U.S. Fixed Income 2004 Outlook & 2003 Year-in ... - Securitization.Net

Nomura Fixed Income Research 

2004 Outlook & 2003 Year-in-Review 

Summary Table of Contents 

Full Table of Contents on page 2 

Economics...........................................................................................................................1 

Market Strategy...................................................................................................................7 

Corporate Bonds ...............................................................................................................10 

Residential MBS................................................................................................................20 

Commercial MBS ..............................................................................................................26 

Asset-Backed Securities ...................................................................................................45 

Collateralized Debt Obligations .........................................................................................51 

Recent Nomura Fixed Income Research ..........................................................................57 

18 December 2003 

I. Economics 

David Resler (212) 667-2415 

Parul Jain (212) 667-2418 

A. Overview 

Just six months ago, skepticism that the long-awaited acceleration in economic activity would finally 

materialize ran deep. Deep enough, in fact, to persuade the Federal Reserve to cut the federal funds 

rate to a 40-year low AND to take the extraordinary step of effectively committing itself to maintain 

this accommodative stance indefinitely. Nonetheless, we held fast to our expectations for a much 

stronger second half, in part because the economy's exceptional resilience in the face of so much first 

half adversity seemed to warrant even greater optimism about the outlook. Moreover, a 

complementary blend of expansive fiscal and monetary policies also made a most compelling case 

for a substantial upturn in economic activity. 

Such optimism proved justified as real GDP growth accelerated significantly in the second half of 

2003. The modest pick-up in activity that began in the second quarter when real output grew at a 

3.1% rate turned explosive in the third quarter as real GDP soared at a spectacular 8.2% pace, the 

fastest quarterly growth in almost twenty years. An assortment of tax cuts aimed at individuals and 

families provided a powerful lift to disposable income, which households wasted no time in spending. 

Providing further impetus to the buying binge, valuations of financial assets began to rise for the first 

time in three years, complementing the steady wealth gains arising from the strong real estate 

market. Rounding out this "perfect storm" of spending incentives, low mortgage rates made it 

especially easy to refinance mortgage debt and extract some of the capital gains from real estate and 

equities. As a result, consumer spending surged ahead at a 6.4% rate in the third quarter, the 

strongest in six years. Unlike previous quarters, the economy also derived considerable strength 

from an upturn in capital spending. Here too, the tax cuts played a big part. Reductions in dividend 

and capital gains taxes, as well as a more generous depreciation schedule spurred businesses to 

invest in new plant and equipment. Not surprisingly, evidence of the revival in business investment 

spending first emerged in the spring, just after the new depreciation schedule took effect. 

Consequently, capital spending, which grew at the fastest rate since early 2000, during the third 

quarter, now appears on a path to recover from the declines of the past three years. 

Please read the important disclosures and analyst certifications 

appearing on the last page. 

Contacts: 

David Jacob 

(212) 667-2255 

djacob@us.nomura.com 

David Resler 

(212) 667-2415 

dresler@us.nomura.com 

Mark Adelson 

(212) 667-2337 

madelson@us.nomura.com 

Arthur Q. Frank, CFA 

(212) 667-1477 

afrank@us.nomura.com 

Louis (Trey) Ott 

(212) 667-9521 

lott@us.nomura.com 

Nomura Securities International, Inc. 

Two World Financial Center 

Building B 

New York, NY 10281-1198 

Fax: (212) 667-1046


Table of Contents 

Economics........................................................................................................................................................................1 

Overview ...................................................................................................................................................................1 

Interest Rate Outlook ................................................................................................................................................4 

Themes and Cross Market Strategy for the First Half of 2004 .........................................................................................7 

Trade Ideas for the First Half of 2004........................................................................................................................9 

Corporate Bonds ............................................................................................................................................................10 

Outlook for the First Half of 2004 ............................................................................................................................10 

Review of 2003 Second Half...................................................................................................................................16 

Residential MBS.............................................................................................................................................................20 

Summary.................................................................................................................................................................20 

Prepayment Outlook ...............................................................................................................................................21 

Spreads...................................................................................................................................................................22 

Coupon Stack .........................................................................................................................................................23 

Relative Value.........................................................................................................................................................24 

Commercial MBS ...........................................................................................................................................................26 

Outlook for 2004 .....................................................................................................................................................26 

Review of 2003 .......................................................................................................................................................30 

Real Estate Markets................................................................................................................................................38 

Introduction .............................................................................................................................................................31 

Asset-Backed Securities ................................................................................................................................................45 


Review of Second Half of 2003...............................................................................................................................46 

Developments .........................................................................................................................................................48 

Off-Balance Sheet Accounting.........................................................................................................................48 

Fraud ...............................................................................................................................................................49 

Credit Card ABS ..............................................................................................................................................50 

NERA Study – Notching...................................................................................................................................50 

Collateralized Debt Obligations ......................................................................................................................................51 


Review of 2003 .......................................................................................................................................................51 

Recent Nomura Fixed Income Research .......................................................................................................................57 

While the heady Q3 growth surge would be difficult to repeat, growth in the fourth quarter remains 

strong and we now estimate that real GDP growth in the second half of 2003 will exceed 6%, more 

that double the rate of expansion in the first six quarters of "recovery" from the 2001 recession. 

Moreover, the strength of this resurgence appears to have finally provided enough traction to keep 

the economy on a trajectory of faster-than-normal growth in the coming year. We remain optimistic 

that the economy can continue to generate growth of around 4% through the first half of 2004 before 

retreating modestly in the second half. 

(2)


U.S. Economic Outlook 

9 

8 

7 

Actual 

CPI Inflation 

Real GDP Growth (annualized quarterly rate) 

Real GDP Growth (4-Quarter) 

Percent 

6 

5 

4 

Forecast 

3 

2 

1 

0 

2003Q1 2003Q3 2004Q1 2004Q3 2005Q1 2005Q3 

The greater balance of aggregate demand across the economy's key sectors is also likely to persist 

in the year ahead. Owing mainly to the inevitable "payback" for the strong sales pace of the third 

quarter, consumer spending is tracking a seemingly anemic growth of about 1.5% in the fourth 

quarter. Except for the drop in vehicle sales, however, spending on other consumer goods and 

services appears to be rising at a healthy and sustainable pace. The 2003 tax cuts will deliver a 

second punch early next year as people claim refunds for overpaid taxes during the past year. Most 

importantly, however, the improvement in labor market conditions should continue to generate the 

income needed to fuel household spending. Six months ago, we argued that employment conditions 

MUST improve for our rather sanguine forecast for the second half of 2003 and beyond to become 

reality. Fortuitously, the job market appears to be regaining its vitality. Four straight increases have 

lifted nonfarm payrolls some 320,000. Data drawn from the household survey indicates the 

improvement may be much better than implied by the establishment survey. The unemployment rate, 

for instance, has fallen 0.5% from its June 2003 peak. 

By shoring up expectations that consumer spending will remain strong, a stronger labor market 

should also help fuel a continuing revival in capital spending. The three-year slump in capital 

spending has left much of the industry strapped with outmoded equipment that firms will be anxious 

to replace now that overall demand is strengthening. Not only are businesses continuing to invest in 

new plant and equipment, they finally seem ready to replenish inventories that have been depleted to 

historically low levels relative to sales. Businesses already appear to have taken the lead in growthenhancing 

activity. Nonetheless, even at the double-digit growth in business investment that we 

foresee, such spending will remain below the third quarter 2000 peak until the fourth quarter of next 

year. 

Stronger business investment will counteract the expected decline in residential investment. 

Responding to the faster growth in real output, market interest rates are projected to move higher, 

cooling the superheated housing market. After yet another record year, sales of new and existing 

homes are likely to fall off but remain at levels that still rank as historically high. As a legacy of 

historically low mortgage rates in recent years, the proportion of households owning their own homes 

has risen to an all-time high, averaging 68.2% this year. Regionally, the West recorded the biggest 

(0.9%) increase in ownership. Low mortgage rates, which have increased "affordability," appear to 

(3)


have encouraged household to acquire their own home earlier. Thus, the ownership rate of 

households headed by the young (under 35) is up 0.7% so far in 2003, while rates among other age 

cohorts have changed little. As a result, the vacancy rate for rental homes has risen to a record high 

9.9%. These data suggest that the forecasted upward drift in mortgage rates could slow or even 

reverse these trends. If so, it should help improve the credit quality of multi-family rental properties. 

Ownership Increases Rental Vacancies 

43 

10.0 

Ownership Rate (under 35 years) (%) 

42 

41 

40 

39 

38 

Ownership Rate (under 35 years) (left scale) 

Rental Vacancy Rate (right scale) 

9.5 

9.0 

8.5 

8.0 

7.5 

Rental Vacancy Rate (%) 

37 

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 

7.0 

Despite the stronger growth we envision for the year ahead, we expect inflation pressures to remain 

dormant. The complex of factors that have enhanced labor efficiency remain intact and though 

productivity growth is likely to moderate, its continued strength will mitigate against an early 

resumption of inflation pressures. Moreover, the surfeit of underutilized resources both here and 

abroad is likely to diminish only gradually. Until the economy fully absorbs that excess productive 

slack it can grow at a rapid rate without encountering inflation-causing strains. Consequently, the 

forecast highlights a combination of low inflation and strong economic growth, reminiscent of 

recoveries following the contractions of 1958 and 1961. 

Rate Forecast 

End of June 2004 End of December 2004 

Federal Funds Rate 1.00% 1.00% 

2-year Treasuries 2.55% 3.10% 

10-year Treasuries 4.65% 5.00% 

B. Interest Rate Outlook 

As the pace of economic activity has accelerated, market interest rates have edged higher. So far, 

these increases have not been especially severe, in part, because the markets seem confident that 

inflation will remain low. Our forecasted path of long-term interest rates mirrors a similar judgment 

about one of the two key determinants of nominal interest rates. Following the insight attributed to 

Irving Fisher, nominal interest rates can be dissected into two constituent elements: a "real" interest 

rate, which over time is determined by the economy's long-run growth potential; and, a premium to 

compensate for the loss of purchasing power caused by inflation. The phenomenal growth in 

productivity in recent years warrants optimism that the economy has the potential to grow at a 3.5% 

rate, if not higher. As the cyclical pressures that have held real interest rates below their long-run 

(4)


potential subside, real interest rates will need to climb toward a rate consistent with potential growth 

to ensure that resources are efficiently allocated and to prevent inflationary imbalances. With the 

business expansion exerting upward pressure on real interest rates, nominal long-term interest rates 

are likely to climb gradually higher. At the same time, prospects that inflation will remain subdued 

until the economy begins to bump into capacity constraints should limit the rise in nominal interest 

rates. However, the extraordinarily sharp gyrations in market interest rates that have surfaced 

periodically during the past two years reflects the instability of perceptions about future inflation and 

growth. In the months ahead, the cyclical uptrend in interest rates will remain vulnerable to similar 

episodes of heightened volatility. Thus, it seems all but certain that the path of long-term interest 

rates will be more erratic than in our forecast, which primarily reflects our assessment of the 

implications of the growth and inflation path we envision. The accompanying chart plots our baseline 

projection and also a forecast range suggested by the intra-quarter range of the recent past. 

7 

6 

Yield on 10-Year Treasury Notes 

(actual and projected) 

Intra-Quarter Range 

Quarterly Average 

Percent 

5 

4 

3 

2000Q1 

2000Q3 

2001Q1 

2001Q3 

2002Q1 

2002Q3 

2003Q1 




2005Q1 

2005Q3 

Two other cyclical regularities are likely to characterize the structure of interest rates within and 

across asset classes. First, the profile of the yield curve is likely to shift considerably in the year 

ahead. For most of the next year, a steady monetary policy will anchor short-term rates. Though 

short-term rates also tend toward a long-run equilibrium, they typically respond more violently than 

long-term rates to actual or perceived cyclical shifts. Near turning points, the money markets often 

become preoccupied with the timing of a shift in monetary policy. In anticipation of expected policy 

moves or in response to unexpected ones, short-term rates move more closely with changes in 

monetary policy than do long-term rates. The Federal Open Market Committee has reaffirmed a 

commitment to maintain an accommodative policy "for a considerable period." Since our forecast 

implies it will be some time before demand will begin to strain productive capacity and begin to pose 

a threat of inflation, we expect this "considerable period" to last throughout the coming year. While 

policy limits the movement of yields at the shortest end of the curve, longer maturities will rise in 

anticipation of the inevitable tightening of monetary policy. Generally, the business cycle generates 

larger departures from "normal" for shorter-term securities. Consequently, yields at this segment of 

the yield curve are currently further below their long-run equilibrium. Yields over intermediate (2- to 

5-year) horizons will probably rise more sharply than yields on securities with longer maturities (10- to 

30-year). Thus, the cyclical expansion should be associated with a flattening of the yield curve. 

Specifically, we expect the spread between 2- and 10-year Treasury notes to decline from an 

unprecedented third quarter average of 255 bp to about 175 bp by the end of 2004. Even this lower 

spread would be nearly double the long-run average spread of about 89 bp, but it would be more 

typical of the yield curve configuration during the early phase of an economic expansion. 

A second cyclical regularity is the compression of credit risk premiums. A strengthening economy 

can be expected to reduce bankruptcy and default risks and generally enhance the credit quality of 

(5)


risky assets. That process has already begun. Default rates have begun to recede, and credit risk 

spreads have narrowed considerably. As the recovery gains intensity in the year ahead, improved 

corporate performance could be expected to foster further compression of credit risk premia. 

The Yield Curve: Average of Monthly Spreads 1982-Present 

3 mo 1-yr 2-yr 3-yr 5-yr 

3mo -- 

1yr 45 -- 

2y 91 46 -- 

3y 113 68 22 -- 

5y 145 100 54 32 -- 

10y 180 135 89 67 35 

(6)


II. 

Themes and Cross Market Strategy 

for the First Half of 2004 

David Jacob (212) 667-2255 

In our view, the overriding theme for the fixed income markets at the start of 2004 is this: The 

economic recovery continues to generate growth without significantly increasing inflation. On 

balance, the Fed's accommodative monetary policy and the President's tax cuts are working. Both 

consumers and businesses continue to spend. Businesses are starting to hire more workers. The 

equity markets are up, credit quality is improving, and core inflation has reached a 40-year low. If the 

economy holds a steady course, even further trouble in the Middle East probably would not derail the 

re-election of the President. In sum, we expect the first half of 2004 to be benign for the fixed income 

markets. 

Our economic forecast calls for a mid-2004 interest rate environment as follows: 4.65% on 10-year 

Treasuries, 2.55% on 2-year Treasuries, and 1.00% on Fed Funds. Our economic forecast also calls 

for GDP to grow at a rate of 4% during the first half of the year. Against this backdrop, we present 

our themes for the next six months: 

1. The recovery continues to generate growth 

2. Consumer spending continues due to a stronger labor market 

3. Business investment in plant and equipment grows 

4. Credit quality improves in the corporate sector 

5. Residential refinancing wave ends 

6. Interest rate volatility declines 

7. Inflation remains tame 

8. Interest rates increase modestly and the curve flattens a bit (2/10 spread) 

9. Forward rates are overstating future rates 

10. Commercial real estate lags in the recovery 

From the standpoint of a U.S. fixed income investor, our themes imply three main trade ideas and two 

secondary ones: 

1. Trade down in credit 

2. Keep on a carry trade 

3. Position portfolio slightly short of duration targets 

4. Sell volatility 

5. Buy out-of-the money caps 

Fixed income investors should remain mindful that interest rates might have reached their cyclical 

lows in 2003. Thus, from a duration standpoint, investors should be slightly short their duration 

target. We emphasize "slightly," because we do not expect interest rates to rise as much as the 

forward market suggests that they will. Given a tame inflation forecast, we expect the Fed to 

maintain its current posture for some time. This means that investors should be able to benefit from a 

carry trade – financing longer duration assets with short-term borrowings – during the first half of 

2004. An investor whose goal is to maximize total rate of return should favor bonds that roll down the 

duration curve to garner excess return. 

In the corporate bond sector, we feel that the down-in-credit trade is attractive because we expect 

corporate credit quality to improve, boosting the ratio of upgrades to downgrades. Moreover, despite 

the seemingly tight spread levels now, historically spreads have been tighter. In our view this, 

combined with the supply-demand equation, will lead corporate spreads tighter yet. 

Across all sectors, we believe that credit quality improvement has so far been concentrated in 

stronger credits. Thus, an investor who is restricted to investment-grade securities should heighten 

his focus on securities in the triple-B-minus range. While spreads on such securities have already 

tightened markedly, there is still room for them to tighten further before they reach their long-term 

historic tightest levels. Of course, particular caution is warranted as one reaches down to 

(7)


triple-B-minus credit level. Keen security-specific selection skills are required to avoid the land 

mines. 

In our view, premium-priced MBS are too expensive; current spread levels do not fully compensate 

investors for prepayment risk. If interest rates, on their upward march, were to temporarily dip below 

4%, some re-financing activity probably would emerge, which could hurt the performance of premium 

MBS. We perceive that many MBS investors have already positioned themselves for a rise in interest 

rates. Their fear of extension risk has bid-up premium-priced MBS. However, they may have 

underestimated the possibility of a dip. 

We feel that residential mortgage credit quality is in reasonable shape. While we do not expect home 

prices to continue growing at the rapid pace of the past few years, neither do we expect them to 

collapse, particularly given our forecast of moderate interest rates and an improving labor market. 

