Metropolitan West Asset Management RMBS Research Winter 2009 By Brian Rosenlund, CFA

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1 Metropolitan West Asset Management RMBS Research Winter 2009 By Brian Rosenlund, CFA Senior Analyst, Structured Products CONTENTS page I. Contractual Obligation...2 II. Advancing Behavior... 3 III. How We Analyze... 6 IV. Conclusions... 7 Highlights & Recommendations > A Servicer s Advancing Obligation Servicers are required to advance principal and interest to the loan trust when borrowers become delinquent on their mortgages as long as they believe the advance is recoverable. > Tracking Advances Investors can track advances by polling servicers directly, reviewing monthly remittance reports and observing loan level trends. Of the three, loan level analysis is the most effective. > Advancing Trends Servicers are advancing on fewer loans reflecting higher loss expectations and idiosyncratic servicer struggles. > Analysis Investors should avoid servicers whose advancing behavior reflects financial distress. Investors should also avoid deals serviced by a well capitalized servicer whose advancing behavior reflects the servicer s higher than average loss projections. Introduction MetWest believes that it is appropriate to minimize exposure to residential mortgage backed securities (RMBS) with servicers that have stopped advancing on a disproportionate number of severely delinquent first-lien loans. In this piece we will show that this behavior is a function of servicer level distress as well as higher than average loss severity projections. Definition When a borrower misses a mortgage payment on a first-lien mortgage the servicing contract obligates the servicer to make the interest and principal payment for the borrower. This is called advancing. The servicer advances the mortgage payment to the certificate holders, expecting to be repaid sometime in the future. In fact, the advance is more than an expectation. Just as the servicer is required to advance delinquent principal and interest for delinquent borrowers, the trust is required to eventually reimburse those advances to the servicer. The reimbursement requirement is fulfilled through collection of liquidation proceeds, late collections, and/or insurance proceeds from the loan that has been advanced upon. If at some point in the future the proceeds from these three sources do not fully pay back the servicer for its prior advances, the servicer may take funds from the general collections account once it determines that prior advances are unrecoverable. Hence, advances are in no way a form of credit enhancement to the deal. Rather, advances are designed to maintain regular cash flow to the certificate holders.

2 I. Contractual Obligation RMBS deal documents describe the contractual obligations of the servicer as they pertain to advancing. With a few exceptions, the language of these documents is standard and covers the following main points: A servicer is obligated to advance on a loan unless the advance is deemed unrecoverable An example should help us see what kind of advances we might deem recoverable versus unrecoverable. A typical subprime loan originated during 2006 has an original balance of $190,000. With an interest rate of 9% and a term of 30 years, that size loan has a fixed monthly principal and interest (P&I) payment of $1,529. We ll assume the property value at origination was $237,500, making the original loan to value ratio (LTV) 80%. When this loan becomes delinquent the servicer must determine whether or not advances would be recoverable. This projection requires a home price change assumption as well as a default timeline assumption. Let s assume the delinquency, foreclosure, REO (real estate owned) timeline is 18 months from start to finish. Let s also assume that home prices remain unchanged from origination to REO liquidation. Each month during the 18-month default cycle that the servicer decides to advance, the servicer would take $1,529 from its balance sheet and pass it on to the trust in behalf of the borrower. Over 18 months the amount advanced by the servicer would be $27,522. The proceeds from the REO sale would be $237,500 since we ve assumed a flat home price scenario. Instead of passing on the full amount to the trust, the servicer would recoup its advances of $27,522. This is structurally possible due to the fact that the servicer s claim on the liquidation proceeds of this property is senior to all certificate holders claims. If the servicer believed such a projection, then it would be required to advance. The advances would be deemed recoverable. If we change our assumptions to a 36-month default timeline and home price depreciation (HPD) of 80%, then the servicer s decision changes. Under that scenario, liquidation proceeds would be $47,500 and total advances would be $55,044. If the servicer believed this was the most likely outcome, it would deem the advances unrecoverable and refuse to advance to the trust. For simplicity we have left out other