Merrill Lynch - Valuing Subordinate ABS

ASSET-BACKED SECURITIES
3 February 2006
Valuing Subordinate ABS

Introducing a New Risk-Adjusted Framework Based on
Home Prices
Contributors
Highlights
Kamal Abdullah
MBS Strategist, MLPF&S
(1) 212 449 9308
Kamal_abdulllah@ml.com
Akiva Dickstein
1) 212 449 1759
akiva_dickstein@ml.com
Shaolin Li
ABS Strategist, MLPF&S
1) 212 449 6891
Shaolin_li@ml.com
Sarbashis Ghosh
ABS Strategist, MLPF&S
1) 212 449 4457
Sarbashis_ghosh@ml.com
Jonathan Braus
1) 212 449 9728
jonathan_braus@ml.com
The role of home prices in the valuation of mortgage-backed securities has long
taken a back seat to that of interest rates. However, over the past few years, investors
have become increasingly aware of the significant impact of home prices on
performance, both in terms of prepayments and in terms of credit. This is most
pronounced in the sub-prime ABS market, where home prices may be the most
dominant factor in driving future performance, especially for subordinate securities.
This relationship has been brought to the forefront over the past several months, as
investors have sought to purchase protection in the ABS credit default swap (CDS)
market, against a downturn in the housing market. Yet, despite this flurry of activity
and exceptionally volatile spreads, there has been little consensus on the appropriate
approach to valuing these securities. In this paper, we present an innovative, optionbased approach to pricing this risk and understanding the implications of various
spread levels. In particular, we find the following:
Home price appreciation going forward may be weaker than it has been over the
past several years. Although hard evidence of a slowdown has been limited, the
most recent data seem to indicate that home price appreciation has decelerated.
Sub-prime mortgages are particularly sensitive to the rate of home price

appreciation (HPA). The rate of HPA affects prepayments, defaults, and loss
severities. Taken together, these findings imply that cumulative losses are
extremely dependent on the housing market.
Armed with the dependence of prepayments and losses on home prices, we are
able to calculate a price for each security in an ABS structure for any given
home price scenario. This immediately allows us to judge what home price
scenarios are required for an ABS subordinate to begin losing value.
Rather than choosing one home price appreciation rate, it is more reasonable to
assume a distribution of possible scenarios. We find that different home price
distributions correspond directly to various spread levels. Not only is the mean
of the distribution important, but also its standard deviation (or volatility). We
accordingly treat subordinate ABS as (short) options on home prices.
By reversing the approach and using observed market spreads to derive an

implied HPA distribution, we establish a calibration with which we can price the
HPA risk embedded in a range of securities. It also provides direct insight into
capital structure pricing and potential relative value opportunities.
In the process, we create a ABS valuation framework that incorporates home prices,
interest rates, and deal structure in a single option adjusted framework.
Merrill Lynch does and seeks to do business with companies covered in its research reports. As a result, investors should be aware
that the firm may have a conflict of interest that could affect the objectivity of this report.
Investors should consider this report as only a single factor in making their investment decision.
Refer to important disclosures on page 25. Analyst Certification on page 24.

Global Securities Research & Economics Group
RC#41403401
Fixed Income Strategy
Valuing Subordinate ABS 3 February 2006
CONTENTS
Section
Page
Section
Introduction
Section
II
Todays Housing Market
Section III
Home Prices and the Sub-prime Borrower
Section IV
Pricing Housing Market Risk Credit-Adjusted OAS
12
Section
Final Thoughts and Direction for Future Work
21
Refer to important disclosures on page 25.
1. Introduction
Over the past several months ABS investors have been grappling with
valuation issues, as spreads on subordinate securities (Baa3, for example)
widened by up to 200 bp in October before tightening back by more than 100 bp
toward the end of 2005 and beginning of 2006. Two factors precipitated much of
this widening: i) an increasing number of investors wanting to take positions
against the housing market and ii) the belief that ABS CDS1,2 (Asset-Backed
Securities Credit Default Swaps) was the best way to do so.
Although spreads have moved dramatically over the past few months, there
remains little consensus as to their proper level. Is a spread of 200 bp rich for
Baa3 ABS? Is 400 bp cheap? What is the appropriate spread level required
to fairly capture the risk inherent in these securities?
This paper will develop a methodology for answering these questions. Our goal
is to understand precisely what kind of housing market is implied by a
particular level of spreads so that we can make informed investment
decisions.
Home prices have a major

