T To:

Kevin Fry, Chair of the Valuation of Secu n r urities (E) T Task Force Mem mbers of the Valuations of Securities Task Force V o

F From: Bob Carcano, Sen Counsel, SVO C nior Eric Kolchinsky, Consultant to the NAIC (RMBS) K C Tim Leaycraft, Consultant to the NAIC (CMBS) L C Hanc cook Lee, An nalyst II, SV VO D Date: Octob 16, 2012 ber 2 SVO Report Final Recomm mendations - Assumption Scenarios and Risk W ns, s Weights for t 2012 the Year-End Financ Modeling Project. cial g _ ___________ __________ ___________ __________ ___________ __________ ___________ __________ ______ R Re: 1 1. Intro oduction After consid A dering the te estimony pro ovided by A ACLI repres sentatives on the call n h on Octo held ober 4, 2012, and review , wing submitte data and c ed comments w found no argument th would we hat c cause us to modify our previous rec m p commendatio The Q& docume contained in Attachm ons. &A ent d ment One r responds to the commen made and the questio we recei t nts d ons ived. We re eproduce, im mmediately b below the r recommenda ations contai ined in the original mem o morandum to the Task F o Force dated September 26, 2012 a entitled Proposed Macroeconom Assump and M mic ptions and S Scenarios to be used for the Year E 2012 r End R RMBS and CMBS Financial Model C ling Project. We request that a mee t eting be sche eduled to ad dopt final c criteria so we can begin the modeling effort for this year end e t g t d.
4 4. Baseli scenario assumptions - The Task Fo ine a orce, in consul ltation with co onsultants to th NAIC and SVO staff he r recommends th the baseline scenario used by a well-res hat e d spected third-p party forecaste should serve as the baselin scenario er e ne f both the RM for MBS and CMB modeling process. Each of the vendors will adjust th modeling parameters to reflect the BS p s heir s same underlyin macroeconomic assumptio ng ons. T table below outlines som of the param The w me meters of the baseline scenario o: Pa arameter Ca Shiller Nati ase ional HPI (Inde 2000Q1 =10 ex 00) Un nemployment rate r Co onsumer Price Index (Index 1982 84 =100 I 0) GD (2005$ Ann DP nualized Grow wth) 2012 Q1 (actual) 127.3 8.3% 228.4 2.0% 2014 Q4 2 (Fore ecast) 138.8 8 6.6% % 243.8 8 4.4% %

T underlying scenario assu The g umes a slow economic recove with a sligh further deter ery ht rioration in res sidential home prices and a slow improve ement in emplo oyment rate in the economy. The baseline scenario represents the medi scenario an carries a ian nd 5 50% and 55% probability wei p ighting for RM and CMBS respectively MBS S, y. 5 5. Other scenarios In addition to the baseline scenario, each of the vendo will model the securities under the r o h ors s f following upsi ide and down nside scenarios.

2012 RMBS Scenarios Aggressive Baseline Conservative Most Conservative

Probability 10% 50% 25% 15%

Timing of Trough Q4 2011 Q4 2011 Q1 2023 Q1 2024

Peak to Trough HPA -34% -34% -37% -60%

Peak to 12/2013 HPA -26% -31% -36% -39%

2012 CMBS Scenarios Aggressive Baseline Conservative Most Conservative

Probability 10% 55% 25% 10%

Timing of Lowest Trough Q1 2010 Q1 2010 Q1 2010 Q1 2014

Peak to Peak to Peak to Trough Secondary 12/2016 Prices Trough -32% -32% -32% -34% N/A -18% -26% -34% -15% -17% -22% -27%

The final losses will be a probability weighted average of valuations across all scenarios. 6. Quality Assurance/Control

In addition to PIMCO Advisory and BlackRock Solutions extensive internal quality control process, the SVO and consultants will conduct quality control checks of the valuation process. These checks will help to ensure that the valuation process is of the quality required. The SVO will run both aggregate quality analytics and randomly sampled CUSIP-specific bottoms-up assessments. Additionally, the SVO has confirmed that PIMCO Advisory and BlackRock Solutions have appropriate procedures in place to ensure that the analysis is free from conflicts of interest.

