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Presentation of: Relative Value in Securitized Investments Insurer Investment Forum VIII March 21, 2013.

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Presentation on theme: "Presentation of: Relative Value in Securitized Investments Insurer Investment Forum VIII March 21, 2013."— Presentation transcript:

1 Presentation of: Relative Value in Securitized Investments Insurer Investment Forum VIII March 21, 2013

2 Page 1 Insurer Investment Forum VIII Agenda I.U.S. Macroeconomic Overview II.Securitized Investment Positioning and Risk within Insurance Strategies III.Relative Value in Asset-backed Securities (ABS) IV.Relative Value in Commercial Mortgage-backed Securities (CMBS) V.The Housing Recovery and Non-Agency Residential Mortgage-backed-Securities (RMBS) VI.Appendix I.Modeling Processes and Case Studies II.Biography

3 Page 2 Insurer Investment Forum VIII The U.S. Macroeconomic Overview An Overview of our Economic Forecast ● Despite larger than anticipated fiscal drag, we are maintaining our projection for 1.5% real GDP growth this year  There has been improvement in the composition of growth over the past few quarters > Private demand (e.g. consumer spending, business investment and housing) added 2.7% to growth in the 4 th quarter  The economy may be poised to rebound from below trend growth from last year > The economy grew at an annual rate of just 1.5% last year versus trend growth of 2.1% since the recovery began in It appears reasonable that in the long run, below trend growth would be offset by slightly higher trend growth going forward. ● Our baseline for 2013 real GDP growth is in the 2.4% to 2.7% range.  Subtract fiscal drag of 2.2% of GDP, which occurs mostly in the second and third quarter when sequestration hits

4 Page 3 Insurer Investment Forum VIII The U.S. Macroeconomic Overview January FOMC Summary ● Largely in line with market expectations. ● Fed views the economy on a moderate growth path with downside risks declining; however:  Concern over automatic spending cuts associated with sequestration ● Household balance sheets are improving, which should support spending; though increases from payroll taxes could have a negative impact ● More businesses reported an improvement in confidence and the prospects of an improved economic outlook ● Extensive and somewhat divided discussion about the efficacy of the Fed’s QE program  Most participants believe asset purchases have been effective in easing financial conditions, though not as fast as the Committee would like  Some expressed concern over costs and risks arising from further asset purchases  Some participants emphasized the Committee should be prepared to vary the pace of purchases, in response to either changes economic outlook or efficacy and costs of such purchases

5 Page 4 Insurer Investment Forum VIII Positioning and Risk within Insurance Strategies Current Strategies and Positioning ● Most of our multi-sector insurance strategies are slightly short duration in the ten (10) year part of the curve (e.g. 0.1 – 0.2 of year) ● Accounts are primarily underweight US Government and Agency securities while correspondingly overweight spread sectors (e.g. Investment grade credit, ABS and CMBS) ● Securitized strategies within insurance mandates consist primarily of investment grade Auto and Equipment ABS, along with well structured legacy CMBS and 2.0/3.0 and five (5) year new issue AAA-rated CMBS ● Given the richness of the new issue non-agency RMBS market and the ratings constraints of our insurance clients, we hold minimal credit sensitive RMBS.

6 Page 5 Insurer Investment Forum VIII Relative Value in Asset-backed Securities (ABS) “It is not the return on my investment that I am concerned about. It’s the return of my investment.” - Will Rogers

7 Page 6 Insurer Investment Forum VIII Relative Value in Asset-backed Securities (ABS) Consider the Investment Landscape and Current Market Challenges, Risks, and Needs: ● Investors face historic low levels of global interest rates ● Given the state of the global economy, monetary policy is likely to remain accommodative for the next several years ● Investors face asymmetric risk/return for extending duration out the yield curve. Real yields are in fact negative ● Investors must navigate continued fiscal turmoil in Europe’s peripheral economies ● Sovereign debt risks continue to pose potential for greater financial contagion, introducing increased counterparty risk ● Investors require a need for diversification, current yield, a return on investment, and critically, a return of investment

8 Page 7 Insurer Investment Forum VIII Relative Value in Asset-back Securities (ABS) Consumer Finance ABS ● Primary ABS Sectors:  Automobile Loan and Lease securities  Equipment Loan and Lease securities  Bank Sponsored, and Retail Credit Card loan-backed securities  Government and select private issued Student loan-backed securities ● The above asset classes represent historically some of the highest quality, best performing sectors, even during the peak of the global financial crisis. ● Newly issued securities in these asset classes are generally characterized by conservative underwriting.