impact on prepays, defaults and
severities, and thus are a
dominant driver of cumulative
losses.
We begin by briefly reviewing housing market trends and show that recent data
have finally indicated that the housing market may be softening. We also discuss
some of the factors that may weigh on home price appreciation going forward,
including declining affordability and a negative media effect.
We then address the impact of home price appreciation (HPA) on sub-prime
borrowers and present a historically motivated model of prepayments, defaults,
and loss severities as a function of home prices. We show that home price
scenarios play a major role in driving all three of these variables, and thereby
serve as perhaps the most critical economic determinant of cumulative losses.
We can calculate the fair price

for any given HPA scenario.
Given that subordinate ABS performance is driven by cumulative losses, and these
losses are inherently driven by home prices, then valuations should depend
directly on home price appreciation.3 Consequently, we can calculate a fair
price on each subordinate security for any given home price scenario.
Introducing an option-adjusted
framework: valuing ABS using
a distribution of home price
scenarios.
Of course, it is difficult to project a single home price scenario with any degree of
certainty. Rather than project a single HPA scenario, we look at value across a
probabilistic distribution. We can take any home price appreciation distribution
and calculate the associated fair value spreads on subordinate securities. These
spreads can then be compared with market spreads to assess whether ABS
subordinates are attractive or expensive. Essentially, this approach represents the
introduction of an option-adjusted framework that puts home prices on near equal
footing with interest rates.
Market spreads can also be

used to imply a distribution of
home prices.
We can also reverse this approach: rather than choosing a home price
distribution and calculating fair value spreads, we can take market spreads
and calculate an implied distribution of home price scenarios. This framework
is analogous to the familiar option-based OAS approach used throughout fixed
income. Just as OAS employs a market-implied price for interest rate risk, this
approach does the same for HPA via the burgeoning market for ABS CDS. As
1
An ABS CDS swap is a synthetic contract between a protection buyer (shorting bonds) and seller
which is modeled after the eponymous, successful corporate contract. Sector and cashflow differences
have given rise to a PAYGO or PAUG structure which is better suited to ABS cashflows. There
are minor cashflow differences between ABS CDS and their cash equivalents including interest
shortfall payments. We ignore these minor differences here. For more information see Lang Gibson,
Structured Finance CDS & Implications for the CDO Market, April 27, 2005, Merrill Lynch
Research.
2
Most recently, trading has begun in ABX.HE a set of synthetic ABS indices that enable one to trade
baskets of single-name ABS CDS. This development further facilitates our proposed methodology by
creating generic and transparent spreads for different points in the capital structure.
3
ABS prices also depend on interest rates which are usually correlated with home prices. Deal
structure, on the other hand, is fully determined at issuance it is not a driver of valuation, but rather a
predictable translation table from drivers to bond cashflows.
swaps and swaptions imply forward rates and volatilities, market spreads on
mezzanine and subordinate ABS, by analogy, imply forward home prices and their
volatility. This implied distribution can be used to value other ABS and generate
rich/cheap relationships across the capital structure.
2. Todays Housing Market

A Spectacular Run for Home Prices, Especially in
Select Regions
Over the past decade, U.S. homeowners have enjoyed near continuous and, at
times, spectacular levels of home price appreciation. Geography has played a
determining role. We summarize home price appreciation by state according to
cumulative five-year HPA using the Freddie Mac/OFHEO repeat sales index
(Chart 1).4 The most recent HPA wave which started in 2004 has been even
more pronounced, with some states appreciating in excess of 25% per annum
while others have remained below 5% (shown in the percentages in Chart 1).
Chart 1: Home Price Appreciation by State
Most Recent
1-Year HPA
Five-Year Cumulative HPA

Red States
Yellow States
Blue States
12%
20-30%
30-60%
60+%
12%
19%
30%
25%
5%
Source: OFHEO
Is the Housing Market Slowing?