Thus, a down-in-credit trade from agency MBS to private-label product may make sense. However, 

two notes of caution: First, credit enhancement levels on private-label MBS are quite low in historical 

terms. The absolute levels of protection leave little margin for error. Second, as we move toward a 

higher-rate environment, mortgage brokers who miss the high origination volumes of recent years 

may try to qualify, un-creditworthy borrowers. 

The weak commercial real estate markets in a recovering economy lead to a more complicated 

analysis for CMBS. Commercial real estate generally lags the rest of the economy. Accordingly, we 

expect greater improvement to arrive in 2005 than in 2004. 

Bush re-election with improving economy should lead to further business growth and more rate rise in 

2005. 

First Half 2004 Market Sector Weightings 

Treasuries 

Underweight 

Agency Debt 

Neutral 

Residential MBS 

Slight Underweight 

Corporate Bonds 

Overweight 

ABS 

Overweight 

CMBS 

Slight Underweight 

(8)


Trade Ideas for the First Half of 2004 

• Corporate Bonds 

○ Trade down in credit to quality BBB bonds. 

○ Buy autos from all maturities. Our top recommendation is Ford Motor Credit, followed by 

GMAC and then by Chrysler. 

○ Industrials: buy GE and Boeing 

○ Information Technology: buy Hewlett-Packard 

○ Media: buy Time Warner and Disney 

○ Food: buy Altria (maturities 36 months and less) and Kraft 

○ Domestic long distance providers: sell Sprint and AT&T. 

• Residential MBS 

○ Buy/slight overweight 30-yr TBA 5s and 5.5s (FNMA, GOLD, and GNMA II only, note 

that this recommendation applies to roll accounts only) 

○ Buy/slight overweight 15-yr TBA 4.5s and 5s (FNMA and GOLD only, note that this 

recommendation applies to roll accounts only) 

○ Buy/overweight conventional low loan balance and new WALA/low WAC 6s and 6.5s 

○ Buy/overweight 6.5% and 7% passthroughs backed by FHA/VA reperforming 

mortgages 

○ Buy/overweight well-structured 7/10-Year PACs backed by conventional 4.5s 

○ Buy/overweight GNMA (I and II) Buydown 6s & 6.5s 

○ Sell/underweight conventional TBA 6s, 6.5s, and 7s 

○ Sell/underweight conventional 4.5% passthroughs 

○ Sell/underweight GNMA TBA 6s & 6.5s 

○ Avoid IOs backed by 6% and 6.5% collateral 

• Commercial MBS 

○ In the investment grade sector, trade down in credit. The best spot will be BBB- from new 

issue deals. The most spread tightening will be in new issue sub-investment grade bonds. 

○ Sell seasoned lower rated CMBS because they may experience downgrades and losses 

as delinquencies increase in 2004. Investors are not being compensated in premium 

priced triple-A-rated CMBS. Front pay triple-A-rated bonds from 2000 vintage should be 

avoided. 

• ABS 

○ 

○ 

○ 

Buy triple-A-rated 5-year fixed rate home equity ABS. 

For more aggressive investors, favor subordinate and mezzanine HELs from top-tier 

issuers. Also, consider new issue manufactured housing and short-maturity exotics. 

Avoid subordinate and mezzanine tranches from lower-tier HEL issuers. 

(9)


III. 

Corporate Bonds 

A. Outlook for the first half of 2004 

1. Spreads 

Trey Ott (212) 667-9521 

Market momentum points to a continued bull market for corporate bonds in the first half of 2004. It is 

unlikely that the high 10.4% return seen over the past 11 months can be sustained, but with strong 

technicals and continued improvement in corporate profits, our outlook for the corporate bond market 

is very positive. With the market flush with cash, declining supply and expectations of continued 

economic improvement should drive spread compression in the months ahead. 

One of the largest drivers of spread compression in the first half of 2004 will likely be the technical 

component of the corporate bond market. Not only are investors holding a larger than desired 

amount of cash, we also expect supply to lag demand, compounding the effect. This compounding 

will exert technical pressure on already tight spreads as investors chase an ever-decreasing number 

of bonds. The lower supply of new issuance will primarily result from several reasons. First, issuers 

do not need capital to fund fixed asset investment. Second, pre-funding of short-term maturities has 

declined since interest rates are expected to remain low. Third, the shift in capital structure from 

short-term to long-term debt has played out. In fact, according to the Federal Reserve, outstanding 

commercial paper is at its lowest level in 11 years, down from its peak in November 2000. Finally, 

pension fund issues are abating. Additionally, on a monthly basis, we expect corporate bond 

issuance to average $38 billion, below the $41 billion that investors will receive in 2004 from coupon 

interest and maturing debt. 

Fundamentally, corporations continue to improve. Over the last 18 months stronger fundamentals 

have been a larger driver of spreads than they will likely be in the early months of 2004. However, 

continued improvement should support spread tightening. As the chart below reflects, internally 

generated funds have increased to highs not realized since the fourth quarter of 2001. Meanwhile, 

capex has fallen to levels associated with the first quarter of 2002. Companies have continued to 

generate cash, but have not been rushed to spend or invest it. With a financing gap of almost zero, 

companies are not required to tap the capital markets to fund expenditures, indicating a more 

conservative capital structure and financial policy. As we mentioned, we expect this to continue at 

least in the near term until solid evidence indicates that the U.S. is expanding for at least 12 months. 

Internally Generated Funds vs. Capex and Financing Gap 

1,000 

950 

900 

850 

800 

750 

700 

650 

600 

1996 

1997 

1998 

1999 

2000 

2001 

2002 

Q1 - 2001 

Q2 - 2001 

Q3 - 2001 

Q4 - 2001 

Q1 - 2002 

Q2 - 2002 

Q3 - 2002 

Q4 - 2002 

Q1 - 2003 

Q2 - 2003 

Billions ($) 

350 

290 

230 

170 

110 

50 

Billions ($) 

-10 

Internal Funds Capex Financing Gap (right scale) 

(10)


Although spreads are tight on a 5-year historical basis, spreads are still much wider than the tightest 

they have traded in the last 10-15 years. Over the past 18 months, average spreads have tightened 

80bp, with 55bp of that occurring in 2003. With expectations high and positive event risk already 

embedded in current spreads we expect most credits to trade on average tighter by another 10-15 

bp. 

Another enabler of spread tightening is the low current Treasury rates. Due to the historically low 

rates, the corporate spread, as a percentage of total yield, is much greater now than in the past. 

When spreads were this tight ten years ago, the Treasury basis was higher and as a result, the 

incremental corporate spread was a much smaller component of the total yield. For example, a 

typical ten-year corporate bond trades at a 75 bp spread to Treasuries. The Treasury is yielding 

4.28%. Therefore, the spread component of the yield is 15% of the 5.03% total yield. Ten years ago 

the total yield was 5.73%, of which the 75 bp spread on the corporate accounted for 13% of the total 

yield. 

2. Issuance 

We anticipate corporate bond issuance of approximately $450 billion in 2004, well below the $521 

billion placed in 2003. On average we expect issuance to run about $38 billion a month compared to 

the $44 billion issued in 2003. At the same time, we expect demand to remain strong over the next 

several months. 

For 2004, we do not expect the many factors that increased issuance in 2003 to remain or recur. 

Over the past year, historically low interest rates drove a shift in balance sheet structure from shortterm 

to long-term debt, propelling issuance well above our initial expectations. Outstanding 

commercial paper is at its lowest since 1992. According to the Federal Reserve, $126.8 billion was 

outstanding in November 2003 compared to the historical high of $315.3 billion in November 2000. 

Some issuers, taking cues from the improving economy and ahead of any inflationary pressure and 

higher interest rates, came to market in 2003 to lock in low rates, essentially pre-funding maturities 

through 2004. 

For example, Ford Motor Company over-funded Ford Motor Credit by $18.0 billion, partly through the 

corporate bond market. Also, General Motors raised $14.0 billion to partially cure its under-funded 

pension plan. These two issuers accounted for 5% of the overall market in 2003. 

In 2003 there was an unusual environment that promoted the issuance of corporate bonds that will 

not likely persist into the first few months of 2004. 1) In an environment of continued low interest 

rates, companies are not expected to pre-fund as much future debt as they have already and 2) as 

the stock market continues to advance, many companies will likely tap the equity market instead of 

the bond market for investment capital. 3) Finally, the shift from short-term to long-term debt is likely 

complete by in large. As these reasons for issuing more debt decline, we expect issuance to fall as 

well. 

As noted, we expect corporate bond new issuance in 2004 to be about $450 billion, well below the 

$521 billion raised in the bond market in 2003. We assume that at least 10-15% of the issuance in 

2003 was due to companies opportunistically coming to market to raise capital at low interest rates, 

primarily to pre-fund maturities for the next 12-18 months, or to term out or lengthen short-term debt. 

General Electric termed out $30 billion of short-term debt alone. Companies like General Motors 

used the bond market to fund contributions to under-funded pensions. At the close of 2003, the 

terming out is mostly completed, the shift to long-term debt is declining and pension returns are 

improving with a recovering economy. Additionally, in our opinion, many companies will increasingly 

use the equity market as a means to fund investment in capital projects and expansion rather than 

the bond market, each of which will diminish the need to raise capital via the bond market. 

(11)


3. Credit 

We expect credit to maintain its current trajectory of improving fundamentals. The bulk of 

improvement has been achieved over the past 18 months, and an improving stock market and 

economy should further bolster balance sheets. Programs put in place in 2003 to improve the capital 

structure and lower overall risk, are expected to continue through the first half of 2004. We expect 

some expansionary capital expenditures, but companies' risk tolerance should still be low at least in 

the first few months, until new plans for growth can be drawn up. Expansionary capital expenditures 

are likely to have low risk and approached cautiously, at least in the first quarter, until economic 

growth is assured. 

One of the key components of credit improvement should come from declining pension fund losses. 

Over the past 11 months, many pension funds have realized investment returns in excess of 15%. 

General Motors is expected to earn an investment return of 20% for the 12 months ended 12/31/03. 

This is far greater than it's expected 9% return. Although returns in excess of 15% do not appear 

realistic over the long-term, if the economy continues to improve, stock market performance should 

likewise be strong and under-funded pension liabilities should begin to subside. Boeing, Ford and 

most other large industrial companies should see the same benefit. This means more cash flow from 

operations could go towards reinvestment in the business instead of reducing an under-funded 

pension liability. 

Finally, we look to the rating agencies for indications of future credit performance. The chart below 

graphs the ratio of negative credit watch listing and the ratio of actual negative rating changes. As 

you can see from the chart, the movement of actual downgrades follows the shift in credit watches by 

about 18 months, which has been relatively consistent since 1994. Thus, according to the chart, it 

appears that as credit watch listings declined in 2003 there should be a corresponding decline in 

downgrades that follows over the next several quarters. This makes sense, as one can assume that 

over the last 24 months the economy has likely culled the weaker players, leaving only stronger 

corporations standing. 

S&P Rating Negative Credit Watch Ratio compared to Actual Negative Rating Change 

9 

8 

7 

6 

Ratio 

5 

4 

3 

2 

1 

0 

1994-Q4 

1995-Q4 

1996-Q4 

1997-Q4 

1998-Q4 

1999-Q4 

2000-Q4 

2001-Q4 

2002-Q4 

2003-Q4 

Credit Watch Ratio 

Actual Rating Change Ratio 

4. Recommendations 

Our overall strategy is that investors continue to pick up additional yield by investing in the lower 

quality triple-B credits. In our view, this strategy will outperform as the economy gets better, company 

fundamentals improve and technical factors play out. As of December 1st, the spread differential 

between a single-A corporate bond and a triple-B corporate bond according to Merrill Lynch was a 

(12)


very attractive 53 bp. Although this spread has tightened from 123 bp in December 2002 according 

to their index, it is still much wider than the tightest spread of 23 bp as of December 1996. Therefore, 

we believe there is an opportunity for additional tightening until the inherent risk outweighs 

compensation for taking that risk. 

a) Recommended Buys 

(1) Autos – All Maturities 

We expect automotive manufacturer bonds to be the highest performing sector in the first half of 

2004. Bonds from Ford and General Motors are currently the widest trading credits in the triple-B 

index. As we mentioned in our October 17, 2003 Ford Motor Company and Ford Motor Credit report, 

we think auto company bonds are yielding a disproportionate amount of return to their associated 

risks. Automakers have proven that they can survive in a tough economy, and although they are 

losing market share to their Asian competitors, 61% of U.S. consumers still choose to buy one of the 

"Big 3" cars or trucks over competitive vehicles. 

Over the next few months, all of the manufacturers will be rolling out new products in every category. 

GM is launching several crossover vehicles in addition to several mid-size sedans to compete with 

Honda's Accord and Toyota's Camry. Ford recently launched its new F-series that continues to win 

automotive awards and accolades while maintaining strong sales, as evidenced by a 10% growth in 

unit sales in November 2003. Cost restructuring programs and recently negotiated labor contracts 

should continue to improve the automakers' bottom lines. Creative marketing and aggressive 

promotions should continue to help them maintain a high level of automotive sales. 

Our top recommendation is Ford Motor Credit, followed by GMAC and then by Chrysler. We are not 

aggressively pursuing DCX bonds because we view them as being more susceptible to negative 

headlines right now. DCX is also behind the other manufacturers in terms of new product rollouts 

and has not yet successfully integrated Daimler with Chrysler. Although a scarcity value exists in the 

DCX bonds, we suggest only slightly over-weighting the credit. Regarding Ford, we recommend that 

investors play the yield curve and own the '08 sector when the spread differential between it and '13's 

is 25 bp or less. If the spread differential between the two is greater than 25 bp we recommend 

investors buy the '13's. Due to the current 33 bp differential we recommend that investors buy the 

Ford 7% of 2013 at a spread to Treasuries of 220 bp. 

For GMAC, we recommend that investors buy the 6.875% notes of 8/12 at Treasuries + 160 bp. 

Automotive Manufacturers – Spread to Treasuries 

Issuer 

10-year Benchmark Bond 

Ford Motor Credit (A3, outlook negative/BBB-, outlook stable) 

220 bp 

General Motors (A3, outlook negative/BBB, outlook negative) 

160 bp 

Daimler-Chrysler AG (A3, outlook negative/BBB, outlook negative) 160 bp 

(2) Media 

Time Warner (Baa1, outlook negative/BBB+, outlook negative) - Time Warner has been one of our 

top picks for the past 18 months. At current levels the bonds are beginning to lose their relative 

value, but we still believe there is some room to tighten. Investors should expect to see several 

events drive the bonds tighter over the next six months. The cable IPO will lower debt by a further 

$2.5-$3.0 billion, bringing net debt to just below the year-end 2004 target of $20 billion. While 

resolution of the Department of Justice and SEC investigations is likely to yield a small financial 

statement revision, resolution of the investigations should be a positive for the bonds. Poor results in 

the AOL division will likely continue to plague the company until they find a way to stem subscriber 

losses while maintaining strong margins. AOL's new Netscape $9.99/month service should help stem 

subscriber losses, but profitability will likely decrease in that division. As each of these events occurs, 

we expect the company will get closer to ratings stability and perhaps even an upgrade over the next 

(13)


12-24 months. We would recommend investors buy the 7.70% bonds of 05/01/32 at Treasuries + 80 

bp. 

Disney (Baa1, outlook stable/BBB+, outlook negative) – Disney should have a strong year after 

beating expectations for its third quarter in 2003. An improving economy should boost revenues and 

profits at its theme parks division. Although we continue to expect headlines regarding the current 

CEO, Michael Eisner, and Roy Disney's fight for control over the company's future, it's ABC 

broadcasting unit is expected to be profitable by 2005 due to higher ad dollars and increased 

margins. The company's studio division is expected to perform well. The company's bonds have one 

of the largest investor bases in the world and, as such, Disney debt will likely continue to trade in its 

current range going forward. We recommend the 6.375% of 3/12 at Treasuries + 60 bp. 

(3) Industrials 

General Electric (Aaa, stable/AAA, stable) – This is one of our perennial favorite industrial credits. 

Jeff Immelt, the company's CEO, launched a reorganization plan in the middle of 2003 through which 

the company will divest its slow growing businesses and acquire higher growth businesses. In 

October, the company announced its acquisition of Vivendi Entertainment that will enhance the NBC 

group. Also in November, the company announced its intention to IPO the Insurance unit to remove 

the volatile effect it had on results. For the full year 2004, the company projected EPS would be flat 

to 2003, but promised double-digit growth in the years to follow. Regardless, the company has 

improved GE Capital's balance sheet through equity injections to better reflect the triple-A rating. We 

expect GE bonds to perform in line with the economy overall, and recommend the GE 5.45% of 

1/15/13 at Treasuries + 60 bp. 

Boeing Capital Corp. (A3, credit watch negative/A, outlook stable) – Amidst negative headlines and 

bad press, Boeing and Boeing Capital Corp. is expected to generate over $1.5 billion in free cash 

flow in 2003. This is cash generated by operations less capital expenditures, interest expense and 

pension contributions. Additionally, the company is expected to generate $2.5 billion in free cash flow 

in 2004. The new CEO Harry Stonecipher's first job is to resolve lingering issues regarding the 

missile defense program and the 767-tanker controversy. We have confidence that he will take care 

of this quickly so that the company can refocus on its next airliner, the 7E7. Although the bonds are 

currently volatile, we expect volatility to diminish as headlines subside and the above issues are 

resolved. Over the longer term, investors should be rewarded for their patience. We recommend 

investors buy the Boeing Capital 5.80% of 01/13 at Treasuries +100 bp. 