important fees that would be generated in the foreclosure process, the eviction process, and the REO sale process. Typically these fees are projected and also impact the recoverability of advances. Servicers reimburse themselves through the collection of liquidation proceeds, late collections and/or insurance proceeds on the loan in question In the previous example we have seen how the liquidation proceeds can be used to reimburse the servicer for advances. Other alternatives for reimbursement are also available depending on the success of borrower-based resolutions (as opposed to collateral-based resolutions) and the presence of mortgage insurance. Repayment Plans If, for example, after six months of delinquency the borrower sets up a repayment plan with the servicer and that repayment plan were successful, then the servicer would be able to recoup its advances as follows: after six months of delinquency the servicer would have advanced $9,000 in behalf of the borrower. A typical repayment plan would involve the borrower putting 50% down on the delinquent amount and spreading the remaining $4,500 over five months. These payments would be over and above the regular $1,529 monthly payment. So the first month of the repayment plan the borrower would pay $6,029. During the final five months of the plan the borrower would pay $1,529 + $4,500 / 5 or $2,429 a month. Thereafter, the borrower s monthly payment would revert back to $1,529. From an advancing perspective, the $9,000 advanced by the servicer would be recouped over the six month repayment plan, thus making the advance justifiably recoverable. Modifications Repayment plans were formerly the most popular form of borrower-based loss mitigation. Recently the balance of repayment maximization loss mitigation strategies has been shifting to loan modifications. A common modification includes an interest rate reduction and a capitalization of missed payments. Extending our example, this would mean a new loan balance of $190,000 + $9,000 and an interest rate reduction of 2.5% per annum. The borrower would be granted a fresh start with a $199,000 loan, an interest rate of 6.5% and a monthly payment of $1,258. Moreover, the borrower moves from being six months delinquent to being current on the mortgage. Since such a strategy does not generate the additional cash flow necessary to repay the servicer for its advances, the servicer must look elsewhere. Once the loan is modified and moved from a delinquent status to current status, the servicer can recoup its $9,000 advance by accessing the cash flows deposited in the general collection account (the sum total of Winter

3 principal and interest paid by all borrowers in the pool of loans). Once again its claim on this pool is structurally senior to that of the certificate holders. Mortgage Insurance Finally, if our loan had mortgage insurance that would absorb the first 20% of loss, the servicer would have to account for this when determining recoverability. For example, in the 80% HPD, 36-month default timeline example above, the addition of mortgage insurance to the loan could have tipped the servicer s determination into the advances are recoverable camp. Proceeds would have been $47, % * $190,000, or $85,500. This amount is in excess of the $55,044 required to pay back the servicer for its 36 months of advancing. If a prior advance becomes unrecoverable then the servicer reimburses itself through the collection account The servicer and/or trustee maintain an account for the collection of payments on the pool of loans underlying an RMBS transaction. Monthly P&I payments, loan payoffs, liquidation proceeds, prepayment penalties, etc. are deposited in this account prior to being distributed to certificate holders. It is from this collection account that a servicer may reimburse itself for prior advances on loans that are no longer deemed recoverable. With a few exceptions the advancing requirement is in force on first-lien loans until the property is liquidated A small percentage of deals (10-15%) allow a servicer to stop advancing after 150 days of delinquency. If a servicer fails to advance then it defaults on its contractual obligation By now it is evident that the recoverability of an advance is highly dependent upon what happens to home prices and default timelines. Servicers have always had to make reasonably accurate home price projections and timeline projections to service their loans profitably. Arguably, they have never had to face so much uncertainty as they do now. They must incorporate the impact of many federal, state and local government driven bailouts and foreclosure moratoriums; extremely restrictive lending standards; home price declines that show no signs of leveling out; and record housing inventory levels. Needless to say, projecting home prices and default timelines three years into the future is an ambitious task. Thus it may be difficult for an observer to claim that a servicer has failed to comply with its contractual obligation by not advancing. Let s assume