Beryl Credit Pulse on Structured Finance

Beryl Credit Pulse on Structured Finance This paper will summarize Beryl Consulting 2010 outlook and hedge fund portfolio construction for the structured finance sector in light of the events of the past two years. We will first provide an overview of the effect of the global crisis on US structured finance hedge fund managers with a particular focus on residential-mortgage backed (RMBS) and commercial mortgage-backed (CMBS) securities. Based on our analysis of credit fundamentals, we will identify areas of attractive return opportunity in this space for the next two years. Finally, we will construct several multimanager credit portfolios. The meltdown in US subprime RMBS, Alt-A RMBS and CMBS markets was one of the major contributing causes to the crisis. Poor credit underwriting standards combined with mortgage structures that proved to be unaffordable to borrowers led to rapidly rising delinquency rates, which translated into record foreclosures and a nationwide fall in housing prices. New origination for subprime RMBS, Alt-A RMBS and securitized CMBS largely ceased during 2008 and 2009, forcing structured finance managers to focus on managing 2005, 2006 and 2007 and earlier- deals that were trading at distressed levels. As a result, a number of hedge fund managers side-pocketed less liquid investments and/or imposed restrictions on client redemptions. Some managers, with less liquid portfolios which were well below their high water marks required to earn incentive fees, closed their funds to new investment and created new vehicles or share classes for future investors. US Structured Finance Market All structured finance markets came under stress during 2008 and 2009, starting with credit deterioration in RMBS and followed by increasing delinquencies and defaults and dramatic spread widening (fall in prices) across all asset classes. RMBS Performance Review - The US RMBS market can generally be divided into prime (borrower FICO score of around 720 or higher), Alt-A or mid-prime (borrower FICO score of around 680 to 720) and subprime (borrower FICO score below 680). The table below shows RMBS prices on selected securities at several points during the past two years: Hybrid Prime Alt-A Option Arm Subprime 30 year Fixed 15 year Fixed Hybrid 30 year Fixed 15 year Fixed Super Senior ABX 2006.2 LCF (last cash flow AAA) 1/31/2008 97 97 99 96 87 95 76 86 6/30/2008 85 93 94 84 69 91 60 69 12/31/2008 78 80 97 47 50 70 42 49 Mar 2009 lows 47 55 96 38 42 64 30 36 6/30/2009 62 70 98 50 56 78 43 31 12/31/2009 74 85 102 64 72 87 53 46 Source: Yieldbook, Amherst Securities 1 The Beryl Consulting Group LLC Credit Pulse, March 2010 All Rights Reserved

The dramatic markdowns in RMBS collateral were driven by both the deteriorating credit quality of the underlying mortgage pools and the significant reduction in liquidity caused by the crisis. Many hedge funds were forced to liquidate RMBS collateral at distressed prices in order to meet client redemption requests. Other financial institutions sought to reduce the size of their balance sheets or improve their capital ratios by removing RMBS collateral from their books. The primary drivers of deteriorating credit quality in the US securitized RMBS markets were: Falling Home Prices/Negative Equity Falling home prices left many homeowners with negative equity. The table below shows the percentage of negative equity in four types of non-agency securitized RMBS: Aggregate Private Label Securitized Universe RMBS Product Performance Status % of Product Balance Housing Price Decline Over 20% Equity 0 to 20% Equity 0 to -20% Equity Under -20% Equity % Negative Equity All Always Performing 59% (23%) 35% 24% 18% 24% 42% All Re-Performing 9% (39%) 19% 21% 19% 41% 60% All Non-Performing 32% (56%) 8% 15% 18% 58% 76% Prime Always Performing 89% (14%) 46% 24% 16% 14% 30% Prime Re-Performing 2% (25%) 32% 21% 19% 28% 47% Prime Non-Performing 9% (42%) 14% 19% 22% 45% 67% Alt-A Always Performing 66% (25%) 31% 24% 18% 26% 44% Alt-A Re-Performing 7% (40%) 18% 19% 19% 44% 63% Alt-A Non-Performing 28% (55%) 8% 15% 18% 59% 77% Option ARM Always Performing 47% (52%) 10% 18% 22% 50% 72% Option ARM Re-Performing 8% (66%) 5% 12% 18% 65% 83% Option ARM Non-Performing 45% (76%) 2% 8% 15% 75% 90% Subprime Always Performing 32% (22%) 32% 26% 17% 25% 42% Subprime Re-Performing 17% (34%) 22% 23% 19% 36% 55% Subprime Non-Performing 51% (50%) 10% 19% 19% 52% 71% Source: Loan Performance, Amherst Securities When homeowners have negative or minimal equity in their homes, they have an increased financial incentive to stop making their mortgage payments. From its peak in the second quarter of 2006 to its most recent report, the S&P/Case-Schiller Composite 20 Home Price Index, an index calculated from repeat sales of single family homes, was down 29.2%. An additional 8-10% drop in home prices is projected by market participants. 2 The Beryl Consulting Group LLC Credit Pulse, March 2010 All Rights Reserved