Attachment One Questions and Answers Document 2012 Year End Project Staff Response to Industry Comments on Proposed Macroeconomic Assumptions, Scenarios and Weightings for Year End 2012 RMBS Q: Housing scenarios that result in a Most Conservative housing price projection that is 4.5 times worse than the average of the five most pessimistic housing economists (out of 103 surveyed) and more than double the single most stressful housing scenario outlined by wall street housing economist models. A: The ACLI claims that the most conservative scenario we used is much too conservative. We believe their analysis over-focuses on this one scenario. The objective for the Task Force and the industry is to ensure that the SVO proposal is reasonable. The only way to evaluate whether a financial model will generate reasonable results is to consider all of the scenarios that are to be used and their relative risk weightings. If one chooses to focus on the Most Conservative scenario one must acknowledge that it is one of four scenarios and that the contribution of the Most Conservative scenario to the overall impact is modified by the other scenarios and the relative weighing assigned to them. The purpose of the scenarios is to divide the future into probable outcomes. In this framework, stress scenarios are intended to stress the present, while aggressive scenarios are meant to be euphoric about the future. Focusing on any one scenario to the exclusion of the others ignores how each scenario supports the others and leads to improper conclusions. A more specific concern with the question is that it compares the average of five base case scenarios to our Most Conservative scenario. Methodologically speaking, this is not an appropriate comparison. The survey data which the ACLI references in this question discusses the mean, i.e., the average (or base case) only and not all other possible cases. To illustrate why this is not an apt comparison, one would not use a survey of prices for economy airline tickets as a reliable measure for what one will have to pay for a first class airfare on a similar flight. Despite the above considerations, we took the opportunity to review the survey and conclude it confirms our initial recommendation that the scenarios we chose are reasonable. Specifically, we found that our Most Conservative scenario is similar to the worst Base Case scenario in the June survey. Consider that banks and other research firms typically provide only one stress scenario in addition to their Base. Since we are using four scenarios we would naturally need to consider how to relate our scenarios to theirs. When we conducted this exercise, we concluded that the stress scenarios referenced by the ACLI is most analogous to our Conservative scenario. Nevertheless, based on the data provided by the ACLI, we find that our Conservative scenario is more optimistic than or similar to all but one of the sample stress scenarios. We derive an added level of confidence in our recommendations because the Conservative and Most Conservative scenarios proposed for 2012 were generated in the same way we have generated them in prior years beginning with 2009 and we note no one has previously expressed concern about this aspect of the process.

Q: Recent market data has shown that the housing recovery is upon us. Why are you being so conservative? A: The recommendations we have made and the modeling process we would conduct for 2012 incorporates the most recently available view of economic conditions: the Base case scenario used in the process is optimistic and incorporates over 20% HPA growth through 2016; the updated PIMCO model incorporates a superior methodology with respect to mortgage loan modifications and the modeling process will use updated loan performance data which will reflect the most current performance. Q: The impact on the 2005-2007 vintage. 82% of 2005-2007 bonds will be hit with higher capital charges A: While many of these bonds will have a small change in the intrinsic price, it is simply not the case that they will be hit with higher capital charges. We estimate that RBC as a percentage of BACV will increase from 3.3% to 4.2% for these vintages a modest increase when you consider that the 20052007 RMBS vintages are the worst performing vintages and are the securities which were at the heart of the financial crisis. In fact, these vintages account for about 92% of all losses captured by the process. And, they account for about 68% of all the BACV held by insurance companies. Furthermore, we estimate that approximately 14% of 2005, 24% of the 2006 and 31% of 2007 vintages (by BACV), respectively, will have an adverse change in designation. Conversely, approximately 9%, 9% and 6% of the respective vintages will have a more favorable designation. That said, higher capital charges would only be triggered if the insurers use of carrying value under SSAP No. 43R caused the holding price to go over the new breakpoints. Q: Certain participants used aggregated data provided by NAICs capital markets bureau to calculate the impact of the weightings and believed that the impact was greater than that provided by the SVO. A: The noted discrepancy is not difficult to explain. Our estimate uses detailed data: i.e., nearly 30,000 individual positions (per company/per CUSIP/per BACV) to generate an estimate of RBC impact. The commentator used aggregate data provided in the April 11th, 2012 Capital Markets report to generate 6 proxy bonds to measure RBC impact. The SVOs impact estimate is vastly more precise because it uses: a) detailed position information b) individual CUSIP results of the new PIMCO model and c) accurately applies RBC methodology to each position. CMBS Q: Fundamental performance today is reflective of the current economic environment and of some of the excesses of legacy issuances from the peak of the market. A: The delinquencies and losses we see today largely stem from legacy issuance from the markets peak years. After having risen for five consecutive months, the delinquency rate has declined for the past two months, and we would expect that decline to continue as the 2012 maturities work their way through the pipeline. Defaults from post-2008 CMBS issuance have been negligible.