that an observer is successful in proving that a servicer failed to advance when it should have. The consequence would be a servicer default, and the trustee could either service the loans itself or assign a new servicer to the loans in the deal. The trustee and/or the new servicer are on the hook for any advances during this transition time as well as when the transition is complete. The terms of the contract (as it pertains to advances) do not change because of a default by the original servicer. Balloon payments and payments from borrowers in bankruptcy are generally not required to be advanced by the servicer If we assume that in our previous example we were dealing with a five-year balloon mortgage, then the balloon payout in month 60 would be $182,172. If the servicer were on the hook for advancing the balloon payment then it would take a much less dire HPD scenario to put that advance into the unrecoverable category. When a borrower files for bankruptcy, an automatic stay becomes effective immediately. During the time when the stay is in effect the borrower is protected from servicer collection and foreclosure efforts. In this period, a servicer s only means of communication with the borrower is through the courts. The courts serve as the intermediary to remit the borrower s payment to the servicer as well. For these and other reasons, the servicing documents typically do not require a servicer to advance on loans whose borrowers are in bankruptcy. II. Advancing Behavior How does an investor track advancing behavior? One approach is to poll servicers. An investor can ask about changes in funding levels on servicer advances, cash available on balance sheet to fund advances, whether or not servicer liquidity will affect the decision to advance, the percentage of the first-lien portfolio for which advances have been deemed unrecoverable, etc. This approach is unlikely to bear much fruit as servicers with difficulties are likely to paint a rosier than reality picture in the interest of survival. Winter

4 Another approach is to extract information from the monthly trustee report derived from the data a servicer sends. Each month the trustee generates a remittance report (remit) describing the cash flows, delinquencies, and losses generated by the underlying loans. This report can be pages in length depending on the trustee. A portion of the report describes the sources of cash flow and the distribution of cash flow. This portion of the report describes the amount advanced by the servicer for the period. However, the servicer advancing number on the remittance report at one prominent trustee has been described as inaccurate. It is a product of trustee accounting rather than an accurate depiction of cash pulled from the servicer s balance sheet for the period in question. Even if the remittance report s advancing number were accurate, it would be very tedious for an analyst to extract servicer level advancing trends from thousands of 200 page reports on a monthly basis. Fortunately, one more source of data is available to identify advancing behavior in loan pools. By analyzing loan level information investors can identify the loans that the servicer has decided to advance upon and, reciprocally, identify the loans on which the servicer has ceased advancing. An example will best illustrate how this is done. The following table contains recent monthly updates to a 100% combined original loan-to-value-ratio first-lien loan on a property outside Chicago, Illinois: Table 1: Loan level advancing example Date Delinquency Status Amortized Balance Closing Balance Servicer Advancing Principal Advanced Interest Advanced Jul-07 Current 359, , NA NA NA Aug-07 Current 359, , NA NA NA Sep , , Advance , Oct , , Advance , Nov , , Advance , Dec-07 Foreclosure 358, , Advance , Jan-08 Foreclosure 358, , Advance , Feb-08 Foreclosure 358, , Advance , Mar-08 Foreclosure 358, , Advance , Apr-08 Foreclosure 358, , No Advance 0 0 May-08 Foreclosure 358, , No Advance 0 0 Jun-08 Foreclosure 358, , No Advance 0 0 Jul-08 Foreclosure 358, , No Advance 0 0 Aug-08 Foreclosure 358, , No Advance 0 0 Sep-08 Foreclosure 358, , No Advance 0 0 Oct-08 Foreclosure 358, , No Advance 0 0 Nov-08 Foreclosure 358, , No Advance 0 0 Source: MetWest Loan Level Database At the loan level, two of the monthly fields reported by the servicer include: Amortized Balance and Closing Balance. The Amortized Balance is the unpaid principal balance on the loan in question based upon the assumption that the borrower (or the servicer via advances) makes all the required principal and interest payments on the loan. The Closing Balance reflects the true unpaid principal balance on the loan owed by the borrower. In amortizing loans that are current (not delinquent), both the Closing Balance and the Amortizing Balance decrease each month with the pay down of principal. In loans that are delinquent and on which the servicer is advancing, the Amortized Balance will decrease each month as the servicer passes on the P&I. In loans that are delinquent and on which the servicer is not advancing, the Amortized Balance will stay the same month over month. For all delinquent loans, both those advanced upon and those not advanced upon, the Closing Balance remains the same as it is intended to reflect the true liability of the borrower. The example in Table 1 indicates that the servicer advanced on this Illinois first-lien loan during the initial stages of delinquency and foreclosure. However, it stopped advancing beginning with the April 2008 reporting period. Winter