Option ARM Mortgages Option adjustable rate mortgages (Option ARMs) include provisions to reset the loan interest rate to a higher level. This can result in monthly payments that are dramatically higher and become unaffordable to the borrower. Pay-option adjustable rate mortgages (Pay-Option ARMs) include provisions that allow the borrower to have the option to choose their payment amount and delay payment of interest and/or principal. The amount of the payment deferment is capitalized onto the loan balance, thus reducing the amount of equity the borrower has in the home in an environment of stable or declining housing prices. This increases the likelihood that the borrower will default on the loan. Reduced Quality of Loan Underwriting Starting with the 2005- origination and escalating in the 2006 and 2007 s, credit standards for RMBS loan underwriting deteriorated dramatically. More stated income and interest only payment loans were included in mortgage pools. Appraisals used to determine eligible loan amounts became inflated. Fraud became more widespread as mortgage originators sought to maintain transaction volume after the best quality borrowers had already refinanced. Rising Unemployment Increasing job losses across all regions of the US left some borrowers unable to afford their mortgage payments. The US unemployment rate, which had been 4.4% as recently as May 2007 increased to 9.8% by February 2010. CMBS Performance Review Other structured finance asset classes also had dramatic price drops. The table below shows the prices of most rating classes (tranches) of CMBS securitizations fell dramatically from January 2008 through April 2009 before the prices on most rating classes recovered later in the year. AAA CMBS prices (CMBX 4-Annex Date 10/25/07) AJ (most junior AAA) AA A BBB BBB- BB 1/31/2008 93 84 83 80 63 56 47 6/30/2008 93 80 73 70 57 47 37 12/31/2008 70 38 32 32 24 22 17 April 2009 lows 65 23 13 13 11 10 8 6/30/2009 73 31 18 16 12 11 6 12/31/2009 83 51 31 24 17 16 5 Source: Markit 3 The Beryl Consulting Group LLC Credit Pulse, March 2010 All Rights Reserved

Some of the contributing factors to the decline in prices for CMBS securitizations include: Aggressive Structuring of Transactions More recent CMBS securitizations had lower required equity contributions than were sustainable in a declining US economy. Economic Downturn Results in Reduced Property Cash Flows As the US economy entered a recession, some businesses were unable to make their scheduled rent payments and replacement tenants paid a lower lease rate. Moody's projects those cash flows for commercial properties will reach a decline of about 20 percent across all property types and markets since the highs reached in early 2008. Declining Property Values Lead to Lower Default Recoveries Declining cash flows and reduced market liquidity led to lower recoveries on the sale of defaulted properties. The Moody's/REAL Commercial Property Price Index showed price declines of 42.9% from the peak of the market just two years ago. With the dramatic increase in delinquencies and fall in residential and commercial property values, the projected losses on RMBS and CMBS deals rated by the rating agencies were well in excess of what had been originally modeled. As a result, the rating agencies made large downgrade adjustments to many of their ratings on RMBS and CMBS securitizations. ABS CDO Performance Review The table below shows the estimated and actual default rates of various rating classes of ABS CDOs. CDOs of subprime mortgage-backed securities issued in 2005-07 Original Tranche Rating Estimated 3-year default rate Actual Default Rate AAA 0.0001 0.10 AA+ 0.01 1.68 AA 0.04 8.16 AA- 0.05 12.03 A+ 0.06 20.96 A 0.09 29.21 A- 0.12 36.65 BBB+ 0.34 48.73 BBB 0.49 56.10 BBB- 0.88 66.67 Source: Donald MacKenzie, University of Edinburgh, Dec 2009 4 The Beryl Consulting Group LLC Credit Pulse, March 2010 All Rights Reserved