Reasons that the Housing Market May Slow
There are a number of reasons to suspect that the recent run in housing prices may
slow over the next few years. First, affordability is down (Chart 2).5 The
composite and first-time homebuyer indices were 138.4 and 80.9 respectively
during 2003. These readings have deteriorated to 117.8 (a 15% decline) and 68.4
(a 16% decline) as of 3Q2005 a direct result of higher home prices and interest
rates.
4
There are numerous methods used to gauge home price growth, each with its own idiosyncrasies and
shortcomings. For the purpose at hand, we simply employ the widely used OFHEO repeat sales index
which is calculated using selected properties that back agency conforming loans.
5
An affordability reading of 100 means that a family with the median income (U.S. Census) exactly
qualifies for a mortgage loan at the national average blended arm-fixed rate on a home valued the
median home price (FHFB).
Chart 2: NAR Affordability Index: Declining Affordability

160
140
120
Index
100
80
60
Composite
40
First-Time Buyer
20
Mar-05
Mar-03
Mar-01
Mar-99
Mar-97
Mar-95
Mar-93
Mar-91
Mar-89
Mar-87
Mar-85
Mar-83
Mar-81
Source: NAR
Could a negative media effect

also play a role in slowing the
housing market?
A second reason that housing could slow going forward is that the perception that
housing could slow going forward a perception that is growing in popularity. As
with any other asset, todays transaction prices are significantly shaped by buyer
and seller expectations of future prices. As sellers anticipate weaker prices ahead,
they are more inclined to negotiate. Buyers, similarly, are less likely to pay up. In
fact, a prevailing belief that the housing market is cooling undermines many a
buyers foundation that housing is a good investment. New buyers in particular
may feel that they can afford to wait, whereas in the past, many felt that if they did
not buy immediately, prices would only increase further. Most housing market
news presently is dedicated to questioning the housing markets sustainable
growth. For this reason alone, it might not be sustainable.
Some Hard Evidence of a Potential Slowing Has Finally Emerged
We have believed that factors such as affordability and market perceptions could
slow the housing market, but hard evidence was near absent throughout most of
2005. However, recent data suggest that the market may in fact be weaker than it
was several months ago.
Hard evidence of a slowdown

has been limited but may have
recently emerged.
For example, according to the NAR, existing single-family supply has been
climbing slowly throughout 2005 from 3.8 months (January) to 4.9 months
(November) almost reaching the indexs 10-year average value of 5.0 months.
Perhaps more importantly, home prices have actually given up ground over the
past few months, even when seasonally adjusted (Chart 3). Over the past six
months, the seasonally adjusted annualized rate of growth is now 5.4%, compared
with 8% for the prior six month period.
Chart 3: Even Seasonally Adjusted, Home Price Growth Has Flattened
Source: NAR, Merrill Lynch
3. Home Prices and the Sub-Prime Borrower

The movement in ABS spreads over the past few months can be tied to investor
indecision about the future direction of home prices. The volatility of the sector
also indicates that investors may be equally uncertain about the appropriate level
of spreads for the associated risk. The goal of this paper is to address this question.
In order to do so, we first must clarify the connection between home prices and
collateral performance.
The sub-prime sector is