(4) Information Technology 

Hewlett-Packard (A3, outlook negative/A-, outlook stable) – In November 2003, HP announced for 

the first time since the Compaq acquisition that it was profitable across all divisions and posted 

earnings from operations of $1.4 billion. Although the company is often criticized for its merger with 

Compaq, it appears to be delivering on all promises, including greater-than-expected cost synergies 

and larger scale. The company continues to wage war on two fronts -- on the hardware side against 

Dell, and on the services side against IBM -- and is proving victorious. On the hardware side, HP's 

Compaq division has the number-one share of higher margined notebooks and the number-two spot 

on desktops. On the services side, the company has been able to win significant contracts from IBM 

as well as being highly competitive on those contracts it may not have won. As much as IBM would 

rather not admit it, HP is attacking its bread and butter. We recommend investors buy the HPQ 

6.50% notes of 07/12 at Treasuries +55. 

(5) Food & Beverage 

Altria (Baa2, outlook negative/BBB+, outlook negative) – maturities of less than 36 months – Altria 

is another issuer that we think will outperform over the next six to 12 months. Fundamentally, Altria 

and its subsidiaries comprise one of the most profitable corporate entities in the U.S. today. The only 

negative, albeit a large one, is the litigation risk associated with the company's Philip Morris USA 

division. Just as the market has grown more comfortable with the U.S. tobacco component of the 

(14)


consolidated business, so too have we. Our analysis leads us to conclude that even if Philip Morris 

USA were to declare chapter 11 in an effort to resolve litigation against it, the corporate veil would 

isolate Altria. With that said, we recommend that investors limit their investments to bonds within a 

three year maturity. It is here that we feel most comfortable gauging the actual risk of the credit and 

that the risk/return trade-off is undervalued. We recommend investors buy the MO 6.375% of 02/06 

at Libor + 150 bp. 

Kraft (A3, outlook stable/BBB+, outlook stable) – Kraft bonds have performed well over the past six 

months and we expect the performance to continue through the next six months. Kraft continues to 

generate significant free cash flow and maintains a very conservative balance sheet. The company 

has several of the strongest consumer brand names in the world. More importantly, the market and 

the rating agencies are beginning to see Kraft's relationship with its parent for the strategic holding it 

really is. We maintain our contention that the value in Kraft is found by staying as far away from the 

tobacco division as possible. There are rumors that Altria may spin-off the foods company in 2004 to 

try and monetize its investment in the company. This would be a significant event for bondholders 

because the ratings drag from Altria would fall away. On a stand-alone basis, we believe the 

company is a solid single-A credit. We are comfortable that ultimately Philip Morris USA's tobacco 

concerns should not materialize into an issue for Kraft. At a spread of 90 bp over Treasuries, we 

think the Kraft 5.25% of 10/01/13 are undervalued. 

b) Avoid 

(1) Domestic Long Distance Providers 

Our opinion on long distance providers has not changed over the past 18 months. We continue to 

believe that the operators exist in an extremely competitive marketplace where they are among the 

weakest players. The Regional Bell Operating Companies (RBOCs) repeatedly take customers away 

from the long distance providers as they try to increase their top line. The RBOCs are much better 

capitalized and compete with a much stronger foundation of local recurring revenues. In addition, 

MCI (formally WorldCom) is expected to come out of bankruptcy in the next six months. The 

company will have dramatically lower debt and an IP backbone that is larger than any of its 

competitors, a foundation from which it can compete. We believe that competition will not decline, 

and, with MCI out of bankruptcy, it should increase. Revenues per voice minute are expected to 

decline further and we don't see any product offerings from the companies that will likely reverse that 

trend. 

Long Distance Carriers – Spread to Treasuries 

Issuer 


AT&T (Baa2, outlook negative/BBB, outlook stable) 150 bp 

Sprint (Baa3, outlook stable/BBB-, outlook stable) 

170 bp 

c) Marketweight 

(1) RBOCs - Verizon, SBC and Bellsouth 

The RBOCs continue to surprise us as they utilize significant free cash flow to reduce debt. Although 

the markets in which they operate are increasingly becoming more competitive, the companies have 

managed to improve their balance sheets. Although we are reluctant to raise our recommendation to 

a buy, if the companies continue to show dominance in their markets and increase cash flow used to 

reduce debt, our opinion could change. Looking forward, we are waiting for MCI (the long distance 

player) to come out of bankruptcy and see its impact on the competitive landscape before we change 

our recommendation on these companies. 

(15)


RBOCs - Spread to Treasuries (bp) 

Issuer 


Verizon Communications (A2, stable/A+, stable) 

90 bp 

SBC Communications (A1, stable/A+, stable) 

80 bp 

BellSouth Communications (A1, stable/A+, stable) 45 bp 

B. Review of 2003 Second Half 

1. Spreads 

In 2003, investors allocated more investments to bonds at attractive spreads due to lingering 

concerns about the stock market, the situation in Iraq, the economy and improving fundamentals in 

the bond market. As a result, corporate spreads tightened significantly and are currently at the 

tightest levels seen in 5 years. It is interesting to observe the difference in spreads between different 

rating categories. According to Merrill Lynch, the average spread differential of 55 bp between 10- 

year triple-B and single-A bonds is at its tightest since June 1998. This is significantly tighter than the 

widest we experienced at the end of 2003 of 123 bp, but is not as tight as the 22 bp differential seen 

in December 1996. These movements were strong, but leave room for additional tightening as the 

economy grows. Below is a chart listing spread movements by sector. Autos had the greatest 

spread collapse, tightening over 140 bp since June and 190bp since January 2003. 

Corporate Spreads - Change in Spread to Treasuries (bp) 

01/01/03-06/01/03 07/01/03-12/12/03 

Industrials -30 -30 

Banks -20 -20 

Autos -50 -140 

Finance -45 -30 

High Quality Telecom -40 unch 

Source: Nomura Securities International 

2. Issuance 

Investment grade issuance through November 2003 totaled $486 billion, well above the $451 billion 

for the same period in 2002. We initially expected companies to clean up their balance sheets rather 

than issue new debt, but the lowest interest rates in 30 years proved an opportunity too tempting to 

resist. 

As seen from the graph below, full-year issuance for 2003 should total approximately $521 billion, 

which is well above 2002's $476 billion. Typically, December is one of the slowest months of the 

year. December 2003, however, should see substantially higher issuance than years past as 

companies race to issue bonds while rates remain low and demand for new paper is high. We 

anticipate issuance for December to reach $35 billion, almost twice our initial expectations for the 

month. 

(16)


Monthly Corporate Investment Grade issuance 

90 

80 

70 

Y-Axis Label 

60 

50 

40 

30 

20 

10 

0 

Jan 

Feb 

Mar 

Apr 

May 

Jun 

Jul 

Aug 

Sep 

Oct 

Nov 

Dec 

2001 2002 2003 (December is Nomura estimate) 

3. Credit 

Credit improved significantly in 2003, especially in the past six months. As shown in the chart below, 

in the fourth quarter of 2003 the ratio of downgrades to upgrades fell to 0.5:1, its lowest level since 

the fourth quarter of 1998. This is a substantial decrease from the highs witnessed in the fourth 

quarter of 2002 at 6.1x. Although the ratio still shows 0.5x more downgrades than upgrades, we 

anticipate the ratio to stabilize around zero in the near future. 

Ratio of negative rating changes to positive rating changes 

7 

6 

5 

Ratio 

4 

3 

2 

1 

0 

1Q'94 

1Q'95 

1Q'96 

1Q'98 

1Q'98 

1Q'99 

1Q'00 

1Q'01 

1Q'02 

1Q'03 

By combining the credit watch events with the actual rating changes, the new ratio indicates that 

credit should be stabilizing overall. As shown in the following chart, for the fourth quarter of 2003 the 

ratio of negative ratings movements to positive movements was 0.9, the lowest ratio since the second 

quarter of 1999 and a substantial improvement over the 2.0x seen in the third quarter of 2003. In the 

first half of 2003, significant downgrades were taken to utilities and financial companies. Credit 

deterioration continued into the second half, but the extent to which credit fell declined from the first 

half. We expect that the ratio of downgrades to upgrades will improve in 2004 as corporations 

continue to work on their balance sheets and the economy move towards recovery. 

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Ratio of negative rating movements to positve movements 

4.0 

3.5 

3.0 

2.5 

Ratio 

2.0 

1.5 

1.0 

0.5 

0.0 

1Q'94 

1Q'95 

1Q'96 

1Q'98 

1Q'98 

1Q'99 

1Q'00 

1Q'01 

1Q'02 

1Q'03 

4. Review of the Mid-year Recommendations 

Performance for the past six months was good. Although many of our recommendations performed 

well in tandem with the overall market, our approach of increasing exposure to riskier credits paid-off. 

The market has gradually become comfortable with assuming more risk over the last 12 months, and 

as such, re-examined some of the wider credits such as Kraft, Hewlett Packard and autos as a 

means of outperforming the market. This strategy worked. Our negative opinion on the long distance 

companies under-perform during the last six months as bonds tightened over 150 bp. As investors 

became more comfortable with risk, they became more comfortable with these credits too. 

Regardless, we continue to feel that those investors who avoid the long distance sector in the long 

run will be vindicated. 

(18)


Company Name 

Recommendation Scorecard 

Recommended 

Date 

Spread or Price 

at Rec. 

(10-year bench) 

Current Price ($) or 

Spread over 

Treasuries (bp) 

BUY 

AOL Time Warner Jul-02 330 bp 80 bp 

Walt Disney Company Jul-02 155 bp 660 bp 

General Electric Dec-02 125 bp 60 bp 

Boeing Capital Dec-02 170 bp 100 bp 

Ford Motor Credit (1 year) Dec-02 L+275 L+70 

Ford Motor Credit Oct-03 +275 220 

GMAC (1 year) Dec-02 L+200 L+50 

Hewlett Packard Jun-03 T+85 55 

Kraft Jun-03 T+95 90 

Market Weight 

General Motors Dec-02 320 bp 160 bp 

Daimler-Chrysler Dec-02 175 bp 170bp 

Verizon Communications Dec-02 90 bp 90 bp 

SBC Communications Dec-02 68 bp 80 bp 

Bellsouth Communications Dec-02 68 bp 45 bp 

Avoid 

Sprint Dec-02 310 bp 150 bp 

AT&T Communications Dec-02 275 bp 170 bp 

* In December 2003 we changed our recommendation in autos from a market 

weight to a Buy. 

(19)


IV. 

Residential MBS 

Arthur Frank (212) 667-1477 

James Manzi (212) 667-2231 

Outlook for 2004: Convexity Inexpensive in MBS Market as Bearish Mood Creates Overpriced 

Premiums 

A. Summary 

Premium prepayment speeds slowed dramatically in November, with 30-year 6s and higher coupons, 

as well as 15-year 5.5s and higher coupons, posting by far their slowest CPRs since September 

2002, when the 2002-3 refinancing wave began. The 163 bp increase in 30-year current coupon 

Fannie Mae yields from an all-time low of 4.18% on June 12 to 5.81% on September 2 ended the 

largest refinancing wave in the 33-year history of the MBS market. As is usually the case when a 

refinancing wave ebbs, prepayment speeds decline more slowly than they sped up when rates were 

falling, a function of mortgage originators working through their backlog of refinancing applications. 

We do not believe that mortgage speeds are going much lower in the near term, however, as the 30- 

year Fannie Mae current coupon yield has fallen slightly below 5.20%, and the MBAA Refinancing 

Index (Refi Index) has climbed back above 2000 (see chart on following page). Yet both the 

passthrough and Trust IO markets are currently priced for a significant slowdown in prepayment 

speeds. Conversely, pay-ups above TBA prices for premium “specialty pools” (low loan balance, 

moderate loan balance, new WALA, low WAC, low FICO, etc.) have declined sharply in recent 

weeks, to levels where adding convexity to an MBS portfolio can be relatively inexpensive. 

With the Freddie Mac primary market 30-year weekly survey rate currently at 5.88%, just 67 bp above 

the June’s 2003 all-time low, we do not believe that premium speeds will slow significantly during the 

first quarter of 2004. Therefore, we believe that TBA 6s and higher coupons are currently priced 

above fair value, and suggest a modest underweight of the premium 30-year sector. In current 

coupons, we believe that the MBS market is fully priced, even slightly rich, compared with Treasuries 

and agencies, but suggest a market weight nonetheless, as conventional 5 and 5.5s are likely to roll 

above carry in early 2004 due to stronger demand from CMO underwriters. Although bank portfolio 

sponsorship of the CMO market has lagged in recent weeks, and in fact banks have been net sellers, 

not buyers, of short CMOs this month, we expect bank CMO demand to bounce back during the first 

quarter of 2004. December bank selling has been largely motivated by a desire to book capital gains 

or to trim balance sheets going into year-end rather than reflecting any reduction in portfolio appetite 

for MBS. With the Federal Reserve Open Market Committee having indicated that short term rates 

will remain low for at least several months to come, the yield curve will likely remain steep at least 

during the first half of 2004, providing an attractive environment for banks to purchase short average 

life CMOs funded at the fed funds rate. At present, PAC/support deals can be priced in both 30-year 

5s and 5.5s, and hence we think those coupons are attractive on both an outright and a dollar roll 

basis. If, as we expect, these dollar rolls trade special by 1-2 ticks per month, the carry advantage 

over Treasuries and agencies will remain substantial, even with spreads on the tight side of their 

historical range. Our Economics Department’s forecast for the continuation of a relatively steep yield 

curve for the first half of 2004 also makes a current coupon underweight a risky position for investors 

in agreement with this outlook. While swaption implied volatility is currently near its average level of 

the past year (17.7% on at-the-money 5x10s – see graph below), it remain over 200 bp above its five 

year average of 15.5%, and we think it is more likely to decline than rise during the first half of 2004, 

which would be a positive development for the relative performance of the MBS market. 

At present, call risk seems to pose a greater threat for MBS relative performance than extension risk; 

with the MBS index already having extended in effective duration from 1.3 years at the end of 

February 2003 to 3.6 years at the end of November, much of the conceivable extension of the MBS 

market has already occurred. So the real risk of MBS underperformance, other than a major yield 

curve flattening taking away the bank carry trade, would be if the 10-year Treasury yield were to 

plunge to 3.75% or below. Such an interest rate move, unexpected by both our Economics 

Department and market consensus, would likely lead to massive activity by mortgage convexity 

hedgers, driving up implied volatility in derivative markets and leading to a renewed wave of 

(20)


refinancing. Since premiums are currently priced as if such a move is a low probability event, this 

would likely cause significant underperformance of high coupon mortgages, and hence overall 

relative underperfomance compared with Treasuries, agencies, and swaps. On balance, we 

advocate a market weight in current coupons and a modest underweight in premiums, but investors 

who believe in our Economics Department’s mildly bearish forecast may want to market weight the 

MBS market as a whole. 

B. Prepayment Outlook 

The November prepayment speeds reported in early December showed the sharp decline in premium 

prepayment speeds that had been expected by market participants since the major rise in mortgage 

rates this past summer pulled the MBAA Refi Index from an all-time record high of 9977.8 to the low 

2000s by summer’s end. Despite the abrupt decline in the Refi Index, premium prepayment speeds 

fell quite modestly through November, due to a huge backlog of refinancing applications from the 

early summer low in mortgage rates. We expect a mild rebound of speeds in December, largely due 

to it being a 22-business day month, compared with only 18 business days in November (counting 

Veteran’s Day as a holiday). January and February of 2004 are both light on business days, with 20 

and 19 respectively, and accordingly we expect slight declines in prepayment speeds for both 

months. From there we expect, at current interest rates (5.20% current coupon conventional yield as 

of the December 17 close, Freddie Mac 30-year weekly survey rate at 5.88% as of their December 11 

release), relatively stable prepayment speeds., with the MBAA Refi Index dropping modestly below 

2000 but staying well above 1500. Thus we expect prepayment speeds of 30-year TBA 6s to remain 

slightly above 30 CPR and speeds of 30-year TBA 6.5s to remain just above 40 CPR for the next four 

to five months, somewhat faster than the market seems to expect given prevailing prices in both the 

passthrough and the IO market. 

MBA Refinancing Index vs. Freddie Mac 30-yr Commitment Rate 

11000 

6.50 

10000 

MBA Refi Index 

9000 

8000 

7000 

6000 

5000 

4000 

3000 

6.20 

5.90 

5.60 

5.30 

Commitment Rate (%) 

2000 

1000 

5.00 

27-Dec-02 

24-Jan-03 

21-Feb-03 

21-Mar-03 

18-Apr-03 

16-May-03 

13-Jun-03 

11-Jul-03 

08-Aug-03 

05-Sep-03 

03-Oct-03 

31-Oct-03 

28-Nov-03 

MBA Refi Index 

Freddie Mac 30yr Commitment Rate 

Sources: Bloomberg, Nomura 

While the MBS market, in our view, is correct in valuing TBA premiums differently now that the 

greatest refinancing wave ever has ended, it has over-priced TBA premiums relative to alternatives 

that offer much more prepayment stability. 