5 There are third party sources for loan level data that provide these loan level fields and allow advancing behavior to be tracked. However, the most prominent of these data providers releases data weeks after the monthly remittance report becomes available to investors. Because of lack of competition in the loan level data industry, there is little incentive to improve efficiency in data delivery. MetWest has created a proprietary loan level data loading system that gives us access to the loan level data just days after the remittance report is released. During the weeks that our competitors wait for delivery of loan level data, MetWest can generate advancing related reports that help us make investment decisions related to advancing behavior. What do recent advancing trends show? We can take the previous loan level example and use the methodology to identify the percentage of seriously delinquent loans for which the servicer has stopped advancing. We can observe that percentage change over time at the RMBS deal level and the servicer level. Recent trends indicate that servicers are advancing less than they did prior to the liquidity crisis and the downturn in housing prices. Figure 1: Percent of seriously delinquent first-lien loans not being advanced upon 50 Industry Deal X Servicer 1 Servicer % Jan-06 Apr-06 Jun-06 Sep-06 Dec-06 M ar-07 Jun-07 Sep-07 Dec-07 M ar-08 Jun-08 Sep-08 Dec-08 Source: MetWest Loan Level Database Industry The industry line represents the monthly average across more than 450 subprime RMBS deals originated during During the first quarter of 2006 servicers advanced on all but 0.39% of serious delinquent first-lien loans. That number has risen to 4.06% during the most recent quarter (Q3 2008). Servicer 1 Servicer 1 (owned by a large U.S. bank) has outperformed the industry advancing average. During the first quarter of 2006, Servicer 1 advanced on all but 0.07% of seriously delinquent first-lien loans. In the most recent quarter, that number has risen to 1.86%. Servicer 2 Servicer 2 is a publicly-owned servicer whose advancing patterns signal consistent underperformance versus the industry. However, during the recent distress that disparity has been magnified substantially. In the first quarter of 2006, Servicer 2 advanced on all but 0.40% of seriously delinquent first-lien loans. In the most recent quarter, that number has risen to an astounding 15.5%. Winter

6 Deal X This deal has drastically underperformed the average as the servicer has stopped advancing on over 45% of seriously delinquent first-lien loans. III. How We Analyze Indicator of financial distress MetWest believes that well-capitalized servicers will not hesitate to advance on virtually all seriously delinquent first-lien loans in both good times and bad times. MetWest also believes that poorly capitalized servicers will take advantage of the ambiguity in the recoverability rule when making the decision to advance or not advance during times of financial distress and home price depreciation. Servicers must finance their advances. Those financing costs cannot be passed onto the trust. It is costly to borrow money these days even for the most secure of cash flows. Moreover, with rising delinquencies, a greater portion of a servicer s balance sheet must be allocated to advances. A servicer that struggles in this area raises many questions. For example, if profitability is being constrained or solvency concerns emerge due to the cost of funding advances, will the servicer be willing to hire the additional staffing required to effectively service the rising pool of delinquent loans? Will the servicer invest in the technology necessary to keep up with the industry? Will loss mitigation incentive plans be strong enough to keep the team of loss mitigators well trained and motivated? Will the servicer prioritize borrow solutions based on profitability (i.e. focus on solutions that consume fewer servicer resources)? Will the servicer be accused of defaulting on its obligation and force the trustee to perform a servicing transfer? It is easy to see the kinds of red flags raised when a servicer s advancing behavior worsens relative to the industry. MetWest believes that servicing performance is compromised in such circumstances. Harbinger of high severities Financial distress cannot explain all of the rise in the advancing trends we have seen. In addition to the idiosyncratic servicer risk discussed, MetWest believes that the industry wide increase in percentage of