9 Page 8 Insurer Investment Forum VIII Relative Value In Asset-backed Securities (ABS) What Consumer ABS Investments Offer: ● High Quality and Strong Fundamentals:  Strong historical credit performance, even during periods of unprecedented stress  Investments backed by homogenous and diversified collateral pools that have been underwritten to conservative standards.  History of positive ratings actions  While sovereign and corporate ratings under pressure since the onset of the crisis, the ABS ratings remains largely stable to positive ● Liquidity:  Self liquidating structures, special purpose bankruptcy remote structures that mitigate individual counterparty risks.  Historically a safe haven for excess liquidity; returns above cash and money market instruments  Short duration alternative to corporate debt  Expected continued strong issuance (Note: $175 Billion in 2012)  TRACE reporting enhances liquidity and increases transparency ● Attractive Risk/Yield Characteristics:  Low interest rate duration risk (e.g. 1 – 3 years)  Attractive yield spread premiums (e.g. margins of +15 to +150 bps vs. swaps or LIBOR based on defined risk tolerances)  A modest return on investment and the expected full return of principal

10 Page 9 Insurer Investment Forum VIII Relative Value in Asset-backed Securities (ABS) Source: Moody’s as of December 31, 2012 *Moody’s to provide in March 2013; † Average to December 31, Consider the credit quality of ABS vs. other securitized investments Structured Finance 12-Month Downgrade/Upgrade Rates by Sector*

11 Page 10 Insurer Investment Forum VIII Relative Value in Asset-backed Securities (ABS) Consider de-leveraging consumers and stronger household balance sheets: ●De-leveraging consumer household balance sheets should translate into continued strong credit performance Source: Bloomberg, Federal Reserve as of January 25, *DSR (Debt Service Ratio) - estimate of the ratio of debt payments on mortgage and consumer debt to disposable personal income.FOR( Financial Obligations Ratio) - takes DSR and adds other payments such as auto leases, rents, homeowners insurance, and property taxes.

12 Page 11 Insurer Investment Forum VIII Relative Value in Asset-backed Securities (ABS) Tactical and Strategic ●ABS investments can be both tactical and strategic. Consider the tactical approach: − Attractive return given lower term structure of interest rates − Shorter duration. Asymmetric risks associated with extending duration out the curve (e.g. Long spread duration and negative inflation adjusted returns − Global economic and fiscal uncertainty ●The tactical play: As monetary policy shifts from accommodative, other more attractive investments may arise ●Conversely consider a strategic approach: ABS investments can be strategic and defensive against rising interest rates Liquidity Considerations ●Tactical: If longer duration alternatives become more attractive, the tactical strategy can be easily unwound −ABS duration “roll-down” (e.g. 0-1 years) allows for more liquid sales transactions −ABS portfolios can be designed to self liquidate through amortization, eliminating need for sales, permitting reinvestment of pay downs in other strategies ●Strategic: If short term rates rise, the ABS portfolio re-prices with the market −Higher current coupons −Low duration risk −Less price sensitivity

13 Page 12 Insurer Investment Forum VIII Relative Value in Asset-backed Securities (ABS) Current Spreads and Yields:

14 Page 13 Insurer Investment Forum VIII Relative Value in Asset-backed Securities (ABS) Current Spreads and Yields:

15 Page 14 Insurer Investment Forum VIII Relative Value in Commercial Mortgage-backed Securities (CMBS) “I would give a thousand furlongs of sea for an acre of barren ground.” -Shakespeare

16 Page 15 Insurer Investment Forum VIII Relative Value in Commercial Mortgage-backed Securities (CMBS) ● Consider improving rent growth and declining vacancy rate among all major property types Source: Amherst Securities Group LP, Property and Portfolio Research as of September 30, Fundamentals: Rent Growth and Vacancies