In spite of the November slowdown in speeds, we believe TBA pools of 6s and especially 6.5s and 7s 

are going to offer sub-par relative returns over the next few months due to prepayment speeds 

stabilizing at close to November levels. For 6.5s and 7s, reperforming FHA/VA passthroughs are a 

good substitute for TBA collateral, as we expect the latter’s prepayments to slow from CPRs in the 

(21)


high 20s to low 30s to the low-to-mid 20s over the next few months. Reperforming FHA/VA pools 

were slower than TBAs to speed up during the summer refinancing peak and are now taking longer to 

slow down, since FHA-to-FHA refinancing requires more time and paperwork then conventional 

refinancing. 1 We are confident, however, that such a prepayment slowdown will materialize over the 

next three months, and with pay-ups above TBA FNMAs having declined to 1-10 for 6.5s and 1-19 for 

7s, there is value in this sector. In mid-premium 6s, where we expect TBA to be prepaying at slightly 

above 30 over the next few months, we prefer low loan balance and low WALA pools, which offered 

strong call protection during the recent refinancing wave, and where pay-ups above TBA prices have 

sharply compressed. For example, defining low balance as pools with average loan size under 

$75,000, moderate balance as pools with average loan size from $75,000 to $100,000, and high 

balance as pools with average loan size above $150,000 (the latter likely to be delivered TBA), the 

most recent 6-month CPRs for low, moderate, and high balance 2002 production 30-year FNMA 6s 

were 20.1, 28.9, and 56.9, respectively. With this amount of call protection, even in a more muted 

refinancing environment, the pay-ups of 14 ticks for low balance and nine ticks for moderate balance 

conventional 6s will be recovered in carry in four to five months, after which the investor owns pools 

with much better convexity than generic pools essentially for free. A less expensive alternative to 

TBA in both 30-year 6s and 6.5s are pools that have both low WALA and low WAC, available in 6s for 

a pay-up of three ticks and in 6.5s for a pay-up of 12 ticks. The pay-ups are mainly for WALA < 2 

months, taking advantage of the fact that even for mid-premiums, there is a “refinancing ramp” of 

about 12 months; the investor gets low WAC for just a tick or so more. The near-term prepayment 

advantage is quite large; for example, all FNMA 6s with WALA = four months prepaid over the last 

three months at 9.6% CPR, while the group of FNMA 6% pools with WALA between 25 and 36 

months (likely to be delivered TBA) prepaid at 50.8% CPR. For a new WALA premium pool, the 

majority of the prepayment advantage over TBA comes in the first four to six months, but the carry is 

so much better than TBA that the premium is expected to be recouped in one month for 6s and in 

three months for 6.5s. 

C. Spreads 

While the ultra-fast premium prepayment speeds of the summer and fall of 2003 significantly eroded 

MBS total returns, the steady tightening of current coupon MBS spreads to Treasuries since the 

beginning of August (see Graph 2) produced total returns for the fixed rate agency MBS market for 

the first eleven months of 2003 of only about 36 basis points less than comparable duration 

Treasuries, a much better performance than in similar high refinancing environments in 1993 and 

1998. 

1 Frank, A. and Manzi, J., Monthly Update on FHA/VA Reperforming Mortgages: Historical Prepayment Speeds, 

Default Losses, and Total Returns, Nomura fixed income research (3 Dec 2003). 

(22)


FNMA Current Coupon Spreads to Treasuries & Swaps 

160 

21 

140 

20 

120 

19 

Spread (bp) 

100 

80 

18 

17 

5 x 10 vol. 

60 

16 

40 

15 

Jan-03 

Feb-03 

Mar-03 

Apr-03 

May-03 

Jun-03 

Jul-03 

Aug-03 

Sep-03 

Oct-03 

Nov-03 

Dec-03 

FNCC / 10yr Treas FNCC vs 10yr Swap 5x10 Vol 


Because we expect premium prepayments to decline very modestly at least through the first quarter 

of 2004, and because MBS valuations are now at a point that further tightening potential is limited, we 

doubt that significant outperformance by the MBS sector is likely for the first half of 2004. At this 

point we suggest limiting MBS to a market weight, with a slight overweight in 30-year 5s and 5.5s and 

15-year 4.5s and 5s to take advantage of incremental returns in the dollar roll market, due to our 

expectatin of strong dealer demand for these coupons for CMO underwriting We also suggest a 

modest underweight of premiums. 

Not only do we anticipate a continuation of fairly rapid premium speeds for at least the next quarter, 

but we think current coupon passthroughs have become slightly rich compared with agencies and 

Treasuries, as mortgage spreads continued to tighten even as the sharp decline in implied volatility in 

the swaptions market ended and volatility found a trading range (see chart above). 

Nonetheless, the risk-reward trade-off does not at the present time dictate an underweight either. If 

rates remain in a trading range or back up modestly, swaption implied volatility is more likely to 

decline than rise from current levels. Our Economics forecast of the continuation of a relatively steep 

yield curve for the first half of 2004 limits the potential for significant spread widening, as REMIC 

underwriters will likely bid aggressively for current coupon collateral if spreads edge wider in the 

absence of a significantly flatter curve. The REMIC bid, driven to a large extent by the insatiable 

appetite of bank portfolios for short average life CMO tranches in an environment where the carry 

over funding costs of such paper is very attractive, should keep conventional and GNMA II current 

coupons rolling above carry, further limiting the potential for sizeable underperformance. So marketweighting 

the MBS sector appears to be the best policy, with incremental return possibilities available 

in dollar rolls for current coupons and pool selection in premiums. 

D. The Coupon Stack 

After over two years of rapid refinancing of higher coupon and extensive issuance of lower coupon 

mortgages, the coupon distribution of the 30-year fixed rate agency MBS market has radically shifted, 

with nearly 70% of the 30-year passthrough market in the just three coupons, 5%, 5.5% and 6%. But 

because the two largest coupons in the MBS market, 5s and 5.5s, have already virtually ceased 

refinancing and are being priced at speeds not much above housing turnover, much of the possible 

duration extension of the MBS market has already occurred. The graph below demonstrates the 

coupon concentration of the current MBS market compared with two and six years ago: 

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Distribution of the Coupon Stack in the Agency MBS Market 

100% 

90% 

80% 

>=8 

>=8 

7.5 

7.5 

7 

6.5 

Percentage of Total 

70% 

60% 

50% 

40% 

30% 

7.5 

7 

7 

6.5 

6 

5.5 

>=8 

7.5 

7 

6.5 

6 

5.5 


ticks above TBA. Since for the next three to four months both of these categories are expected to 

prepay at about 20 CPR slower than TBA pools, the carry will compensate investors for the payups, 

even in the highly unlikely event that the pools trade at TBA prices four months from now. Of course, 

the low loan balance pools should permanently prepay more slowly than the universe, due to the 

lower mortgagor monthly savings and smaller broker incentive to refinance low balance mortgages, 

while the advantage of new production pools will diminish significantly over time. 

The 15-year current coupon sector is currently fairly valued versus the 30-year sector, given its lower 

option cost, and with extension fears prevalent in the market, has become popular collateral for 

REMIC underwriters. Thus we expect 15-year 4.5s and 5s to dollar roll above fair value, and would 

slightly overweight these coupons to take advantage of the rolls. Premium 15-year 5.5s and 6s are a 

little less attractive than lower coupons on an OAS basis and are not as likely to roll as well; we would 

therefore avoid TBAs and invest in low loan balance and new WALA – low WAC pools in these 

coupons. 

In the CMO market, there is currently good value in discount intermediate and long PACs backed by 

30-year 4.5s and 5s, which are paying well within their bands and are offered 5-10 bp OAS cheaper 

than the underlying collateral. In particular, we like PACs backed by 4.5s, which offer inexpensive 

call protection for rate declines up to 100 bp that are currently undervalued by the market. These 

bonds represent an attractive alternative to owning 4.5% collateral, that unlike 5% collateral is likely 

to dollar roll at carry and offers an insufficient yield premium for its inferior convexity to discount 

PACs. 

A new development in the Ginnie Mae market is the issuance of premium buydown pools in both the 

GNMA I and GNMA II programs. Prior to July 1, 2003, most FHA buydown loans, in which the home 

seller (often the builder of a new development) pays 2% interest in year one and 1% interest in year 

two, were placed into generic GNMA II pools. GNMA, however, changed their pooling rules effective 

July 1, 2003, limiting buydown loans to a 10% maximum of the original principal balance of a new 

GNMA II pool. As a consequence, several originators have begun to create both GNMA I and II 

buydown pools, which currently trade far below TBA prices in spite of much slower expected 

prepayments in their first two years, when the interest payments are being subsidized by the seller of 

the home. In GNMA 6s (I & II), buydown pools are currently offered at 14 ticks below TBA; in 6.5s, at 

12 ticks below TBA. While these pools are not TBA-deliverable even after the buydown period 

expires, these sub-TBA prices make them very attractive for buy-and-hold investors. A GNMA 6.5s 

newly issued buydown pool prepays as if it were a GNMA 4.5s in year one and as if it were a GNMA 

5.5 in year two, since the mortgagor is receiving a 200 bp subsidy in year one and a 100 bp subsidy 

in year two. Once the GNMA buydown market grows and receives more investor focus, we doubt 

these large discounts from TBA prices will last. We recommend non-dollar roll investors purchase 

GNMA 6% and 6.5% buydown pools as a substitute for GNMA TBA 6s and 6.5s. 

(25)


V. Commercial MBS 

David Jacob (212) 667-2255 

A. Outlook for 2004 

1. Issuance 

We think that 2004 United States commercial mortgage backed securities (CMBS) issuance could 

approach the 1998 record of approximately $75 billion. Unlike the residential mortgage market, 

CMBS have very strong prepayment protection of the underlying mortgage loans, leaving issuance 

driven by the property markets' demand for capital, and the intensity of competition among traditional 

lenders in supplying that capital. 

Our forecast for a moderate rise in interest rates will lead to some slow-down in acquisition financing, 

but that will be more than offset by the need to re-finance more than $20 billion of maturing 10-year 

balloon loans originated in 1994, and 7-year balloon loans from the boom years of 1997 and 1998. 

Additionally, as real estate markets begin to recover, and particularly if property values reflect an 

anticipated increase in rents as vacancies ease, transactions could pick up. Moreover, a gradually 

improving real estate market should make renovation and rehabilitation projects more feasible, further 

driving loan demand. 

2004 Loan Maturities by Property Type 

8 

7 

6 

Amount ($Bil) 

5 

4 

3 

2 

1 

0 

Total = $20.0 Bil. 

Office 

Retail 

Hotel 

Apartment 

Mixed Use 

Unknown 

Industrial 

Other 

Healthcare 

Self Storage 

Property Type 

Sources: Trepp LLC, Nomura 

We expect some change in the mix of loans. A flatter yield curve will likely curtail some demand for 

5-year balloon loans as well as floating rate product. Maturing healthcare loans likely will be 

challenged to find lenders, but a recovery in the hotel sector should facilitate CMBS lending in the 

lodging sector. 

(26)


CMBS Market Breakdown by Loan Maturities 

Issue Year 

1998 1999 2000 2001 2002 2003 

1-7 yrs 6% 11% 8% 11% 12% 26% 

>8 94% 89% 92% 89% 88% 74% 

2 – 10 spread 13.9 21.9 -22.5 119.0 198.3 236.8 

Note: 2-10 spread refers to the average daily closing yield spread between the 2-yr and 10-yr 

Treasury over the year. 

Source: Bloomberg, Intex, Nomura 

2. Credit 

We expect a continued increase in CMBS delinquencies, despite general economic improvement. 

We expect "core" delinquencies (at least 60 days delinquent+REO) for seasoned conduit and fusion 

deals to reach 2.6% to 2.7% from the about 2.0% currently. 

Moreover, we expect a modest increase in balloon defaults. This continuing deterioration in credit 

performance will occur even though it is likely that vacancies have peaked and rents have bottomed 

in many markets. 

Defaults occur when two conditions exist: (1) when a borrower cannot pay debt service and (2) the 

property value is worth less than the value of the debt on it. Generally speaking, borrowers do not 

default as long as they can pay their debt service. A volatile income stream on a property, however, 

increases the probability of insufficient income to service the debt. 

Hotels and healthcare properties, which have no leases and are operating businesses, tend to have 

volatile income streams, making delinquencies in these sectors proportionately higher than for 

offices, retail, and industrial properties. When economic recovery is at hand, however, lenders favor 

properties with no leases or short leases where rents can quickly be adjusted upwards, such as 

hotels, multi-family properties, and warehouse properties, where growth can prompt increased 

demands for space. Healthcare properties remain challenged. 

In contrast, with slow projected growth in office sector jobs, office properties could languish 

throughout 2004, and we expect an especially difficult first half. Our fear is that rising interest rates 

will nudge up cap rates without a commensurate increase in rents. Moreover, as leases rollover in 

the current weak market environment, covering debt service will become harder. In addition, as 

borrowers try to refinance their balloon mortgages, those with high vacancy rates will have difficulty. 

The oversupplied multi-family market should improve with rising interest rates as at-the-margin 

prospective homebuyers are forced to rent. Hotels will continue to recover and an increasing number 

of loans should find their way into CMBS, but their risky nature will always limit the amount of hotel 

exposure in any deal. Retail should be influenced by consumer spending, and while the consumer 

benefited from residential mortgage refinancing and the tax cut in 2003, those gains are played out. 

Performance in 2004 will depend upon whether the economic recovery puts people back to work or 

not. Anchored grocery properties will continue to perform, but mall properties need a consumer with 

discretionary cash. 

When talking about credit we need to consider defaults and severity as well. According to the 

October 14, 2003 Fitch study, CMBS Loan Losses: Property Type Highlights and Trends, loss 

severity for retail loans reached 46.6% (includes loans in fixed-rate conduit, large loan, and fusion 

deals rated by Fitch from 1993-2002) and is a function of how much the value of a property has fallen 

and the speed of resolution. Healthcare properties, according to Fitch, took an average of 33.6 

months for disposition. 

(27)


With real estate fundamentals still very weak, and with the increasing propensity to litigate, we think 

severity can increase in 2004. For loans where there are A/B notes or participated loan structures, 

the severities can be even worse than for traditional loan structures. 2 The multiple parties involved in 

these loan structures can delay the resolution and increase expenses to a securitization trust. These 

structures, where the loan itself is tranched into participated A-notes and a B-note, can also lead to 

unexpected interest short falls. 

While we expect credit to continue to deteriorate into 2004, the levels are very modest by historical 

standards and will still not be large enough to hurt investment grade CMBS credit performance 

(although investors will probably contrast the trend with improving performance in the corporate 

sector). On the other hand, below-investment-grade classes from moderately seasoned deals will 

likely feel the impact of the poor real estate fundamentals in 2004. 

Looking at performance by vintage, new deals are insulated in the near term, but their higher 

leverage and lower subordination leaves an investor with a smaller margin for error. Subordination 

levels for triple-A-rated CMBS tranches are around 20% today, compared to roughly 30% five years 

ago. The November 13, 2003 Moody's report, CMBS Loan Delinquency Rate Ramps Up Sharply As 

Leverage Increases, substantiates this concern. For example, the authors found that delinquency 

rates double for loans with LTVs of 80% to 90% versus loans with LTVs of 75% to 80%, and then 

more than double again for loans with LTVs greater than 90%. Deals from the 1998 vintage will 

continue to perform well compared to the 2000 vintage despite somewhat higher securitization LTVs, 

due to the built up equity from property appreciation. 

Floating rate loans could have some problems, particularly those that need to be re-financed in 2004. 

Many of these were originally 3-year loans on properties that were to be repositioned, but the weak 

real estate markets may make them difficult to re-finance. 

3. Spreads 

Senior investment grade CMBS are not cheap on a historical basis. They are fairly valued 

versus corporate bonds and fair to slightly cheap to residential mortgage products. CMBS 

have tightened less during 2003 than other sectors, because investors recognize that the real estate 

recovery will lag the economic recovery. The real estate recovery will vary by property type and 

location, and on average, could take until the end of 2004 or well into 2005 for commercial real estate 

to begin to benefit from an improving economy. If delinquencies rise only modestly, as anticipated, 

spreads on CMBS relative to other sectors should hold in. On the other hand, if delinquencies were 

to unexpectedly rise sharply, spreads would widen across the board. In our view, CMBS spreads will 

not tighten further versus Treasuries unless corporate bond spreads and RMBS spreads continue to 

tighten. By the end of the year, as the recovery takes hold, we expect senior investment grade 

CMBS spreads to main their levels versus corporates and tighten somewhat versus RMBS. 

For CMBS rated at or below triple-B-minus, the spread story is a bit more complicated. Real estate 

fundamentals are weak, yet the market is anticipating a recovery. In our view this will lead a 

significant bifurcation in spreads between the new issue market and the secondary market for these 

credits. On the one hand, as delinquencies and defaults creep up, spreads on lower rated classes of 

outstanding deals, will widen. Tranches will be traded on a very deal specific basis. On the other 

hand, in the new issue market, investors will bet that loans that are made in the current weak 

environment are underwritten with the current property level statistics, and therefore, will bid strongly 

for the lower rated classes, leading to a continuing flattening of the new issue CMBS credit curve. 

While scenario analysis shows how well CMBS interest-only tranches (IOs) holdup under stress 

scenarios, we think their spreads have tightened too far too fast and are vulnerable at current levels. 

2 For a description of these structures see Chambers, D. and Lynn, Z., Participated CMBS Loans: Too Many 

Cooks in the Kitchen?, Fitch special report (18 Nov 2003). 

(28)


Whole loan spreads are relatively wide to triple-B-rated CMBS. We expect them to tighten in the first 

half of 2004. 


We expect a healthy supply of new issues, but sufficient demand to keep spreads stable in the most 

senior classes. With premium CMBS trading at almost even spread to par-priced bonds, we think 

investors are simply not getting paid to take what admittedly looks like a small risk at this point. For 

some seasoned deals, the risk may not be that small as delinquencies increase, and defaults lead to 

prepayments without penalties and a shortening in duration via recoveries. 