ABS CDOs are re-securitizations of other structured finance asset classes, primarily tranches backed by subprime and Alt-A RMBS, and to a lesser extent, CMBS. The large magnitude of the downgrades in RMBS and CMBS tranches triggered the Event of Default tests in many ABS CDOs, which were calculated based on the rating levels of the underlying securities, resulting in the collateral in many of these deals being liquidated at distressed prices. The distressed collateral prices were so low that all but the most senior tranches of these ABS CDOs typically had zero recovery value. Distressed ABS CDO liquidations caused further downward pressure on RMBS and CMBS prices and caused many financial institutions to realize immediate and substantial losses on their ABS CDO portfolios. Current RMBS Credit Fundamentals The table below suggests that 12.75% of the 55.9 million homes in the US with a mortgage will eventually liquidate. These numbers encompass loans that are already delinquent. They do not capture loans that are current and will go delinquent going forward. Performing loans are going delinquent at a far more rapid pace than loans are liquidating. Category (seasonally adjusted) MBA Delinquency Survey % Probability of Liquidation (based on estimated cure rates) Probability Weighted Liquidation (delinquency x probability of default) Foreclosure 4.47% 100.0% 4.47% 90+ days delinquent 4.41% 98.3% 4.34% 60-89 days delinquent 1.67% 92.7% 1.55% 30-59 days delinquent 3.57% 67.0% 2.39% Total Distressed Inventory 14.12% 12.75% Number of Defaults (in million, based on 55.9 million homes) 7.89 7.13 Source: Loan Performance. Mortgage Bankers Association (MBA), Amherst Securities The following tables show how the average projected cumulative losses on subprime and Alt-A RMBS collateral are projected to exceed the credit enhancement that was built in to even the AAA-rated tranches of these securitizations. 5 The Beryl Consulting Group LLC Credit Pulse, March 2010 All Rights Reserved

Subprime RMBS (borrower with tarnished credit, FICO score below 680) 2005 2006 2007 Expected Loss at Origination based on historical observations Indicative Required Credit Enhancement Levels for Each Original Rating Level (factoring out credit given for excess spread) Moody's 1/15/10 Projected Cumulative Loss Rates (as % of Original Pool Balance) 19% 38% 48% 3.5-5% AAA 29% AA 21% Source: Moody's, Treesdale Partners A 15% BBB 11% BB 8% If current delinquency and housing price trends continue, it is possible that final cumulative subprime losses could approach 60% in some cases, with a range of around 30-60%. Alt-A (midprime) RMBS (includes stated income loans, non-conforming, 680 to 720 FICO) 2005 2006 2007 Expected Loss at Origination based on historical observations Indicative Required Credit Enhancement Levels for Each Original Rating Level (factoring out credit given for excess spread) Moody's 1/15/10 Projected Cumulative Loss Rates (as % of Original Pool Balance) 14% 29% 25% 0.75%-1.25% AAA 6% AA 3% Source: Moody's, Treesdale Partners A 2% BBB 1.25% BB 0.75% Alt-A RMBS average losses are projected to well in excess of average AAA credit enhancement for each of the 2005, 2006 and 2007 s. 6 The Beryl Consulting Group LLC Credit Pulse, March 2010 All Rights Reserved