Q: Underwriting standards have decreased recently but are not comparable to the more optimistic standards seen at the peak of the cycle; to some extent, re-leveraging of the CMBS market acts as a credit positive by allowing more loans to successfully refinance. A: Post-crisis issuance has shown negligible collateral default activity, and while underwriting standards have declined, they are nowhere near the excesses seen at the markets peak. Q: Issuance and pricing of CMBS has become more bullish in recent months, a rational reaction to improved CRE valuations and historically stimulative monetary policies.

A: Increased issuance and pricing of CMBS are a natural consequence of stimulative monetary policies. While we agree that these factors are positive and supportive of increased CMBS lending capacity and more successful refinancing outcomes for marginal loans, we believe there to be a reasonable likelihood that the rally cannot be sustained given the lagging pace of recovery in CRE assets and the lackluster prospects for the drivers of near term CRE performance. Q: Please provide additional detail on the nature of the perceived incremental downside risk.

A: SVO recommendations address a concern not reflected in the commentators comment letter: i.e., we are about to enter a period of large waves of CMBS and real estate loan maturities written at the peak and at the values then prevailing. To be specific, we anticipate that in the period between 2015 2017, more than $340 billion will mature. This level of maturity experience represents approximately 65% of all outstanding CMBS. Avoiding potentially massive maturity defaults and liquidations will require growth in property level net operating income (largely a function of rents), and an increase to the capacity of fixed rate capital sources. The risk we see is that it is not clear today whether both of these requirements to a successful maturity refinance transition will materialize. Consider that office and retail (strip centers and regional malls) account for just over 60% of all CMBS loans. According to REIS (a commercial real estate research firm), 4Q2012 vacancy rates for both office and retail have been stuck near cyclical highs. Not surprisingly, this persistent vacancy has produced minimal opportunities for landlords to raise rents. As shown in the table below, office and retail rents have increased by less than 1.5% year over year, lagging the trailing 12-month inflation rate of 1.7%.

Vacancy Current Peak

Increase -0.50% -0.2% -0.7% $ $ $

Rents Current 1 Yr. 28.23 $ 19.05 $ 39.24 $ 27.84 18.97 38.81

Increase 1.4% 0.4% 1.1%

Office Strip Centers Malls

17.1% 10.8% 8.7%

Source: REIS

17.6% 11.0% 9.4%

In our assessment we recognized that measured by pricing and issuance, the CMBS market is healthier today than it was last year, when it was largely shuttered by the risk-off trade stemming from the Euro and US fiscal crises. However, we conclude that the CMBS market is no more stable today than it was last year, and far less stable than it was presumed to be when the 2011 economic assumptions were formulated, just prior to last summers market turmoil. We see an ample list of potentially disruptive domestic and world events on the horizon, any one of which could potentially shut down the CMBS market. With commercial real estate performance on a flat trajectory, the CMBS market proving itself subject to highly disruptive shocks, and simply with less time in which to grow clear of the coming wave of loan maturities, we deem it reasonable to conclude that downside risk for CMBS relative to last years assumptions has clearly increased.