In the near term, we expect IOs to widen on technical factors. In our view, IO investors should 

differentiate more on deals that have a high concentration of loans with A/B notes, mezzanine debt 

and preferred equity. All of these increase the probability of default even though the deals statistics 

show modest leverage. 

Within the investment grade sector, the triple-B sector at 90 bp versus swaps is most vulnerable to 

widening, particularly early in the year when insurance companies may prefer filling their whole loan 

quota rather than buying into the triple-B CMBS sector. 

In the new issues market, we think the triple-B-minus and below credits could tighten, as investors 

begin to sense that real estate markets have bottomed and that underwriting is reflective of this 

environment. 

With a more difficult credit year ahead, investors in the secondary CMBS market need to be very 

discriminating about the structure, collateral mix, vintage and performance history of deals in the 

secondary markets. As deals pay down, and time passes, the initial characteristics can change 

significantly. While in most cases subordination improves, the collateral mix can deteriorate. 3 

One novel idea might be to consider deals with credit tenant structures. During the economic 

downturn, these deals were shunned for perceived corporate credit risk. As the economy improves, 

these could look stronger. 

5. Trends in 2004 

The b-buyer market continues to expand, with as many as eight potential bidders requesting 

information sometimes. Liquidity too is improving. Given this strong demand, modest tightening in 

the below-investment-grade classes is possible, despite a weak real estate market. 

Other developments we see are: 1) subordinate buyers bidding as a team or in partnership; 2) more 

frequent securitization of mezzanine debt as mezzanine money appears amply available and new 

funds are appearing regularly; 3) loans in the $60-$80 million range having more pooled capital 

structure in place of A/B structures as investors tolerate higher leverage and bigger loans in fusion 

deals and; 4) more hotel deals in terms of total volume (not percentage) that are readily absorbed in 

what will be a strong issuance year for CMBS. 

We think that rating agency leverage has gone about as far as it can, particularly as interest rates 

begin to move up in 2004. Moreover, subordination for conduit loans in the mid-range size will not 

tighten much more in 2004 only because the levels have moved too quickly. 

With single asset deals and large loan deals still disfavored by investors, we expect to see an 

increasing number of fusion deals. In addition, the average loan size of the top 10 deals will likely 

continue to increase. 

3 Phillips, J. and Hoyt, E., Aging Deals: Changes in CMBS Diversity and Loan Concentration Over Time and Other 

age Related Issues, Nomura fixed income research (8 October 2002) 

(29)


Vintage 

Top Ten Percentages & Average Loan Sizes by Deal Type and Vintage 

Deal Type 

Amount 

Issued 

($bn) 

# of Deals 

Average 

Top Ten 

(%) 

Average 

Deal Size 

($mm) 

Average 

Loan Size 

of Top Ten 

($mm) 

Conduit 27.75 31 32.65 895.2 29.2 

2000 Single Borrower 4.25 14 100 303.8 30.4 

Large Loan 0.39 1 100 393.2 39.3 

Conduit 35.88 35 33.88 1025.1 34.7 


Large Loan 1.94 3 100 646.3 64.6 

Conduit 35.15 35 37.91 1004.3 38.1 


Large Loan 5.13 6 98.17 855.5 84.0 

Conduit 53.40 47 44.24 1136.1 50.3 

2003 Single Borrower 8.58 28 98.96 306.5 30.3 

Large Loan 11.79 13 90.20 906.8 81.8 

Source: Trepp LLC 

Other trends we anticipate will be: 1) a preoccupation with interest short falls and the role of the 

special servicer, especially as delinquencies rise; 2) the increasing diversion of multi-family loans to 

conduits and away from the agencies which tightened their requirements and leverage; and 3) 

(despite lacking appeal to b-buyers) the increased availability of tenant-in-common (TIC) structures 

where borrowers buy properties as tenants in common and each TIC is a separate special purpose 

entity (SPE) much like a syndicated loan. 

Finally, while the terrorism insurance issue is off the table for now, the availability and utility of 

environmental insurance has decreased due to policy changes by insurance providers. In particular, 

environmental insurance had been available to cover existing conditions, so where no party had been 

identified to clean up a condition a lender or buyer could instead buy environmental insurance for a 

tainted property (in addition to the individual's liability on the carve-outs). The insurers offering such 

coverage have since limited what they will cover, so instead of having coverage for the loan amount 

as was previously offered, one may now be limited to the costs necessary to meet local 

environmental law. This may still leave one with a tainted property that can not be sold for the loan 

amount, so the coverage does not eliminate the problem the way the old coverage did. 

B. Review of 2003 

1. Issuance 

CMBS issuance was approximately $71 billion in early December, and total 2003 issuance is likely to 

be approximately $75 billion. Whether considering the CMBS market by itself, or looking at the whole 

loan market, 2003 was a very strong issuance year. 

Unlike issuance volumes in the residential mortgage market, which were driven by low interest rates 

and record re-financing activity, the volume of commercial mortgage debt issuance has added to the 

dollar volume outstanding. 

According to the 25 th anniversary edition of Emerging Trends in Real Estate, by ULI and 

PricewaterhouseCoopers, institutional real estate debt now exceeds $2 trillion for the first time. 

All major lending sources increased their lending, but banks far and away lead the pack. Banks now 

comprise about 42.6% of the institutional real estate debt compared to non-government CMBS with 

16.1% and life insurance companies with 11.5%. 4 

4 Basel II may could cause bank's to lower their allocation to real estate loans as it will likely require banks to hold 

more capital against real estate loans. 

(30)


Lending activity was brisk and property acquisitions drove a significant portion of the volume. Low 

interest rates helped to lower cap rates, which in turn motivated sellers. Buyers locked-in low interest 

rates to support their cap rates, and lenders, both traditional and the CMBS market, accommodated 

borrowers with more aggressive leverage. 

Domestic CMBS Issuance 1998-2003 

80 

70 

Q1 Q2 Q3 Q4 

60 

Amount ($bn) 

50 

40 

30 

20 

10 

0 

1998 1999 2000 2001 2002 2003 

Sources: Commercial Mortgage Alert, Nomura 

The conduit and fusion deal type continued to grow as the format of choice for CMBS issuance. 

Together, these accounted for 67% of deals in 2003 (year to date) compared to 60% in 2002. We 

expect this format to continue to dominate CMBS issuance. With the increasing percentage of larger 

loans in these deals, rather than simply using constant default rates (CDRs) as stress scenarios, we 

believe investors need to run a combination of CDRs on the set of loans with small balances and net 

operating income (NOI) stresses on the larger size loans since straight CDR analysis will not 

adequately capture the loans' lumpiness. This is particularly true in looking at CMBS IOs since much 

of their performance is driven by defaults. Although big loans may use an A/B note structure to lower 

leverage, it does not reduce the probability of default, but the loss severity. 

In 2003, retail loans increased their share of CMBS deals to over 33% of the new issue market, up 

from 30% in 2002, whereas office loans continued to decline, running currently at less than 25% of 

new issues. Insurance company lending trends were similar, with an increasing allocation to retail, 

and a decreasing allocation to offices. For example, in the third quarter of 2003, insurance 

companies allocated 29.4% of commitments to the retail sector and 28.8% to the office sector, 

whereas a year ago they allocated 19.3% to retail and 23.7% to offices. 

2. Credit 

CMBS delinquencies rose steadily in 2003. The "core" (60+90+foreclosure and REO) delinquency 

rate for CMBS conduit/fusion deals reached 2.04% as of November 2003. 

(31)


Delinquencies in CMBS Conduit/Fusion Deals 

Delinquency (%) 

2.0% 

1.8% 

1.6% 

1.4% 

1.2% 

1.0% 

0.8% 

0.6% 

0.4% 

0.2% 

0.0% 

ACLI 

Core 

Jun-00 

Dec-00 

Jun-01 

Dec-01 

Jun-02 

Dec-02 

Jun-03 

Note: Core = 60 + 90 + Foreclosure + REO 

Sources: ACLI, Trepp LLC, Nomura 

According to RealPoint Research, "the total unpaid principal balance for specially-serviced CMBS" 

that are delinquent is running at about $4.73 billion as of September 2003, up from $3.69 billion in 

October 2002. 

Hotel and retail loans account for the largest percentage of delinquent loans with hotels comprising 

24.83% of delinquencies and retail 23.16%. As in prior periods, hotel delinquencies greatly exceed 

their representation within the CMBS universe, whereas retail delinquencies remain underrepresented. 

Healthcare, which will continue to diminish as a sector in CMBS, also remains overrepresented. 

Office delinquencies are fewer than those of retail, but increased the most over the past year and we 

expect continued increases in 2004. In the October 14, 2003 report by Fitch, CMBS Loan Losses: 

Property Type Highlights and Trends, the rating agency also concludes that the office and industrial 

sectors will continue to demonstrate increased defaults and losses over the next 18 to 24 months. 

(32)


CMBS Delinquencies by Property Type 

35% 

30% 

25% 

% of Market 

% of Delinquencies 

Percentage 

20% 

15% 

10% 

5% 

0% 

Retail 

Office 

Multi-Family 

Lodging 

Industrial 

Other 

Mixed Use 

Mobile Home 

Healthcare 

Self Storage 

Sources: Trepp, Nomura 

2.0 

CMBS Conduit/Fusion Delinquencies 

12.5 

1.8 

1.5 

10.0 

Total Delinquency (%) 

1.3 

1.0 

0.8 

7.5 

5.0 

0.5 

0.3 

2.5 

0.0 

Jan-00 Jan-01 Jan-02 Jan-03 

0.0 

Office Multi-Family Industrial 

Retail Healthcare (right scale) Lodging (right scale 

Sources: Trepp, Nomura 

(33)


In terms of geography, Texas and Florida show the highest levels of delinquency, together 

comprising close to 19% of delinquent loans, while California, which comprises about 8.5% of 

delinquencies, is under-represented given its roughly 20% portion of outstanding CMBS loans. 

Special servicer portfolios (not surprisingly) continue to have a relatively large proportion of hotel 

loans. There is significant concentration of specially serviced loans with the top six servicers having 

an 87.2% market share. Over the past year, special servicers' tactics and their aggressiveness in 

resolving a loan have been scrutinized. One key issue is whether the special servicer should adopt a 

higher risk profile in litigation to try and get more, but potentially lose more. The question becomes 

even more complicated when the special servicer is the owner of one of the junior classes in the deal. 

The worst vintage by the measure of its delinquency rate continues to be deals done in 1995, coming 

in at above 8%. This is followed by the 1997 vintage with delinquencies running above 4%. By dollar 

amount, 1998 has the largest percentage of total delinquencies, but to date, it was the largest 

issuance year. Most studies continue to show that defaults for a pool peak around the fourth year 

after origination and then decline. Thus, we would expect to see the delinquency rate from the older 

vintages to begin to decline in 2004. In contrast, we believe that some of the more recent vintages, 

such as 2000, will have below-average performance as they were underwritten when rents and rent 

growth were at their peak. 

CMBS Delinquencies by Origination Year 

9% 

8% 

7% 

Total Delinquency (%) 

6% 

5% 

4% 

3% 

2% 

1% 

0% 

1994 

1995 

1996 

1997 

1998 

1999 

2000 

2001 

2002 

2003 

Sources: Trepp LLC, Nomura 

At the writing of our mid-year report (which included ratings actions taken through May 30, 2003), the 

total upgrade-to-downgrade ratio across all investment grade and non-investment grade classes was 

about 0.96. Since then, upgrades have significantly outpaced downgrades, and year-to-date, the 

total upgrade-to-downgrade ratio is approximately 1.7 to 1 (672:388). As is usually the case, classes 

initially rated investment grade accounted for the lion's share of the upgrades (575 out of 672), while 

subordinate classes took a majority of the downgrades (229 out of 388). 

(34)


An interesting ratings trend that we are starting to see more of is the simultaneous upgrade and 

downgrade of different classes from the same deal. This was highlighted by a recent Fitch report, 5 

where such a ratings action is referred to as a "barbell" effect. The authors write, "As loans amortize 

or pay off, investment-grade classes experience increased credit support, becoming even more 

protected from losses. The payoffs, however, frequently have the opposite effect on lower-rated 

tranches as riskier loans begin to make up a larger proportion of the remaining collateral." We expect 

this type of ratings action to become more common as loans from older deal vintages begin losing 

their prepayment protection and refinance into the current, borrower friendly, low-rate environment. 

Leverage has continued to increase by all measures. Moody's stressed LTV for the conduit portion of 

rated deals has reached over 90%. According to the most recent (NCREIF) report, institutional 

owners of real estate have been increasing their leverage, as have the REITs (currently over 50%). 

In addition, the percentage of levered properties in the NCREIF universe has doubled in the past four 

years. 

At the same time, subordination levels have been trending down. Much of the recent drop in 

subordination is due to the lower leverage from the A/B structure of the large size loans in the fusion 

deals. Still, the protection is less than it used to be both at the triple-A level and the triple-B level, and 

it is quite clear from the performance numbers that the original subordination levels were probably too 

conservative. 

Moody's Stressed LTV for Conduit Portion of Rated Deals 

92 

91 

90 

Stressed LTV (%) 

89 

88 

87 

86 

85 

84 

1Q99 

2Q99 

3Q99 

4Q99 

1Q00 

2Q00 

3Q00 

4Q00 

1Q01 

2Q01 

3Q01 

4Q01 

1Q02 

2Q02 

3Q02 

4Q02 

1Q03 

2Q03 

3Q03 

Source: Moody's 

5 See MacNeill, M., O'Rourke, M., and Johnson, B., 2003 CMBS Upgrades and Downgrades, Fitch special report 

(10 Dec 2003). 

(35)


Trends in Conduit and Fusion Subordination Levels 

31 

13 

29 

12 

27 

11 

Aaa Subordination (%) 

25 

23 

21 

19 

10 

9 

8 

7 

Baa3 Subordination (%) 

17 

Aaa Sub % (left scale) 

Baa3 Sub % (right scale) 

15 

Q1 98 

Q3 98 

Q1 99 

Q3 99 

Q1 00 

Q3 00 

Q1 01 

Q3 01 

Q1 02 

Q3 02 

Q1 03 

Q3 03 

6 

5 

Sources: Moody's, Commercial Mortgage Alert, Nomura 

3. Spreads 

Spreads on CMBS versus Treasuries and swaps have tightened over the past year and are close to 

the tights for the year. The biggest move was in the triple-B and IO classes which have tightened by 

60 bp and 80/140 (PAC, Companion) bp, respectively. In the most senior classes, we are currently at 

the tightest levels since 1998. The move in the IO spread, both PAC IOs and companion IOs, over 

the past several months has been extraordinary. What is somewhat surprising is that given the 

increasing number of b-buyers, the spread for BB and B rated bonds has hardly moved, perhaps 

reflecting the views of these real estate experts that there are still some rough waters ahead in the 

commercial real estate markets. 

In addition to the overall tightening, the credit curve has continued to flatten. The spread between 

triple-B and triple-A CMBS narrowed from 95 bp to 57 bp. In contrast, the spread between triple-B 

CMBS and whole loan commercial mortgages widened by approximately 25 bp. Given this relatively 

wide spread, we expect that at least at the beginning of 2004, those insurance companies that still 

have whole loan departments might be more inclined to originate whole loans, and leave the triple-B 

CMBS for the CDO market. 

(36)


CMBS Spreads as of 5 Dec 2003 

3mo 6mo 1yr 

Z 

Stdev 

Tight 

Wide 

Mean 

Z 

Stdev 

Tight 

Wide 

Mean 

Z 

Stdev 

Tight 

Wide 

Mean 

Last 

5-yr AAA/ Swaps 32 33 37 31 2 (0.5) 33 37 30 2 (0.5) 37 46 30 5 (1.0) 

10-yr AAA/Swaps 33 34 38 31 3 (0.3) 34 38 31 2 (0.7) 39 50 31 5 (1.0) 

AA / Swaps 42 43 47 40 3 (0.4) 43 47 40 2 (0.5) 48 64 40 7 (0.9) 

A / Swaps 51 53 57 50 3 (0.5) 51 57 48 3 (0.1) 58 84 48 10 (0.7) 

BBB / Swaps 90 99 110 90 7 (1.4) 99 110 90 6 (1.4) 114 145 90 18 (1.4) 

BBB- / Swaps 145 151 165 145 6 (1.0) 154 165 145 7 (1.3) 164 185 145 13 (1.5) 

5-yr AAA/ Treas 73 75 83 70 3 (0.5) 74 91 66 6 (0.2) 78 93 64 9 (0.6) 

10-yr AAA/Treas 72 76 87 72 4 (0.9) 77 94 68 7 (0.7) 81 96 68 9 (1.0) 

AA / Treas 81 85 97 81 5 (1.0) 85 101 77 7 (0.6) 90 110 77 10 (0.9) 

A / Treas 90 95 107 90 5 (1.0) 94 108 83 8 (0.5) 100 130 83 12 (0.8) 

BBB / Treas 129 141 160 129 9 (1.3) 141 161 129 10 (1.2) 156 191 129 19 (1.4) 

BBB- / Treas 184 193 215 184 8 (1.1) 196 219 184 11 (1.1) 206 231 184 14 (1.6) 

BB/Treas 475 475 475 475 0 NA 475 475 475 0 NA 484 500 475 11 (0.9) 

B/Treas 975 975 975 975 0 NA 975 975 975 0 NA 975 975 975 0 NA 

Collateral Strip IO 275 293 300 275 12 (1.5) 296 300 275 9 (2.4) 310 325 275 16 (2.2) 

PAC IO/Treas 65 69 80 55 6 (0.7) 79 100 55 12 (1.2) 100 145 55 25 (1.4) 

Companion IO/Treas 350 379 425 350 27 (1.0) 400 425 350 30 (1.7) 434 490 350 42 (2.0) 

CMBS Whole Loan/Treas 152 158 168 152 5 (1.2) 157 170 148 6 (0.8) 166 189 148 12 (1.1) 

CMBS Whole Loan vs. 