Current CMBS Credit Fundamentals The table below shows that even though the average CMBS borrower is underwater from an equity standpoint (62% of loan to values (LTV) are greater than 100%), 83% of the properties are still generating enough cash flow to cover debt servicing costs (they have a debt service coverage ratios (DSCR) of 1.0 or greater). This indicates that the decline in net operating income (NOI) on the properties is less than the reduction in commercial property prices. LTV and DSCR Profile for the Securitized CMBS Universe Source: TreppLoan, OWS DSCR (Debt Service Coverage Ratios) below 0.85 0.85 to 1.0 1.0-1.15 1.15 to 1.30 1.30+ Total LTV 0 to 75 0% 0% 0% 0% 15% 15% 75 to 100 0% 0% 1% 2% 20% 23% 100 to 125 0% 0% 1% 5% 15% 22% 125 to 150 0% 10% 22% 1% 0% 33% 150+ 5% 2% 0% 0% 0% 8% Total 6% 12% 24% 8% 50% Moody's CMBS Conduit/Fusion November 2009 Loss Estimates By Vintage Source: Moody's, Treesdale Partners Vintage Expected Case Loss Stress Case Loss Average Original Credit Support, using CMBX as a proxy Weighted Average 1996 1.3% 1.9% AAA 30.0% 1997 3.5% 4.8% AA 10.2% 1998 4.0% 5.5% A 7.5% 1999 3.2% 4.6% BBB 4.5% 2000 2.0% 2.5% BB 2.5% 2001 2.2% 2.9% 2002 2.2% 2.9% 2003 2.0% 3.2% 2004 2.6% 4.4% 2005 4.0% 8.4% 2006 4.6% 12.2% 2007 5.4% 14.7% 2008 5.8% 15.7% 4.1% 11.9% Expected Loss at Origination=1.75%-2% 7 The Beryl Consulting Group LLC Credit Pulse, March 2010 All Rights Reserved

Under Moody s Stress Case assumptions, AA-rated CMBS tranches could, on average, suffer realized losses. Attractive Return Opportunities for US Structured Finance Although asset prices have recovered dramatically in many sectors of the structured finance market, the underlying credit fundamentals remain weak, if not distressed. Significant additional market price appreciation in most sectors is highly unlikely. Market liquidity has improved dramatically from the depth of the crisis in April 2009 with the US government, hedge funds, re-remic (re-securitization) issuers and Public Private Investment Program (PPIP) sponsors continuing to be purchasers of paper. Financing for private purchases has become more available. The Troubled Asset Relief Program (TALF), launched by the Federal Reserve in March 2009, offered cheap loans that investors used to buy newly created bonds backed by auto, credit card, student loan and equipment loan debt. It was created when the market for these asset-backed securities froze in 2008 when investors lost confidence in the collateral backing them. We believe the expiration of the TALF program in March 2010 is unlikely to have a major affect on the stronger issuers and higher quality bonds as these deals no longer rely on the TALF program. However, deals backed by floorplan, private student loan, retail credit card and subprime auto loans are likely to be more impacted by the expiration of the program, but they represent a relatively small part of new issue market. Home Affordable Modification Program (HAMP), part of the US Treasury s Home Affordability & Stability Plan, was designed to help at-risk homeowners by providing a framework for consistent handling of modifications. In our opinion, the HAMP program has been largely unsuccessful. Only 13% of the modifications include the principal reduction necessary for negative equity mortgage modifications to be effective. The re-default rates for HAMP loans 12 months after modification range from 41% to 65%, depending on the loan type. The credit fundamentals of RMBS are still weak. However, mortgage technicals are strong and therefore we believe will provide sufficient price support. The Financial Accounting Standards Board s (FASB) proposed position would allow other-than-temporary impairments (OTTI) to be marked to expected credit losses rather than expected fire sale prices. This suggests limited selling by regulated entities. If this relief was not forthcoming, rating downgrades would have triggered selling. In November 2009, the National Association of Insurance Commissioners (NAIC), chose Pacific Investment Management Company (PIMCO) of Newport Beach, California, to conduct a loan level analysis of more than 18,000 RMBS securities owned by US insurers. These PIMCO evaluations replaced rating agency ratings in determining how much capital insurers need to have to guard against losses on these investments. The PIMCO valuations projected lower losses than the ratings-based approach and this provided capital relief that further reduced insurance company pressure to sell these securities. The deposit base for US banks has grown by close to a trillion dollars since 2007. With interest paid on investor deposits near zero, there is a significant spread to be earned by investing in risk assets. This steady demand for assets should drive spreads tighter (prices higher), even in the face of some further deterioration in credit 8 The Beryl Consulting Group LLC Credit Pulse, March 2010 All Rights Reserved