17 Page 16 Insurer Investment Forum VIII Relative Value in Commercial Mortgage-back Securities (CMBS) Source: Source. Jeffries and CB Richard Ellis as of September 30, data is for Fundamentals: Net Absorption Rates ● Absorption rates remain positive among all major property types, with industrial and hotel showing stronger upward momentum

18 Page 17 Insurer Investment Forum VIII Relative Value in Commercial Mortgage-back Securities (CMBS) Source: Real Capital Analytics, Wells Fargo Securities, LLC as of December 31, ● Consider current cap rate spreads relative to 10-Year Treasuries. Cap rate spreads are poised to converge from historically wide levels. Fundamentals: Cap Rates and Spreads

19 Page 18 Insurer Investment Forum VIII Relative Value in Commercial Mortgage-back Securities (CMBS) ● Very low levels of construction spending will persist given continued problems with legacy construction loans. * Preliminary Source: U.S. Census Bureau as of December 31, Fundamentals: Construction Spending

20 Page 19 Insurer Investment Forum VIII Relative Value in Commercial Mortgage-backed Securities (CMBS) ● Consider the quality of newly originated commercial real estate loans. Today’s loans consist of much stronger credit characteristics versus loans originated at the peak of the credit cycle (2006 through 2008)* * Data as of February 14, Source: Standish, Trepp® and deal prospectuses and past 6 months are for fixed rate conduit transactions only.

21 Page 20 Insurer Investment Forum VIII Relative Value in Commercial Mortgage-backed Securities (CMBS) * Data as of February 14, Source: Standish, Trepp® and deal prospectuses and past 6 months are for fixed rate conduit transactions only. Current Spreads and Yields:

22 Page 21 Insurer Investment Forum VIII The Housing Recovery and Non-Agency RMBS “The dream of our older generation was to pay off the mortgage. The dream of our current generation is to get one.” - Unknown

23 Page 22 Insurer Investment Forum VIII The Housing Recovery and Non-Agency RMBS ●Supply is beginning to reach an equilibrium with demand. ●Over-supply was result of over-building when home prices were rising and high defaults when home prices were declining. ●Existing home sales inventory has fallen to 1.74 million homes* from a peak of 4.04 million homes in July This is now close to historical norms. ●Shadow Inventory is the number of properties that are either in foreclosure or real estate owned but not listed for sale. Shadow inventory is down 34% since the peak of million home in January Q ●We expect the shadow inventory to continue to decline, leading to less distressed sales. * Source: National Association of Realtors as of January 2013

24 Page 23 Insurer Investment Forum VIII The Housing Recovery and Non-Agency RMBS ●Home sales have been trending upward for several months. ●Existing home sales are up 1.9% in January 2013 versus a year ago. ●New home sales have risen 28.9% in January 2013 versus a year ago, but are still close to historic lows. ●Pending home sales, which tracks the number of home re-sales under contract, have been increasing. Pending home sales is a leading indicator of existing home sales by one or two months.

25 Page 24 Insurer Investment Forum VIII The Housing Recovery and Non-Agency RMBS ●Home affordability is close to all-time highs. High levels of affordability have traditionally translated into more home sales ●At the current level of the NAR Homebuyer Affordability Index, a borrower who earns the median income in the U.S. can afford 201% of a median-priced existing single family home ●Lack of job growth during the recession led to many echo boomers, those born between 1982 and 1995, staying at home or renting. New household formation ran below trend from and suggests that lack of demand was one of the causes of the excess housing supply. ●Estimates are that actual household formation is more than two million households below trend. We expect that an economic recovery will boost the momentum in housing as this pent-up demand eventually absorbs the excess housing inventory.

26 Page 25 Insurer Investment Forum VIII The Housing Recovery and Non-Agency RMBS ●Home prices are a lagging indicator of a housing recovery, but the data is starting to turn more positive. ●The Case Shiller Index is up 6.8% in December 2012 from December The CoreLogic Home Price Index rose 8.3% in the same period. ●Median prices on existing and new home sales are also rising. The median price of existing homes is up 12.3% in January from a year earlier. The median price of new homes is up 2.1% in January from a year earlier. ●The mix of sales has contributed to the better year-over-year home price numbers. There have been fewer distressed home sales, as well as an improvement in pricing on distressed sales. Modification programs, increased short sales, and REO to Rental programs have all helped to improve pricing on sales. ●We still expect seasonal weakness through the winter, but feel that prices have bottomed and should begin rising in 2013.