BBB 

23 17 25 8 6 1.2 16 25 1 6 1.2 10 25 (6) 9 1.6 


200 

CMBS Spreads to Swaps (Dec 2003 vs Dec 2002) 

180 

160 

3-Dec-02 

3-Dec-03 

145 

145 

Spread (bp) 

120 

80 

46 

50 

64 

84 

90 

40 

32 

33 

42 

51 

0 

5-yr "AAA" 10-yr "AAA" AA A BBB BBB- 

Sources: Nomura 

While CMBS has tightened substantially, it underperformed corporate bonds, which in the A-rated 

industrial sector tightened by roughly 60 bp. RMBS also outperformed CMBS for the year, with 10- 

year PACs tightening by 20 bp and 10-year sequentials tightening by 33 bp, although their total return 

was adversely impacted a bit by their negative convexity. 

(37)


C. Real Estate Markets 

a) Overview 

Cap rates in most markets dropped throughout 2003, but by a lesser amount than Treasury rates. 

While total returns for real estate were solid in 2003, this was largely a function of the income 

component, rather than price appreciation. Investors who had hoped that economic recovery would 

quickly turn around the demand for space were disappointed by the outcome. The reality is that the 

property market fundamentals are weak, and their recovery will lag economic recovery by a good 18 

months in many sectors. 

Vacancies have probably peaked, and rents are bottoming. In fact, the decent performance in the 

face of such weak fundamentals could be attributed to the lower interest rates, which supported 

returns by bringing cap rates down. The problem for the property markets is that as interest rates 

rise, cap rates will be pushed up without a commensurate rise in NOI. 

Historical Cap Rates for Various Property Types 

12.0 

8.0 

11.5 

7.5 

Cap Rate (%) 

11.0 

10.5 

10.0 

9.5 

9.0 

8.5 

7.0 

6.5 

6.0 

5.5 

5.0 

4.5 

8.0 

7.5 

1Q 1995 

1Q 1996 

1Q 1997 

1Q 1998 

1Q 1999 

1Q 2000 

1Q 2001 

1Q 2002 

1Q 2003 

10-yr Treasury Yield (%) 

4.0 

3.5 

Office Retail Industrial Apartment Hotel 10-yr Treas 

Sources: RERC Real Estate Report, Nomura 

Beyond the near term, the kind of economic recovery we have will significantly impact the recovery in 

the property markets. Demand for office space is driven by employment. If service sector and even 

high-tech jobs continue to be outsourced overseas, the recovery in the office property market and 

industrial R&D market will be anemic. The key to continued performance in retail is obviously the 

consumer, and whether the consumer performs now that the tax cut and cash-out 

mortgage/refinancing wave is over. 

NCREIF Total Returns 

Total Income Appreciation 

3Q 2003 1.97 1.90 0.07 

2Q 2003 2.09 1.98 0.11 

1Q 2003 1.88 1.96 (0.08) 

4Q 2002 1.67 1.96 (0.29) 

1-yr 7.84 8.03 (0.18) 

3-yr 7.87 8.43 (0.53) 

5-yr 9.47 8.44 0.97 

10-yr 9.73 8.68 0.98 

Source: NCREIF 

(38)


b) Sector Review & Outlook 

Historical & Projected Vacancies by Property Type 

18 

16 

14 

12 

Vacancy (%) 

10 

8 

6 

4 

2 

0 

1997 

1998 

1999 

2000 

2001 

2002 

2003E 

2004P 

2005P 

2006P 

2007P 

Retail Industrial Office Apartment 

Source: REIS 

Historical & Projected Effective Rent Growth by Property Type 

15 

Effective Rent Growth (%) 

10 

5 

0 

-5 

-10 

1997 

1998 

1999 

2000 

2001 

2002 


2004P 

2005P 

2006P 

2007P 

Retail Industrial Office Apartment 

Source: REIS 

(1) Multi-family 

Apartment properties performed reasonably well for the 12-month period ending with the third 

quarter. Apartment and retail properties were the two sectors showing property price appreciation in 

the NCREIF index. For the one-year period, apartments showed a 2.33% appreciation return that, 

combined with a 6.44% income return, had a total return of 8.87%. 

(39)


Competition from single-family homes has been a factor pressuring apartments over the past several 

years as buyers, who had been on the edge, were able to qualify for mortgages with the historically 

low interest rates. In particular, some of the apartments catering to the middle- and middle-upper 

class were negatively impacted. Lower-income apartments have not been hit as much. The effects 

have shown up and are reflected in a rising vacancy rate and negative to low-positive effective rent 

growth. 

We agree with the common view that a rising interest rate environment will alleviate some of the 

pressure. However, because of the current over-supply in some markets and the fact that there has 

been a run-up in prices, this market will struggle through 2004. 

(2) Office 

The office market by every measure is in pain. For the past three quarters, there has been negative 

absorption, rising vacancy, and declining effective rent in over 60% of the top 50 markets, according 

to REIS. In fact, the office market has been suffering for several years. 

REIS Suffering Meter: Number of Top 50 Office Markets 

Experiencing: 

Negative 

Declining 

Rising Vacancy 

Absorption 

Effective Rent 

Q1 2003 31 35 42 



Source: REIS 

Of all the major property types, offices had the poorest performance, showing a 4.19% total return for 

the past four quarters, and 1.25% in the most recent quarter, as measured by NCREIF. Offices lost 

3.95% in price last year, they report, with an average price change of –2.82% per year for the past 

three years. Regional conditions were even worse. Western region offices lost 4.15% per year over 

the past three years. These drops are why balloon risk, especially for 5-year balloon mortgages 

originated in 1999, is significant! 

Moreover, NOI will certainly suffer as leases begin to rollover in the next several years as some rental 

rates have fallen to mid 1990's levels or lower. REIS projects negative effective rent growth for 2004. 

Historical Cap Rates for the Office Sector 

12.0 

8.0 

11.5 

7.5 

Cap Rate (%) 

11.0 

10.5 

10.0 

9.5 

9.0 

8.5 

7.0 

6.5 

6.0 

5.5 

5.0 

4.5 

8.0 

7.5 

1Q 1995 

1Q 1996 

1Q 1997 

1Q 1998 

1Q 1999 

1Q 2000 

1Q 2001 

1Q 2002 



4.0 

3.5 

CBD Suburban 10-yr Treasury Yield 

Source: RERC Real Estate Report, Nomura 

(40)


While office cap rates declined a bit in 2003, suburban offices are at the same levels as mid 1999 

even though Treasuries have dropped by over 200 bp. Vacancy rates are comparable to those of 

1993. Unless the economy becomes super-charged, it will take a while to absorb the space. The 

only good thing that we can say about the office market is that 2004 will probably not be worse than 

2003. 

(3) Retail 

It is a relief to move the discussion from offices to retail. Retail has been the shining star, supported 

by an insatiable American consumer who could spend during the economic slowdown because of tax 

cuts and cash-out refis. Vacancies remain well below the peaks set in the early 1990's real estate 

recession. REIS projects increasingly positive effective rent growth for the next several years. While 

all retail sectors have participated, retail power centers seem to have done the best. On a total return 

basis, retail posted a 3.04% return in the third quarter of 2003 and one-year return of 15.28%, 

according to NCREIF! According to REIS in the last quarter, less than 25% of the top 48 markets 

experienced declining effective rents. Long term, Internet shopping remains a threat and concerned 

investors should focus on grocery-anchored retail. 

Historical Cap Rates for the Retail Sector 

12.0 

8.0 

11.5 

7.5 

Cap Rate (%) 

11.0 

10.5 

10.0 

9.5 

9.0 

8.5 

7.0 

6.5 

6.0 

5.5 

5.0 

4.5 

10yr Treasury Yield (%) 

8.0 

4.0 

7.5 

3.5 

1Q 1995 

1Q 1996 

1Q 1997 

1Q 1998 

1Q 1999 

1Q 2000 

1Q 2001 

1Q 2002 


Retail - Regional Malls 

Retail - Neigh/Comm 

Retail - Power Centers 

10-yr Treasury Yield 


(4) Industrial 

Industrial properties, usually considered a very stable property type, have had a bad three years. 

According to Torto Wheaton Research (TWR), vacancies in the industrial market have shot up from 

6.3% in 2000, to 11.7% in the third quarter of 2003. Over this same time period real rents declined at 

an accelerating rate. These statistics indicate that this downturn is much worse than the 1991 

decline. 

To understand this terrible performance on the one hand, and the decline in cap rates to below 9% on 

the other hand, one must first recognize the significant difference in performance between research & 

development (R&D) space and warehouse/distribution space. Using NCREIF return data, warehouse 

properties showed a 0.31% annual price change over the last three years. R&D on the other hand 

showed an annual decline of –3.35% for the last three years. This dichotomy is evident by the gap in 

cap rates between the two property sub-types. 

(41)


Historical Cap Rates for the Industrial Sector 

Cap Rate (%) 

12.0 

11.5 

11.0 

10.5 

10.0 

9.5 

9.0 

8.5 

8.0 

7.5 

8.0 

7.5 

7.0 

6.5 

6.0 

5.5 

5.0 

4.5 

4.0 

3.5 

1995 Q1 

1996 Q1 


1997 Q1 

1998 Q1 

1999 Q1 

2000 Q1 

2001 Q1 

2002 Q1 

2003 Q1 

Warehouse R&D 10-yr Treasury Yield 


NCREIF Appreciation Returns for the Industrial Sector: 

Warehouse versus R&D 

Warehouse R&D Industrial (Total) 

3Q 2003 0.33 (0.60) 0.20 

2Q 2003 (0.46) (3.33) (0.76) 

1-yr (0.06) (7.57) (0.88) 

3-yr 0.31 (3.35) (0.12) 

5-yr 1.21 (0.01) 1.15 

10-yr 1.56 2.22 1.72 

Source: NCREIF 

The R&D sector was decimated by the bursting of the tech bubble and will likely remain mired for a 

long time to come. To see how bad the market is consider the examples cited in the Korpacz Real 

Estate Investor Survey, 4 th quarter 2003. They note that vacancy rates for flex/R&D in Dallas/Fort 

Worth, Denver, and Portland reached 12.2%, 17.3%, and 29.4%, respectively, in the third quarter of 

2003. 6 On the other hand, the warehouse/distribution centers, in our view, should begin to feel the 

effects of the recovering economy in the coming year. According to REIS, 2004 should bring a 

modest increase in effective rents, and bring some relief to vacancies. 

Another cut at the data reveals an additional performance aberration. The performance by region 

varied greatly. The western region and the eastern region showed a 1.02% and .76% average 

annual price appreciation, respectively, for the last three years, whereas the midwest and southern 

regions showed -0.99% and –2.52% returns, respectively. The coasts tend to benefit from the 

storage of goods coming from overseas. The improving economy should eventually increase 

consumer demand for goods. 

Some analysts cite the fact that the weaker dollar will lead to a drop in imports, which in turn, will hurt 

demand for warehouse/distribution space. While this true to some extent, it should be offset by two 

important factors. First a growing amount of our imports are from China, which thus far (since 1994) 

6 The Korpacz Report used data from CoStar Realty Information 

(42)


has pegged its currency to the U.S. dollar. Secondly, warehouse facilities are used to some extent 

for exports as well, which would benefit from the weaker dollar. 

(5) Hotel 

The hotel market has a long way to go to recover. In 2003, the gap between cap rates and Treasury 

rates reached the widest level in our data series. 

Historical Cap Rates for the Hotel Sector 

12.0 

8.0 

11.5 

7.5 

Cap Rate (%) 

11.0 

10.5 

10.0 

9.5 

9.0 

8.5 

7.0 

6.5 

6.0 

5.5 

5.0 

4.5 


8.0 

4.0 

7.5 

3.5 

1995 Q1 

1996 Q1 

1997 Q1 

1998 Q1 

1999 Q1 

2000 Q1 

2001 Q1 

2002 Q1 

2003 Q1 

Hotel 

10yr Treasury Yield 


We believe that the hotel sector will benefit greatly from the economic recovery in 2004. 

Pricewaterhouse Coopers, in their September 2003 Hospitality Directions Forecast Alert predicts a 

4.9% increase in RevPAR (revenue per available room) in 2004. This is the largest percentage 

increase in RevPAR since 1997. While the increases will be larger in the upscale segment, they are 

not sufficient to overcome the severe declines of the past several years. On the other hand, 

according to Pricewaterhouse, the midscale segment will experience gains in RevPAR which will 

more than offset the 2% decline suffered in the 2000-2003 time period. As is usual at this point in the 

cycle, RevPAR is being driven by increases in occupancy rather increases in Average Daily Room 

(ADR) rates. 

Occupancy rates most likely bottomed in the second quarter at about 58.1% and are very slowly 

creeping back up. PwC forecast occupancy by the end of 2003 to rise to 60.1% and by the end of 

2004 to hit 60.8%. The main reason for this very slow trend is that supply growth did not slow down 

as much as it should have during this recession. According to Smith Travel Research, room supply 

increased by 2.3% in 2001, 1.7% in 2002 and by 1.3% as of October 2003. 

The quite dramatic drop in the value of the dollar versus European and Japanese currencies should 

benefit the travel hotel sector. In addition, travel associations are expecting an increase in domestic 

leisure travel. The Travel Industry of America is forecasting a 4.4% increase in domestic and 

international visitor spending in 2004 and a 4.6% increase in 2005. 

Business travel is a bigger factor than leisure travel when it comes to hotel profitability and demand. 

Unfortunately, business travel has remained weak. Despite the slow recovery expected in the 

important business segment, the credit trend is improving. As noted in a recent report on the lodging 

(43)


sector by CreditSights 7 "debt coverage measures have stabilized for the major lodging companies." 

As a result, CreditSights raised their outlook for the sector from underweight to marketweight. 

With regard to hotel financing we believe there will be two distinct trends that will have implications for 

lender performance. First, the bad news: there are still many weak hotels with loans that were made 

in 1995 that will be looking for financing in 2004 and 2005. Some of these will end up in special 

servicing. The holders of the most junior classes from CMBS deals with these loans will continue to 

suffer from the loans. 

On the other hand, given the slowly improving fundamentals and the very risk averse stance of 

CMBS b-buyers, new hotel loans in 2004 CMBS deals should perform very well. 

7 CreditSights, U.S. Morning Comment (17 Dec 2003) 

(44)


VI. 

Asset-Backed Securities 

A. Outlook for the 2004 

1. Issuance 

Mark Adelson (212) 667-2337 

Beth Hoyt (212) 667-2339 

We expect ABS issuance to either remain flat or to decline slightly in 2004. The potential for higher 

interest rates dampens the prospects for repeating this year's blockbuster level of activity in the home 

equity ABS sector. The credit card and auto sectors have the potential to grow, but probably not 

enough to offset contraction from HELs. Pressure on the automakers' corporate credit ratings could 

be an important driver of increased auto ABS issuance in 2004. 

The manufactured housing sector is positioned for a resurgence in 2004. The union of Oakwood and 

Clayton Homes under the Berkshire Hathaway umbrella is the best news for the sector in more than a 

year. If the combined Oakwood-Clayton entity becomes a somewhat active ABS issuer, it may 

re-establish the MH sector's credibility and spur other would-be issuers to enter the market. 

However, even if a renewed MH ABS sector emerges and achieves issuance levels on par with 2002 

or 2001, it will still not be a material amount relative to the whole ABS pie. 

Likewise, we feel that issuance activity in ABS backed by commercial assets is poised to rebound in 

2004. Economic recovery reasonably should bring with it greater demand for equipment. 

The following table summarizes our projections for 2004 ABS issuance levels in the various major 

asset categories: 

Projected 2004 U.S. Public/144A ABS Issuance by Asset Class 

($ billions) 

Credit Cards 75 

Autos 90 

Home Equity 165 

Manufactured Housing 5 

Student Loans 40 

Other 30 

Total 405 

2. Credit Trends 

With the U.S. economy starting to bounce back, we anticipate a generally positive credit trend in 

2004. We expect the prime-quality, top-tier auto and credit card sectors to continue their role as the 

anchor that has allowed the ABS market (as a whole) to maintain a reputation for high credit quality. 

Deals from other sectors likely will display either improving credit quality or a slower pace of 

deterioration, in either case reflecting improvement in the general economy. We expect that the pace 

of downgrades will slow down in virtually all ABS sectors. 

On the other hand, many situations involving distressed ABS will persist through 2004 and will be a 

nagging reminder of the problems of the past three years. Uncertainty will continue to burden 

troubled deals from various sectors. Examples include credit card deals from NextCard and First 

Consumers, equipment leasing deals from DVI, many outstanding MH deals and the ill-fated National 

Century Financial Enterprises (NCFE) deals. 

3. Spreads 

For the first half of 2004, we expect spreads on triple-A-rated ABS to revisit the tight levels that they 

achieved around mid-year 2003. More specifically, we expect slight tightening for card and auto ABS 

and moderate tightening for HELs. 

