar mortgages (underlying collateral,
design, rates and maturities) are combined into a single
group
• Mortgage documents associated with this group are
delivered to a custodian and are assigned an
identification (pool) number
• A Mortgage Backed Security (MBS) is issued with a face
amount equal to the cumulative outstanding principal
balance of the mortgages (original balance)
• The mortgages that have been pooled together serve as
the collateral for the security
• Most MBS are guaranteed and/or issued by a U.S.
Government Agency (FNMA, Freddie Mac or GNMA)

69. Agency Conforming MBS Origination Process
Individual Mortgages
Residential loans Average Balance $125,000
Gross WAC: 8.50%
originated within the
Pooled by Mortgage Banks
conforming Agency
guidelines are
Judged for Sale by Balance
guaranteed by an Conforming (2000 cap of $275,000),
Non-Conforming
Documentation and Pay Histories
Agency, sold to the gg
Street then either
traded in pass-
through form or used GNMA 8.50% 8.50% FNMA/FHLMC
to structure a CMO… BOUGHT BY
AGENCIES
-.44 %
-.06 %
(servicing fee)
(guarantee fee)
-.25 %
-.25 %
(next
FHA/VA 8.00% 8.00% FNMA or FHLMC 30 Yr.
page)
Mortgage Banking
TRADING (Sells - Buys)
Trading Desk
CMO Desk
PO
6.5 yr
F Z
STRUCTURING Floater $50mm
P2
CMOs $40mm 20 yr
$100mm
6.5 yr
REMICs PA PB 4 yr
$250mm $50mm S
E.G.: $500 FNMA issue 5 yr 10 yr Inverse
Floater
$10mm
6.5 yr
END Agencies
Banks &
Insurance
PURCHASERS Mortgage
~ 20% Companies &
Servicers
Regional Desks
~ 40-50% ~ 20%

70. Non-Conforming MBS Origination Process
Individual Mortgages
Average Balance $125,000
Loans that do not Gross WAC: 8.50%
conform to Agency Pooled by Mortgage Banks
standards are sold in
“whole loan” form or Judged for Sale by Balance
Conforming (2000 cap of $275,000),
structured into a Non-Conforming
Documentation and Pay Histories
senior/subordinate
private label CMO…
Either Whole Loans
(previous Loan Geographical locations, zip code, property type,
page) Characteristics pay history, original and current LTV,
Reviewed: occupancy, purpose, insurance
Ability to Pay Willingness to Pay Value of Asset
D e t e r m i n e d B y:
Credit Underwriters GSMC Custodian
- Income verification - Tape data - BPO
- Asset verification - Current 12 month pay - Appraisal
- Financial ratios (FICOs) history - Geography
- 30,60,90, 120+ day
- Zip Code
delinquencies
- Age
Or Senior/Subordinate
96% 4%
Tranche by Credit
Tranche by Time AA 15% 13.1 yr
Subordinated A 15% 13.5 yr
Aaa BBB 12% 13.8 yr
$50 mm 6 yr Tranche
BB 19% 14.2 yr
$30 mm 12 yr B 12% 15 yr
UR 27% 16 yr

71. Who Buys Mortgages?
Mortgage Security Holdings by
Banks and Investor Type in 2002…
Agencies drive
investment flows Amounts in $US billions Agencies
in the mortgage 32%
market, holding
nearly 60% of all Pension Funds
MBS 9%
Life Insurance Co's Foreign Investors
11% 15%
Other
Banks 8%
24%

72. Overview of the U.S. Mortgage
Securities Market
• Largest Sector of the U.S. Debt Market:
– Aggregate current principal amount outstanding mortgage loans is over $4.9 trillion as
compared to about $3.3 trillion of government securities and $4.4 trillion of Corporate
bonds.
– Mortgage backed securities (MBS) are an integral part of any broad portfolio exposure
to the U.S. Government securities. The U.S. investment grade corporate debt market
is less than 1.5 trillion in size.
• MBS can enhance portfolio performance significantly
– Major mortgages indices have outperformed comparable duration U.S. Treasuries by
an average of more than 140 bp over the past 10 years.
– The U.S. mortgage market consists of a wide array of securities to suit most investor
needs. A full range of credit qualities, durations, risk profiles and yields exist in this
market.
• High Credit Quality
– Most of the MBS market is issued by U.S. Government agencies which have an
implied AAA rating: GNMA issues carry full faith and credit of the U.S. Government,
Fannie Mae and Freddie Mac have the implicit backing of the U.S. Government.
– Non-agency mortgage securities mostly consist of AA or better rated bonds. Lower
72
rated securities (down to single-B) are also available.

73. What’s the catch?
• You are purchasing a product with an
imbedded call option
– Duration is very hard to determine.
– Variability in Average Life can be substantial
• You are purchasing an amortizing product
– Reinvestment of Principal monthly can reduce
yield.

74. "Duration" Deserves Special
Focus in Mortgages...
• Modified duration, Macaulay duration, cashflow duration: all
measure a mortgage's price sensitivity to rate movements,
assuming the cashflows are held constant.
– Usually not a good assumption in mortgage product owing to
prepayments
– Durations often quoted as a percentage of modified duration
• Option-adjusted duration (OAD), model duration: measure price
sensitivity for small rate movements, assuming constant OAS
– Doesn't account for how securities actually trade
– Reliant on prepayment model
• Empirical duration, EOAD: regression of performance vs rates
– can be price or OAS vs rates
– adjusted for volatility, slope of the curve

75. Prepayment Risk
• Prepayment Option
– Any payments by borrower made in excess of scheduled principal
payments are called prepayments
– The option is defined by the borrower's right to prepay all or part of the
mortgage at any given time
– The uncertainty for the mortgage holder which results is termed
prepayment risk
• Prepayment Motivation
– Prepayment may occur for one of several reasons
• sale of property
• default
• refinancing
– Motivations beyond rational economic considerations play an important roll
in assessing prepayment risk
• Risk for Mortgage Holder
– Interest rate risk (re-investment risk): Should mortgage be fixed-rate,
market risk arises as a result of prepayment if rates fall and coupons are
above market
– Liquidity risk: Should mortgage portfolio be securitized for debt issuance,
prepayment implies the need to raise new financing 75

76. Duration and Convexity
• Duration (simply): price
yield
• Convexity is the change in Duration as yields change
Positive Convexity Negative Convexity
Price Price
45 40
40 35
35 30
30 25
gain from gain from
25 convexity 20 convexity
(negative)
20 15
15 10
10 5
5 0
2 3 4 5 6 7 8 2 3 4 5 6 7 8
Yield (%) Yield (%)

77. Options and Convexity
• If you are long a call option – are you long
gamma or short gamma?
• Why is being long an MBS similar to being
short a call option? Who are you short this
option to?
• Can you hedge this with options?