27 Page 26 Insurer Investment Forum VIII The Housing Recovery and Non-Agency RMBS * Data as of February 14, Source: Standish, Trepp® and deal prospectuses and past 6 months are for fixed rate conduit transactions only. Current Spreads and Yields:

28 Page 27 Appendix ABS Modeling Process Standish’s ABS modeling process is a comprehensive approach that considers issuer-specific collateral credit and prepayment behavior, while also considering deal- and vintage- specific characteristics. Its process is dynamic and continuously calibrated to consider the effects of changing collateral performance, loan prepayment patterns, and servicer behavior. Highlights of our process include: ● Expected Loss  Loss to liquidation projection.  Assumptions periodically adjusted to reflect changing collateral performance. ● Default Propensity  Default timing curves fit to modeled deal expected loss.  Adjusted for issuer, collateral characteristics, and macro environment. ● Loss Severity  Collateral and vintage specific assigned severities.  Adjusted periodically given performance and outlook for after market disposition. ● Voluntary Prepayments  Collateral and vintage specific assigned speeds.  Pricing speeds adjusted to incorporate expected defaults (involuntary prepays). ● Other  Intex used as primary cash flow engine.  Utilize third party and internally developed research to analyze collateral at a granular level.  A multi-scenario approach to evaluate risk across a range of outcomes.

29 Page 28 Appendix ABS Investment Process Example – Auto ABS CONCLUSION: Tighter issuer underwriting standards and higher required credit enhancement from the rating agencies should help this deal perform at least in-line with historical issuance. Our stress scenario attempts to approximate what a 'double-dip' scenario may look like and assumes a repeat of the increased default rates seen in 2008/2009. We are comfortable that this harsh scenario results in implied ratings that are only one rating category below our base case ratings. Given the de-leveraging nature of the structure, the break-even default rates will increase over time and provide added protection to these deals. Case Study: 2010 Vintage Subprime Auto ABS C Tranche Standish, Intex as of December This case study is representative of a type of ABS investments owned and managed in client portfolios, and highlights the fundamental drivers of our investment process.

30 Page 29 Appendix ABS Investment Process Example – Auto ABS Standish, Intex as of December This case study is representative of a type of ABS investments owned and managed in client portfolios, and highlights the fundamental drivers of our investment process. Timeline Notes: Dec Changed base case default assumption to 80% of initial curve; Mar Changed base case default assumption to 60% of initial curve; May Changed base case default assumption to 50% of intial curve & base case severity assumption to 60%; Aug Moody's rating raised from A1 to Aaa; Dec S&P rating raised from A to A.

31 Page 30 Appendix Sample Model Output – Auto ABS Standish, Intex as of December This case study is representative of a type of ABS investments owned and managed in client portfolios, and highlights the fundamental drivers of our investment process.

32 Page 31 Appendix Sample Model Output – Auto ABS Standish, Intex as of December This case study is representative of a type of ABS investments owned and managed in client portfolios, and highlights the fundamental drivers of our investment process.

33 Page 32 Appendix CMBS Cash Flow Modeling Process Standish’s CMBS modeling process is a comprehensive approach that utilizes a combination of structural and loan-level analysis. Its process is dynamic and continuously calibrated to consider the effects of property income, refinancing and modification options, and servicer/special servicer behavior. Highlights of our process include:  Default Propensity −MSA and property type specific NOI vectors, cap rate assumptions, and refinance requirements determine involuntary term defaults and balloon extensions −Factor adjustments for modification and servicer behavior  Loss Severity −Customized default timing and severity expectations based on vintage and status −Calibrated for modification and servicer/special servicer behavior −Dynamic collateral loss severity, formulated through capital markets refinance methods  Voluntary Prepayments −Call protection and voluntary prepayments −Evolution of cap rates −Term structure of interest rates, yield curve shape, and volatility  Other −Trepp used as primary cash flow engine −Other structural features including credit enhancement, transaction triggers, covenants and other factors −Utilize third party and internally developed research to analyze collateral at a granular level −A multi-scenario approach to evaluate risk across a range of probable outcomes