(45)


We expect that 2004 will bring a further modest spread tightening for subordinate and mezzanine 

ABS tranches. Improving consumer credit quality, driven by generally improving economic 

conditions, likely will be the primary factor. We expect the impact to be most pronounced in triple-B 

HELs, where the combination of sub-prime borrowers and structural leverage amplify the effects of 

economic improvement (or deterioration). However, investors should not expect dramatic tightening; 

subordinate and mezzanine tranches already achieved a notable measure of tightening in the second 

half the 2003. 

In addition, spreads on certain off-the-run deals could experience substantial tightening. Many 

market participants used 2003 to think about the issues of company risk and fraud. Now, some 

market participants have regained confidence that they can differentiate situations that are well 

protected from those that are not. 

Expected Tightest Spreads to Swaps on Selected 

Fixed-Rate, Triple-A-Rated ABS in 2004 (basis points) 

Asset Class ↓ Average Life→ 2 3 5 10 

Credit Cards 2 3 8 24 

Prime Autos 5 3 

Home Equity/Sub-Prime Mortgage 35 38 62 114 


For the first half of 2004 we recommend a somewhat aggressive posture. In broad terms, we 

recommend triple-A-rated 5-year fixed-rate home equity ABS because we feel that they have the best 

chance to gain on spread tightening and because they offer better carry than prime-quality card and 

auto ABS. 

In addition, for investors with a more aggressive disposition, we recommend subordinate and 

mezzanine HELs from top-tier issuers. Those securities offer a good opportunity to benefit from the 

expected economic recovery. However, they have already experienced substantial spread 

tightening, and opportunities for further tightening may be limited. We do not recommend 

subordinate and mezzanine tranches from lower-tier HEL issuers because we remain wary of 

headline risk and expect tiering to remain a permanent feature of the HEL landscape. 

We also recommend considering new issue manufactured housing ABS, if any appear on the scene 

in 2004. We expect that new MH deals will be substantially stronger than those of recent vintages. 

We remain wary of outstanding deals from the 1999 through 2002 vintages. 

Improvement in the economy bodes well for off-the-run ABS sectors. Recent experience teaches that 

if an off-the-run deal gets into trouble, it is much more likely to occur during tough times than 

otherwise. Thus, for the off-the-run areas we favor short maturities. Investors at the front ends of 

exotic deals stand to earn attractive spreads while leaving the great majority of risk with the holders of 

longer tranches. Tranches that mature in two or three years stand a reasonable chance of being 

retired before the next cyclical downturn. 

B. Review of the Second Half of 2003 

1. The Big Picture 

a) Issuance 

We expect that overall U.S. public and 144A ABS issuance will reach approximately $420 billion by 

the end of 2003. We had revised our original prediction of $365 million to $400 million in our midyear 

report. It seems that actual full-year issuance will slightly surpass our revised projections. 

As stated in our mid-year report, HEL ABS issuance has been substantially greater than we had 

originally predicted for 2003. We expect home equity issuance to surpass $200 billion by year-end. 

(46)


Auto issuance has been slower than 2002, and will most likely reach $85 billion. Credit card issuance 

has slowed somewhat from its faster pace at mid-year and will only reach $65 billion by the end of 

2003. 

The following table shows our current estimates for how 2003 will wrap-up, together with our initial 

and revised mid-year projections. 

2003 U.S. Public/144A ABS Issuance by Asset Class 

($ billions) 

Asset Class 

Original 

Projection 

(at end of 2002) 

Revised Projection 

(as of June 2003) 

Estimated 

(as of December 

2003) 

Credit Cards 69 85 65 

Autos 90 80 89 

Home Equity 140 180 210 

Manufactured Housing 4


number of home equity securities were helped by upgrades. The rating agencies upgraded 131 

tranches from 56 deals. 

Credit card ABS experienced downgrades to 29 tranches from 11 deals. Most were concentrated in 

the sub-prime Metris Master Trust. Twenty-four tranches from eight Metris deals suffered 

downgrades. Credit card ABS experienced upgrades to only seven tranches from three deals. 

c) Spreads 

The second half of the year brought spread widening in home equity and prime auto ABS. Most of 

the widening occurred in August and September. As we approach year-end, ABS spread movements 

year-to-date have displayed a slight tightening trend. In our mid-year report, we had predicted ABS 

spread widening for the second half of the year, but we expected that it would occur mostly in the 

fourth quarter rather than in the third. 

The following table summarizes the spread movements relative to swaps for fixed-rate top-tier paper 

from the major asset classes at various average lives: 

Fixed-Rate ABS – Triple-A-Rated 

Change in Spread to Swaps (bp) in Third and Fourth Quarters of 2003 


Credit Cards 

Q3 0 0 -2 -2 

Q4 0 0 -1 -1 

Prime Autos 

Q3 2 2 

Q4 -1 0 

Home Equity/Sub-Prime Mortgage 

Q3 14 16 27 10 

Q4 -6 -6 0 -3 

The next table summarizes representative spreads to swaps for fixed-rate top-tier paper from the 

major asset classes at various average lives, as we approach year-end. 

Fixed-Rate ABS – Triple-A-Rated 

Approximate Spreads over Swaps (bp) Approaching Year End 2004 


Credit Cards 4 5 8 24 

Prime Autos 7 7 

Home Equity/Sub-Prime Mortgage 47 50 88 120 

2. Developments 

a) Off-Balance Sheet Accounting 

As a whole, 2003 brought a flood of developments affecting the off-balance sheet treatment of 

securitizations. The areas most directly threatened were asset-backed commercial paper (ABCP) 

and collateralized debt obligations (CDOs). For now, the threat to ABCP has largely subsided. It 

appears that many ABCP program sponsors will be able to restructure their programs to avoid 

consolidation, if they want to. CDOs seem to be facing greater uncertainty. 

During the second half of 2003, key developments came from several different directions including (1) 

Financial Accounting Standards Board (FASB), (2), the Securities and Exchange Commission (SEC), 

and (3) U.S. bank regulators. FASB and its staff issued a number of interpretations and proposals, 

including a significant proposed amendment to FIN 46. 8 The SEC released its congressionally 

mandated study "on the adoption by the United States financial reporting system of a principles- 

8 Financial Accounting Standards Board, Exposure Draft, Proposed Interpretation Consolidation of Variable 

Interest Entities a Modification of FASB Interpretation No. 46 (31 Oct 2003) (available at 

http://www.fasb.org/draft/ed_prop_interp_vie.pdf). 

(48)


based accounting system." 9 The SEC's study urges a shift toward an accounting framework that is 

primarily principles-based, but which also includes rules to provide an appropriate amount of 

implementation guidance. The bank regulators published interim rules and proposed permanent 

rules that prevent consolidation of ABCP programs on bank financial statements for risk-based 

capital purposes. 10 

The whole subject of off-balance sheet treatment for securitizations is becoming increasingly arcane 

and convoluted. For readers who want to delve more deeply into the issues, we recently published a 

more expansive treatment of the subject in a report titled Off-Balance Sheet Update (November 

2003). 

b) Fraud 

During the second half of 2003, the ABS market continued to wrestle with the issue of fraud in 

securitizations. The subject was a central theme at the ABS East conference in October. The 

(allegedly) fraud-tainted NCFE heath-care deals remain unresolved and at the center of extensive 

litigation. 11 At this point, it seems likely that litigation will continue through 2004 and possibly even 

beyond 2005. 

Unfortunately, NCFE was not the only reminder of fraud risk during the second half of 2003. In early 

September, Spiegel released an "Independent Examiner's Report" revealing that the company had 

made material misstatements and omissions in the sales of credit card ABS and that it had 

manipulated interchange rates to improperly avoid breaching excess spread triggers. 12 The 

deception committed by Spiegel is important because it serves as a reminder that even a seemingly 

reputable enterprise may commit fraud under conditions of financial distress. 

Also, early December brought a reminder of the ill-fated CFS transactions. On December 3, a Tulsa, 

Oklahoma jury found former CFS boss, Bill Bartmann, "not guilty" on 57 counts of fraud. It remains to 

be seen whether ABS investors will pursue Bartmann's personal assets in civil litigation. Before 

NCFE, the CFS charged-off credit card deals represented the worst beating that the ABS market had 

ever dished-out. On roughly $1.6 billion of securities, investors recovered only $70.7 million. 13 

Responding to heightened sensitivity to fraud risk, the American Securitization Forum (ASF) 

announced an initiative to develop guidelines and "best practices" for ABS issuers. That initiative 

may prove to be a strong, positive development for the ABS market. In a similar vein, a rising 

number of market participants are calling for increased third party oversight for deals with significant 

9 United States Securities and Exchange Commission, Study Pursuant to Section 108(d) of the Sarbanes-Oxley 

Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting 

System (25 Jul 2003) (available at http://www.sec.gov/news/studies/principlesbasedstand.htm). 

10 Office of the Comptroller of the Currency [hereinafter "OCC"], Federal Reserve System, Federal Deposit 

Insurance Corporation [hereinafter "FDIC"], and Office of Thrift Supervision [hereinafter "OTS"], Risk-Based 

Capital Guidelines; Capital Adequacy Guidelines; Capital Maintenance: Interim Capital Treatment of Consolidated 

Asset-Backed Commercial Paper Program Assets, 68 Fed. Reg. 56530 (1 Oct 2003); OCC, Federal Reserve 

System, FDIC, and OTS, Risk-Based Capital Guidelines; Capital Adequacy Guidelines; Capital Maintenance: 

Asset-Backed Commercial Paper Programs and Early Amortization Provisions, 68 Fed. Reg. 56568 (1 Oct 2003). 

11 National Century Financial Enterprises (NCFE) filed for bankruptcy in November of 2002. Previously, the 

company had completed dozens of purported healthcare securitizations. The company and its principals have 

been accused of fraud in connection with those deals. Roughly $3.35 billion of outstanding securities have 

defaulted, and estimates of ultimate losses to investors have run higher than 85%. The main component of the 

alleged fraud is that collateral for the deals either was ineligible or did not exist. The revolving nature of the 

collateral pools combined with the absence of meaningful third-party oversight arguably enabled NCFE to 

perpetrate that aspect of the fraud. A secondary aspect of the NCFE fraud involves the company's diversion of 

reserve funds that formed a part of its deals' credit enhancement. Investors have alleged that the trustees for the 

NCFE deals should have prevented the company's diversion of the reserve fund balances. See City of Chandler 

et al. v. Bank One et al., No. CV2003-010173, (Ariz. Superior Ct. Maricopa County, filed 23 May 2003) 

12 Spiegel, Inc., Form 8-K Current Report (12 Sep 2003) 

13 For a more extensive discussion of the CFS transactions see ABS Credit Migrations, Nomura fixed income 

research report at 20 (updated 5 March 2002). 

(49)


potential for fraud risk (e.g., revolving pools of specialty assets). The broader subject of "company 

risk" – of which fraud risk is just one of several dimensions – was a central theme at the ABS East 

conference in October. Several highly respected ABS professionals expressed the view that 

"bankruptcy remoteness" is illusory and that ABS should be considered a special case of "super 

secured" debt. Just a few years ago, many market participants would have thought such remarks 

virtually heretical. 

c) Credit Card ABS 

A variety of credit card ABS issuers made important corporate announcements in the second half of 

2003. In late July, Sears announced that it would sell its portfolio and operations to Citigroup. Sears 

credit card ABS tightened by 10 bp to 20 bp in response to the news. In early August, GE Capital 

announced its plans to securitize its private-label and retail credit card receivables. GE's Monogram 

Credit Card Bank of Georgia reportedly has more than 100 million accounts representing about $60 

billion in receivables. In late September, Metris completed a $590 million portfolio sale and replaced 

its $610 million 2001-1 series with a private conduit facility. Later, the company sold another $495 

million of its credit card portfolio and announced that it would delay filing its third quarter financial 

reports. In late September, Target announced its plans to issue $3 billion in credit card ABS through 

its Target Credit Card Master Trust. In late October, Bank of America announced that it would merge 

with FleetBoston Financial. According to the merger parties, the combined entity will be the fifth 

largest bank card issuer in the U.S., with $47 billion in managed outstandings and 35 million 

accounts. 

d) NERA Study – Notching 

The long awaited NERA study on structured finance ratings was released in early November. 14 We 

believe the study was disappointingly inconclusive. We have not observed any subsequent change 

in rating agency notching practices, nor do we expect to observe any change. However, we feel that 

the NERA study has potentially important implications for regulators. The study's inability to conclude 

that the ratings from different rating agencies perform similarly calls into question the increasing 

regulatory use of ratings. The regulatory use of ratings presumes that corresponding ratings from 

different rating agencies are equivalent. If that presumption cannot be analytically supported, entire 

regulatory regimes might be based more on wishful thinking than on fact. 

We reviewed the NERA study more extensively in a report titled NERA Study of Structured Finance 

Market Ratings – Market Implications, dated November 6. 

14 Carron, A.S., Dhrymes, P.J., and Beloreshki, T.N., Credit Ratings for Structured Products – A Review of 

Analytical Methodologies, Credit Assessment Accuracy, and Issuer Selectivity among Credit Rating Agencies, 

National Economic Research Associates (6 Nov. 2003). 

(50)


VII. 

Collateralized Debt Obligations 

A. Outlook for 2004 

David P. Jacob (212) 667-2255 

Michael van Bemmelen (212) 667-9504 

We expect corporate spreads in the U.S. to continue to tighten modestly during 2004. The highgrade 

Dow Jones TRAC-X index of the 100 most actively traded corporate credits (in CDS form) may 

reach as low as 40 bp by mid 2004. Any further drastic tightening would put the index at Japanese 

levels, where credit spreads are an average of 30 bp for the 50 most actively traded credits (in CDS 

markets) at year end 2003. 

In the more dynamic U.S. economy, the spread market is reaching the tightest level we expect to see 

during the expansion. The dominance of credit upgrades over downgrades that we foresee for 2004 

will support very tight levels for the upgraded credits, and support tightening pressure on the 

corporate market as a whole. 

The CDO picture is not as rosy because in the past, the rating agencies only reluctantly downgraded 

deteriorating CDOs, and that was too little and too late. We believe that even if a large number of 

credits included in CDOs were to be upgraded, it will not erase the negative overhang and result in 

CDO tranches being upgraded during 2004. 15 The pace of downgrades for the sector, however, will 

continue to slow during the first half and the credit lows may finally be reached in mid 2004 for most 

CDO types. 

We see good value in the credit index products, which will benefit from the tightening, as well as from 

improved liquidity as this market matures. The TRAC-X indexes in un-funded (derivative) form trade 

as tight as 3 bp bid-ask for both the high-yield and high-grade pools. For funded credit tranches, 

where dealers provide only a "one-way market", index spreads are currently wider, but the product 

has the potential to tighten as the product matures. 

B. Review of 2003 

1. New Credit Derivative Product 

a) Recent Developments 

An exciting development for investors in Credit Products is the emergence of credit indexes based on 

diversified pools of 50 to 125 individual Credit Default Swaps (CDS). Two competing products that 

have emerged during 2003 are TRAC-X and iBoxx, each of which is promoted by approximately a 

dozen dealers. 16 The high-grade corporate iBoxx index of 125 credits began trading in the U.S. on 

October 20, followed in November by the iBoxx high-yield index. 

TRAC-X results from an April 1, 2003 merger of two dealers' fledging efforts. The sponsors rebalanced 

the TRAC-X indexes every six months to include the 100 most actively traded CDS during 

the previous six months in the newly calculated index. The weight of each CDS in the index is 1%. 

Since CDS trading data is not publicly available, the selection procedure for new index names was 

not transparent to market participants. Additionally, TRAC-X was perceived as being too dependent 

on its two sponsors, and it lacked third party overview. 

The TRAC-X sponsors invited Dow Jones Indexes (DJI) to assume responsibility for the product, 

including future re-balancing of the index, effective November 24. As a result, the indexes were 

renamed Dow Jones TRAC-X Indexes and currently benefit from third-party overview. By the first 

15 One CDO sector remains an exception: the residential mortgage backed CDOs have seen such high prepays 

and increases in support levels that credit performance has been excellent including a number of upgrades. 

16 Nomura International Plc., an affiliate of NSI, makes a market in the TRAC-X index. 

(51)


quarter of 2004, DJI will take over the actual calculation and distribution of index values. DJI is 

currently putting together regional Advisory Committees in the U.S., Europe and Asia composed of 

credit derivatives market makers who will provide input for the inclusion of credits in the index at the 

semi-annual reset dates. At mid-December, 12 indexes were part of this CDS index family17. DJI 

completed their first rebalancing under preliminary procedures on December 3, when 14 credits were 

replaced in the 100 name high-yield TRAC-X NA index. 