seriously delinquent loans not advanced upon over the past two years is a reflection of servicers projecting longer default timelines and home price declines into their loan level modeling. Under these more distressed projections, even a well-capitalized servicer would push a higher percentage of severely delinquent loans into the unrecoverable category. This phenomenon helps to explain why Servicer 1, a relatively well capitalized servicer, would decide not to advance on 1.86% of their seriously delinquent first liens when at the beginning of 2006 that number was 0.07%. Figure 2 below further illustrates the point. Figure 2: Percent of seriously delinquent first-lien loans not being advanced upon 6 Industry Deal Y Servicer % Jan-06 Apr-06 Jun-06 Sep-06 Dec-06 M ar-07 Jun-07 Sep-07 Dec-07 M ar-08 Jun-08 Sep-08 Dec-08 Source: MetWest Loan Level Database Winter

7 Deal Y is serviced by the well-capitalized Servicer 1. Yet, on this deal the percentage of seriously delinquent loans Servicer 1 has decided not to advance upon is higher than the industry average and much higher than the Servicer 1 average. Instead of assuming servicer financial distress from the advancing performance of this deal we would conclude that this pool of loans will have higher than average severities relative to the rest of the pools that Servicer 1 and the industry service. The meaning in this divergence shouldn t be discounted as it reflects the servicer s own opinion on the pool of loans it is servicing. The servicer sees many more data points than investors. It observes how distressed borrowers across the country respond to its outreach attempts on a daily basis. If a well-capitalized servicer deems advances to be unrecoverable on a higher than average percentage of severely delinquent loans, investors would be well served to take note. Thus, it is not only important to have an opinion on the servicer of a pool of loans, we can gain additional information on the pool performance based on the servicers own projections as they manifest themselves in servicer advancing behavior. VI. Conclusions In this analysis we have shown that servicers have an obligation to advance on loans when they deem those advances recoverable. Servicer advancing behavior is best monitored through loan level data. MetWest has a time advantage when analyzing loan level, deal level and servicer level advancing trends and can make investment decisions accordingly. Industry advancing trends reflect financial distress at some servicers as well as an increase in loss severity expectations. All else equal, investors should minimize exposure to servicers that have stopped advancing on a relatively high percentage of first-lien severely delinquent loans. Investors should also minimize exposure to RMBS deals whose advancing trend is underperforming the well capitalized servicer s trend. Issue selection processes and tools illustrated throughout this presentation are samples and may be modified periodically. Such processes are not the only tools used by the investment teams, are extremely sophisticated, may not always produce the intended results and are not intended for use by non-professionals. Certain tools and databases are the proprietary property of the vendors mentioned. Investment strategies may not achieve the desired results due to implementation lag, other timing factors, portfolio management decision-making, economic or market conditions, or other unanticipated factors. The views and forecasts expressed in this material are as of the date indicated, are subject to change without notice, may not come to pass and do not represent a recommendation or offer of any particular security, strategy, or investments. Data displayed with this report represents the most current available at the time of publication. Subsequent data results, or release of different data, could lead to different conclusions, as could a differing view of the importance of certain data points. Securities discussed are not recommendations and are presented as examples of issue selection or portfolio management processes. They have been picked for comparison or illustration purposes only. No security presented within is either offered for sale or purchase. MetWest reserves the right to change its investment perspective and outlook without notice as market conditions dictate. While we have gathered this information from sources believed to be reliable, MetWest cannot guarantee the accuracy of the information provided. To receive a complimentary copy of MetWest s current Form ADV Part II, MetWest s proxy voting policies and procedures, or to obtain additional information on MetWest s proxy voting decisions, please contact MetWest s Client Services Department. You also may receive additional information by contacting MetWest s Client Services Department at (310) This presentation contains material that is protected, individually and collectively, by copyright, trademark or other proprietary rights of Metropolitan West Asset Management LLC or others as indicated. Winter