fundamentals. Even if the Fed engages in tightening, there remains some Fed induced liquidity that is yet to be fully invested. This can provide price support for structured finance for the short to intermediate term. We have identified the following attractive return opportunities in structured finance for the next 12 to 18 months: Long Non-Agency Senior RMBS Tranches Current prices for non-agency senior RMBS tranches imply continued deterioration in the housing market. Even after the 2009 rally in these securities, market prices continue to reflect worse scenarios for home prices, defaults, recoveries and prepayments than are currently being observed. Public Private Investment Program (PPIP) managers provide another source of demand for these securities with close to $20 billion of purchasing power. The recently announced changes in the HAMP modification program focus on principal reduction for mortgages that, based on current appraisals, have negative equity. Owners of senior tranches of non-agency RMBS deals could see increased value in bonds trading at a discount if more modifications are successful and these mortgages are refinanced, resulting in these loans being repaid at face value. The securities that will benefit most will be those with high default rates and low dollar prices. Short CMBS The fundamental picture for CMBS looks as bleak as residential, but CMBS currently trades at least 500bps tighter than RMBS. Most CMBS are structured as balloon mortgages, and given that exiting refinancing is difficult to obtain compared with the pre-2008 market in which they were originated, the securities have very substantial rollover risk. There are more than $150 billion of loans bundled into CMBS that will come due between now and 2012. Long New Issuance Structured Finance Paper If new issuance of structured finance paper returns to the market in any significant volume in the future, and there are some signs it may do so, the significantly wider offering spreads combined with discount pricing will make the securities more attractive than the bonds offered pre-2008 and the level of credit enhancement for a given rating level will be greater. Idiosyncratic Opportunities The structured finance market has a number of sectors where the market significantly discounts intrinsic value due to complex structures, lack of liquidity, as well as lack of transparency. Examples of these securities include insurance receivables, manufactured housing bonds, rental fleet asset-backed securities, student loan auction rate securities and trust preferred CDOs. 9 The Beryl Consulting Group LLC Credit Pulse, March 2010 All Rights Reserved

Conclusion & Recommendation Hedge funds that focused their investments in structured finance collateral had, for the most part, a difficult year in 2008, but their returns generally recovered during 2009. For 2010 and beyond, manager focus will shift from market timing to security selection. Security selection, trading skill and risk management will be important determinants in generating acceptable returns during 2010 and beyond, as the delinquencies and projected losses on many of the pools backing subprime RMBS, Alt-A RMBS and CMBS securities are projected to be, on average, in excess of the credit enhancement available to cover those losses. Beryl believes it has selected a universe of potential managers that meets these criteria. A robust organization with institutional quality infrastructure is essential. When constructing its Structured Finance Hedge Fund Cohort, Beryl chose funds that focused primarily on US structured finance securities. The Cohort consists of 8 funds that invest on a long/short basis, often with a long bias, and typically utilize hedging as a significant part of their investment strategy. Beryl believes it has constructed a portfolio of managers that, based on their level of experience and quantitative tools, can generate above market average returns with lower volatility. The portfolio of US structured finance managers can be invested in as either a bespoke strategy or in combination with other hedge fund investment strategies. The portfolio can also be customized to meet investors investment objectives and liquidity requirements. For more information about our selection process and our selected candidate managers please contact john@berylconsulting.com or vidak@berylconsulting.com About the Author: John Sherman is Senior Advisor, Hedge Funds and Structured Products at the Beryl Consulting Group LLC. Mr. Sherman has twenty three years of combined experience in credit analysis, investment manager evaluation and selection, operations, portfolio construction, and risk management. Most recently, Mr. Sherman was a Consultant with the Alternative Investments Group at Silvercrest Asset Management, where he selected hedge fund managers for its funds of funds and private client portfolios and focused primarily on emerging market, corporate credit, and structured finance investment strategies. Prior to Silvercrest, he held positions with the Portfolio Strategies Group at J.P. Morgan Investment Management, Structured Finance Ratings at Standard & Poor s, and Bayerische Landesbank (Bayern LB), where he was a Vice President responsible for its CDO portfolio. Over the course of his career, he has performed due diligence on over 200 managers in the United States, Europe, and Asia. John has a BS in Finance from Lehigh University and an MBA in Finance and International Business from the Stern School of Business at New York University. 10 The Beryl Consulting Group LLC Credit Pulse, March 2010 All Rights Reserved