Between its launch on April 1, 2003 and DJI's involvement in November, over $150 billion linked to 

the Dow Jones TRAC-X Indexes traded. Trading volume is not easily compared to new issue 

volume, which is the measure tracked for funded CDOs. It is interesting, though, to compare the 

index trade data to global issued volume during 2003 for all CDO types, which we estimate at $95 

billion. Combining the two independent index efforts, as is expected to eventually occur, would 

further promote trading volumes and liquidity of the index product. In the current strong credit 

environment, liquidity in the high-yield index is phenomenal with two-way markets at 3 bp bid-ask 

spreads quoted. The real test for the product's value to Credit investors is during periods of spread 

widening, when there is traditionally limited liquidity in the underlying fixed-income securities. 

b) Product Background 

The credit derivatives market is experiencing explosive growth, as can be seen in the surveys by the 

British Bankers' Association (BBA). Notional amount stood at $180 billion in 1997, but had increased 

10-fold by 2002. The latest survey of BBA members forecasts a global market of $4.8 trillion for 

2004, with half of this amount consisting of CDS. During its early phase, transactions typically were 

initiated by a commercial bank or others with long positions looking for protection on existing 

exposures. Acceptance by bank regulators of CDS as an effective hedge for existing bank exposure 

gave the market a boost. Convergence in certain documentation issues further helped standardize 

trades, which currently occur under 2003 ISDA agreements. On the other hand, investors in this 

market using CDS as an instrument to create long positions prefer the customized tranches of CDS 

pools. The structure is similar to a funded CDO with a manager having wide discretion in selecting 

exposures, either before closing, or worse, after closing the transaction. Since each pool has 

different components and often is governed by unique documentation, liquidity remains limited. The 

lack of liquidity has led to additional loss in value after credit stress appeared. The new indexes 

avoid the moral hazard risk because their composition is based on the most active traded CDS during 

the six-month period before the index reset. Investors choose exposure to high-yield vs. high-grade 

and the geographic area they prefer. 

The indexes trade both in unfunded (derivative) format as well as in funded format. The latter is often 

referred to as a Credit Linked Note (CLN) because investors in the funded index purchase an actual 

security (note) and the repayment is linked to performance of the referenced index. Currently, there 

is limited standardization in the funded index. Clearly, in a funded and credit-tranched form the index 

is an attractive alternative to an actively managed CDO. A tranched index has the potential to 

outperform a comparable CDO class because of its lower fee and expense basis and much improved 

liquidity. Despite improvements in disclosure and underwriters' efforts to establish a secondary 

market, most tranches of CDOs still trade "by appointment only." 

Dealers in credit derivatives and related CDS indexes are trying to make their product more attractive 

to traditional buy-and-hold investors. One of the factors restraining these institutional investors from 

entering CDS markets is the need for specialized back-office systems and procedures to confirm and 

track their CDS exposures. In response to this need, DTC has announced that it has about a dozen 

dealers signed up to use the DTC system to confirm CDS trades. The first trades were entered in the 

fourth quarter of 2003. This may be a step in the direction of creating a liquid and transparent market 

in CDS, which over time may become more similar to the corporate bond market than an OTC 

derivative market. 

17 Most notable composites are: Dow Jones TRAC-X Europe, Dow Jones TRAC-X NA (North America), Dow 

Jones TRAC-X NA High Yield, Dow Jones TRAC-X Japan, and Dow Jones TRAC-X EM (Emerging Markets). 

(52)


Several factors are coming together in establishing the index product. Evolution of financial 

technology is widely credited as the driving force behind this group of products. However, we believe 

recent investor skepticism regarding managers' added value is an important driver behind the move 

to index trading and will continue to force dealers to take this product to its logical next phase, as is 

explained below. 

c) Next Steps 

DJI is taking the TRAC-X index product to several global exchanges to try and get listings for 

exchange-cleared trading and establish a platform for further innovation. The stated target is to roll 

out exchange-traded credit futures by the middle of next year. According to DJI, they have seen 

"tremendous interest" in issuing structured products, exchange-traded derivatives and Exchange 

Traded Futures based on the Dow Jones TRAC-X Indexes and expect to issue the first licenses 

soon. 18 Clearly, a widely accepted and listed contract with its own futures and options would be a 

watershed event for global credit markets. Despite the existence of bond indexes, there are few 

effective futures contracts available to fixed-income investors to take broad market positions. For 

instance the lack of activity in trading futures on the Municipal Bond Index (MBI) prompted the Bond 

Market Association (BMA) to field a task force to investigate. Some of the task force conclusions 

pertaining to the MBI apply to the older CDS indexes as well. 19 However, by retaining DJI, TRAC-X 

has incorporated many of the BMA recommendations for improved index trading, and the current 

momentum leads us to expect TRAC-X to become a platform for developing a new generation of 

derivatives. 

During November 2003, the TRAC-X sponsors replaced the EM index of CDS with the existing 

emerging markets bond index EMBI. The methodology of calculating the EMBI, or any other bond 

index for that matter, is fundamentally different from the CDS indexes. Bond indexes are widely 

accepted by investors as performance benchmarks when compiling their portfolios. CDS indexes are 

still at the early stages of building investor acceptance, but by their design of pooling the 100 most 

actively traded CDS each at 1% of the index, they are more focused on CDS dealers. Fixed income 

fund managers need weights for each credit, which are more reflective of the size of traded debt. 

The substitution of the EMBI for the TRAC-X EM may be the beginning of a more investor-friendly 

CDS index. 

2. Credit Developments 

a) Upgrades Back in Vogue 

During 2003, the credit cycle continued its move off the 2002 through, as evidenced by defaults 

statistics, see Table. 

Default Rate of U.S. Corporate Bonds 

(as a percent of outstandings) 

2002 2003 

High-Yield 7.44 5.68 

High-Grade 0.61 0.11 

Combined 3.29 2.42 

Source: Standard & Poor's, 2003 Year-End U.S. Corporate 

Bond Review and Forecast, December 9, 2003 

18 The consortium behind iBoxx, which includes Deutsche Boerse, has also stated their intention to introduce 

exchange-traded futures on the credit index by mid 2004. 

19 Bond Market Association Municipal Bond Futures Task Force, Creating a Viable Contract: Issues and 

Recommendations Relating to the Municipal Bond Futures Contract, (May 2000) (available at 

http://www.bondmarkets.com/Market/MuniBondFutTaskFrc500.pdf). The report listed the following requirements 

for a successful futures contract on the bond index: more transparency, third-party oversight, an objective set of 

criteria for including a bond in the index, a live market in the underlying index, disclosure of prices and dealer 

quotes, disclosure of credits eligible for future inclusion. 

(53)


Rating Agencies are catching up with the development and the downgrade-to-upgrade ratio for all 

corporate and structured debt has improved from 6:1 for 2002 to a ratio of 3:1 for the 2003 first half. 

The downgrade-to-upgrade ratio as calculated by Moody's for non-financial corporations is rapidly 

moving back to parity. This ratio stood at 1:1 for the period 1993-1997 but had deteriorated by 2002 

to a reading of 3:1 for count downgrades and 23:1 for dollar volume of affected debt, see Table. 

Downgrade-to-Upgrade Ratio 

Period By Dollar Volume By Number 

1993-1997 1:1 1:1 

2000 3:1 2:1 

2001 6:1 4:1 

2002 23:1 6:1 

Quarter 1, 2003 9:1 3:1 

Quarter 2, 2003 7:1 3:1 

Quarter 3, 2003 - 2.1:1 

Source: Moody's Investors Service, November 18, 2003 

As we predicted in the Nomura 2003 Outlook, the ratios downgrade-to-upgrade for ABS and CDOs 

have not turned as dramatically. High pre-pay speeds on Mortgage Backed Securities have 

improved the leverage ratios for CDOs backed by mortgage securities, which resulted in a number of 

upgrades. Downgrades however were still widespread in 2003, albeit at a slowing monthly rate. 

Moody's placed 60 CDO tranches on review for downgrade and four on review for upgrade during the 

Third Quarter, bringing the total on watch to 155 for downgrade and eight for upgrade. This ratio 

leaves us still with negative overhang, which is no longer present in the corporate market. 

b) Managers Overpaid? 

Early during 2003, Moody's published a report, which was one of the few critical studies addressing 

CDO managers' performance. 20 After the initial report on this comparison, Moody's started publishing 

widely followed monthly performance indexes for CDOs. Unfortunately the index for each year's 

CDO origination (cohort) is based on the monitored CDOs. Since the index is effectively the average 

performance of the group, roughly half of the deals (and the managers) appear as under-performing 

and the other half as out-performing the "market." A more critical yardstick is the performance of the 

CDO cohort versus a broad market index, such as Moody's applied in the referenced report. 

Comparing performance of CDOs to an index lead to the conclusion that CBO managers, as a group, 

had under-performed the broad high-yield market. The managers' weak performance was largely 

blamed on industry concentration (in Telecom) and to an aggressive investment philosophy. The 

term "aggressive" refers to managers' tendency to purchase the cheapest asset for a given rating, 

which in a deteriorating credit environment results in more severe portfolio deterioration. Moody's 

estimated that for some mezzanine CDO classes the manager caused four additional notches of 

downgrades versus what would have happened to the rating if simple reinvestment rules had 

prevailed. These comparisons will not help convince investors to stay active in the managed CDO 

sector. In addition to paying annual fees to the collateral manager, there is a cash transfer at the 

CDO closing from investors paying 1.5% to 2.5% in fees and expenses to underwriters, rating 

agencies and other service providers. 

3. Spread and Issuance 

The divergent movement in ratings between CDOs and underlying collateral is one of the reasons 

that spreads on CDOs and collateral are moving out of synch. Spreads on new-issue CDOs had 

followed the collateral spreads down in an initial tightening of both types of securities during the first 

quarter of 2003. The triple-A-rated class for synthetic CDOs at mid-December stands at a spread of 

95 bp, which is a bit wider than end of the first quarter 2003, and only marginally better than the 

beginning of the year. Mezzanine classes with triple-B ratings reveal a similar pattern of coming 

down from the year-end 2002 spread widening but have gone sideways throughout the rest of the 

20 Fu, Y. and Harris, G., U.S. High-Yield CBOs: Analyzing the Performance of a Beleaguered CDO Category, 

Moody's special report (21 Jan 2003). 

(54)


year. The effect for CDOs of collateral spreads contracting and liability spreads holding steady is 

reduction in arbitrage profits. 

Spread of Synthetic AAA CDO vs. TRAC-X 2002 Index North America 

190 

160 

TRAC-X 

AAA CDO 

Basis Points 

130 

100 

70 

40 

6/1/2002 

8/1/2002 

10/1/2002 

12/1/2002 

2/1/2003 






Not surprisingly, the compression of arbitrage opportunities has squeezed issuance globally of 

investment-grade CDOs down by 30% to an estimated $17.5 billion for 2003 versus $25 billion in 

2002. However, continued growth in two CDO segments, high-yield loan backed (CLO) and 

structured product backed, offset part of the decline and Moody's forecast a drop of 15% in rated U.S. 

CDO volume for the year, see Chart. The CLO and structured products remain fertile ground for the 

CDO structure, because of limited secondary markets in these products, especially for the triple-B 

and lower-rated securities, which make up the collateral for the CDOs. Furthermore, investors may 

lack the expertise to select the assets, thus an experienced fund manager with an aligned interest 

could add value. 

(55)


U.S. Rated CDO Transactions and Volume (all collateral types) 

90 

80 

70 

60 

Volume (left scale) 

Number (right scale) 

180 

160 

140 

120 

$ Billion 

50 

40 

30 

20 

10 

100 

80 

60 

40 

20 

0 

0 

1995 

1996 

1997 

1998 

1999 

2000 

2001 

2002 


Source: Moody's 

The increasing popularity of credit index trading for both high-yield and high-grade corporates may 

permanently reduce the volume of CDO issuance. The CDO vehicle is not very efficient for taking 

short or medium-term positions in a generic credit product. The explosive growth of CDOs during 

1996-2002 can be traced to strong demand from two separate investor constituencies. Both these 

constituencies may be enticed to transact in the credit index market. 

Commercial Banks, which sponsor CP conduits and other structured vehicles have a strong demand 

for Triple-A and AA rated investments with modest claims on bank regulatory capital. CDOs provided 

both the rating and a pick-up in spread of 20-30 bp versus similar rated liquid ABS investments. 

Following credit stress on CDOs and regulatory pressures, the commercial bank vehicles have 

become less active in funded markets. Most of the large international banks do actively trade the 

credit indexes. Since positions in the index are marked-to-market, these require limited amounts of 

regulatory capital. 

The second group of traditional CDO investors, the mezzanine class buyers, consists mostly of fixedrate 

investors who had to reach for yield in the falling interest rate environment since the mid-1990s. 

This group of investors has seen the value of their CDO holdings severely reduced. Total return on a 

portfolio of mezzanine tranches yielding 200-240 bp over the comparable benchmark will be severely 

affected by the non-performance of relatively few positions. There are enough mezzanine classes 

trading for pennies on the dollar in the high-yield, high-grade and CDS sectors to go around. This 

investor base has further been hurt by the lack of liquidity and very large bid-ask spreads, quoted 

even by the original lead managers on the CDOs. Thus the mezzanine CDO investor is also a fertile 

prospect for index investing, but this investor base needs a more bond-like product. Implementation 

of the plans to turn the credit indexes in full-fledged bond products will enhance its acceptance. 

— E N D — 

(56)


Recent Nomura Fixed Income Research 

Fixed Income General Topics 

• U.S. Fixed Income 2003 Mid-Year Outlook/Review (27 June 2003) 

• Off-Balance Sheet Update (24 November 2003) 

• NERA Study of Structured Finance Ratings – Market Implications (6 November 2003) 

• U.S. Fixed Income 2003 Mid-Year Outlook/Review (27 June 2003) 

• Report from Arizona: Coverage of Selected Sessions of the February 2003 

Securitization Conferences (18 February 2003) 

• Senate Report Attacks Structured Finance (6 January 2003) 

• Securitization Glossary (26 November 2002) 

MBS 

• Monthly Update on FHA/VA Reperforming Mortgages: Historical Prepayment Speeds, 

Default Losses, and Total Returns (3 December 2003) 

• Australian MBS Primer (9 September 2003) 

• Agency Capped Callable LIBOR Floaters Offer Structuring Flexibility to Create 

Investment Profiles That May Be Difficult to Create in New Issue CMO Floaters (2 July 

2003) 

• A Journey to the Alt-A Zone (3 June 2003) 

• Oops… They Did It Again – Jumbo MBS Credit Enhancement Levels Keep Falling 

(2 April 2003) 

• Monthly Update on FHA/VA Reperforming Mortgages: Historical Prepayment Speeds, 

Default Losses, and Total Returns (4 March 2003) 

• Terrorism Insurance Update (published in Nomura CMBS Weekly Report, 7 June 2002) 

CMBS 

• GNPL REMIC Factor Comparison (28 October 2003) 

• GNMA Project Loan Prepayment Report (14 October 2003) 

• CMBS Watchlistings, Downgrades, and Surveillance (2 October 2003) 

• Temporal Aspects of CMBS Downgrades and Surveillance (1 July 2003) 

• Some Investment Characteristics of GNMA Project Loan Securities (1 May 2003) 

• CMBS Credit Migrations (4 December 2002) 

ABS 

• ABS Gold Coast Report: Coverage of Selected Sessions of ABS East 2003 

(20 October 2003) 

• What a Coincidence? – One Reason Why CDOs and ABS Backed by Aircraft, 

Franchise Loans, and 12b 1 Fees Performed Poorly in 2002 (19 May 2003) 

• Healthcare ABS Primer (18 October 2002) 

• ABS Credit Migrations (9 Jan 2002, updated 5 March 2002) 

Corporates 

• U.S. Corporate Monthly - November (8 December 2003) 

• Toys "R" Us, Inc. - (18 November 2003) 

• U.S. Corporate Monthly - October (10 November 2003) 

• Ford Motor Co./Credit Corp. (17 October 2003) 

• U.S. Corporate Monthly – September (8 October 2003) 

• Nomura Credit Quarterly – September 2003 

• U.S. Corporate Monthly – June (9 July 2003) 

• U.S. Corporate Monthly – May (8 June 2003) 

(57)

NEW YORK TOKYO LONDON 

Nomura Securities International Nomura Securities Company Nomura International PLC 

2 World Financial Center, Building B 2-2-2, Otemachi, Chiyoda-Ku Nomura House 

New York, NY 10281 Tokyo, Japan 100-8130 1 St Martin's-le-grand 

(212) 667-9300 81 3 3211 1811 London EC1A 4NP 

44 207 521 2000 


New York 

David P. Jacob (212) 667 2255 International Head of Research 

David Resler (212) 667 2415 Head of U.S. Economic Research 

Mark Adelson (212) 667 2337 Securitization/ABS Research 

Arthur Q. Frank (212) 667 1477 MBS Research 

Louis (Trey) Ott (212) 667 9521 Corporate Bond Research 

Parul Jain (212) 667 2418 Deputy Chief Economist 

Elizabeth Hoyt (212) 667 2339 Analyst 

James Manzi (212) 667 2231 Analyst 

Edward Santevecchi 

Analyst 

Kumiko Kimura (212) 667 9088 Translator 

Michiko Whetten (212) 667 2338 Translator 

Tokyo 

Nobuyuki Tsutsumi 81 3 3211 1811 ABS Research 

London 

John Higgins 44 207 521 2534 Head of Research - Europe 

Each of the research analysts referenced on page 1 hereof with regard to the section of this research report for which he or she is 

responsible certifies that all of the views expressed in this report accurately reflect his or her personal views about any and all of the subject 

securities or issuers discussed herein. In addition, each of the research analysts referenced on page 1 hereof hereby certifies that no part of 

his or her compensation was, is, or will be, directly or indirectly related to the specific recommendations or views that he or she has 

expressed in this research report. 

© Copyright 2003 Nomura Securities International, Inc. 

This publication contains material that has been prepared by one or more of the following Nomura entities: Nomura Securities Co., Ltd. ("NSC") and Nomura Research 

Institute, Ltd., Tokyo, Japan; Nomura International plc and Nomura Research Institute Europe, Limited, United Kingdom; Nomura Securities International, Inc. ("NSI") and 

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Securities Co., Ltd., Taipei, Taiwan; or Nomura Securities Co., Ltd., or Seoul, Korea. This material is: (i) for your private information, and we are not soliciting any action based 

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