34 Page 33 Source: Trepp as of February This case study is representative of a type of CMBS investments owned and managed in client portfolios, and highlights the fundamental drivers of our investment process. Insurer Investment Forum VIII CMBS Case Study: 2005 Vintage AJ Tranche ● This is a typical 2005 deal with three tiers of original "AAA" bonds; 30% "last cash flow", 20% "AM/A4B", and 13.6% "AJ”. ● Deal losses have accumulated to 2.2% of original balance, typical for a 2005 vintage deal. ● Paydowns, amortization and liquidations have increased AJ credit enhancement over time. ● Appraisal reductions to limit advances, and coupon modifications have caused interest shortfalls that are affecting up to class J. Collateral Analysis Deal Structure

35 Page 34 Appendix CMBS Case Study: 2005 Vintage AJ Tranche Performance Trends Since purchase: ● Monthly losses have been trending down ● Total deal losses have been rising more slowly than prepayment, resulting in improved enhancement metrics. ● DQ/SS, modified and servicer watchlist exposure have all slowly trended down, resulting in an improved outlook. Source: Trepp as of February This case study is representative of a type of CMBS investments owned and managed in client portfolios, and highlights the fundamental drivers of our investment process.

36 Page 35 Appendix CMBS Case Study: 2005 Vintage AJ Tranche Modeling Assumptions ● Modified “hopes notes” are assumed to be written off at maturity ● Large non-performing loans and performing but specially serviced loans are assumed to be modified with 10% loss, 10% paydown and 2 year extension with 20% severity. ● Medium to small non-performance loans and performing but specially serviced loans are assumed to be liquidated within a 18 months horizon with 50% severity. ● Always performing loans are assumed to default if Debt Service Cover Ratio (DSCR) is less than 0.95, with a loss severity dependant on property value and remaining balance. ● Currently performing and not specially serviced loans are projected to extend if estimated refinancing proceeds are less than the balance at maturity. Source: Trepp as of February This case study is representative of a type of CMBS investments owned and managed in client portfolios, and highlights the fundamental drivers of our investment process.

37 Page 36 Source: Trepp as of February This case study is representative of a type of CMBS investments owned and managed in client portfolios, and highlights the fundamental drivers of our investment process. *Purchased on 4/26/2012 at $98.2 † Includes defeased loans and liquidating dq/ss/modified loans Appendix CMBS Case Study: 2005 Vintage AJ Tranche Modeling Output ● Price increase from $98.2 on 4/26/2012 to $104.5 on 2/15/2013. ● No loss expected, with expected remaining Credit Enhancement of at least 9%. ● Standish internal rating of A to AAA, signaling upgrade potential. ● Loss-adjusted yield to maturity from 3.50% to 3.80%.

38 Page 37 Appendix Biography Thomas Graf, CPA Tom is Managing Director and Senior Portfolio Manager for Global Securitized Strategies. He is responsible for overseeing Standish's securitized investments that include non-agency residential mortgage-backed (RMBS), commercial mortgage-backed (CMBS) and consumer asset-backed (ABS) securities. In addition, Tom leads Standish's Global Workout Solutions business, a fiduciary advisor service for institutions holding distressed and illiquid assets. Tom joined Standish in 2008 from Gulf Stream Structured Advisors, where he was Chief Investment Officer and Senior Portfolio Manager. Prior to joining Gulf Stream in 2006, Tom was Director of Securitized Products and Senior Portfolio Manager for Wachovia Corporation. At Wachovia Tom actively managed over $16 billion of non-agency securitized investments that were part of total return and interest rate risk management strategies. Prior to joining Wachovia in 1992, Tom was a certified public accountant for both Price Waterhouse and KPMG. Tom holds a B.S. degree from The University of Akron. He has 26 years of combined finance and investment management experience. CFA ® and Chartered Financial Analyst ® are registered trademarks owned by CFA Institute.

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