especially sensitive to the
housing market.
The sub-prime sector is perhaps the only arena in the mortgage backed securities
market in which home price exposure dominates that of interest rates. On the
prepayment side, lower credit borrowers display significant sensitivity to home
prices. They generally have fewer financial resources beyond their home and have
come to rely on its appreciation to fund other financial obligations through cashout refinances. The recent strong housing market accompanied by agreeable
interest rates led sub-prime borrowers to extract home equity through cash-out
refinancings at a record pace in 2004. Deals backed by 2003 vintage loans
routinely have been prepaying at 40-50 CPR (or more) during the past year,
despite no obvious rate incentive. On the credit side, strong home prices have
similarly kept defaults low, as borrowers who could no longer afford monthly
payments were more likely to sell the home and pocket any built up equity rather
than default on the loan and relinquish the property.
With home prices mainly rising,

how do you quantitatively
determine their impact?
We are interested in quantifying the relationship between prepayments and

defaults on one hand and home prices on the other. It is impossible to do this on a
national level because the housing market has been too strong. Simply put, the
sub-prime market has yet to be proven in a nationally weak housing market. This
is very fortunate for borrowers and investors, but somewhat unfortunate for
researchers!
Use a horizontal analysis to

tie HPA to loan performance
This relationship, though, can still be addressed through the use of a horizontal
analysis in which HPA variations by geography correlated with local loan
performance serve as a proxy. For example, if two pools with identical
characteristics (FICO, LTV, grade ) were located in Texas and California, the
performance of each would be tied to local HPA. If Texas and California pools
prepay at 25 CPR and 50 CPR respectively, the disparity would be attributed to
differences in state level HPA (say 4% and 20% per annum).6
We utilize this approach using Metropolitan Statistical Area (MSA) level home
prices and performance. We provide historical sub-prime prepayments and
defaults by HPA level (Charts 4a & 4b). We have included all securitized subprime loans originated between 1999 and 2005.7,8
6
This approach has two shortcomings. First, other relevant variables at the geographic level are
subsumed in to the HPA variable (unemployment, etc). Second, loan performance in a national
housing downturn could be unlike that observed locally. Nonetheless, the horizontal analysis of HPA is
the only empirically available method of extracting home price driven performance.
7
The average LTV = 80%, the average FICO = 618, 75% of the loans have prepayment penalties, and
the product mix is 25% FRM / 55% 2/28 Hybrids / 20% Other. The observation period is 1999-2005.
8
The additional structure visible is due to inclusion of all loan types (fixed, 2/28s, 3/27s, all penalty
types.)
Chart 4a: Historical Subprime Prepayments by Age and HPA

< 2.5%
5%
10%
15%
20%
80
70
60
CPR
50
40
30
20
10
0
3
12
15
18
21
24
30
36
48
60
Age (months)
Source: Merrill Lynch and Loan Performance
CDR
Chart 4b: Historical Subprime Defaults by Age and HPA

< 2.5%
5%
10%
15%
20%
16
14
12
10
8
6
4
2
0
3
12 15 18 21 24 30 36 48 60
Age (months)
Defaults are defined as 90+ days delinquent

Subprime performance goes

hand-in-hand with home price
appreciation.
The sensitivity of sub-prime loan performance to home prices is astounding. A

pool exposed to 15% HPA versus flat home prices prepays 20 CPR faster.
Similarly, by month 36, the same pool would be defaulting at only 8 CDR instead
of 12 CDR.
An interesting observation involves the < 2.5% HPA and 5% HPA buckets.
Although both prepay at nearly the same speeds, they exhibit marked default
differences with age. This makes sense because there is a financial threshold
below which cashout refinances are not feasible. Nevertheless, just 5% equity
growth per year materially reduces default likelihood.
High HPA low loss severity.
Loss severity, like prepayments and defaults, is a crucial ingredient when

accounting for deal performance. As can be seen, HPA profoundly shapes it as
well (Chart 5).9
9
The observed loss severity seasoning curve can be explained for newer loans by
Chart 5: Loss Severity versus Home Price Appreciation

50
Loss Severity (%)
45
HPA < 2.5%
40
HPA=5%
35
HPA=10%
30
HPA=15%
25
HPA=20%
20
15
10
5
3
12
15
18
21
24
30
36
48
60
Age (months)
The are several reasons for this dependence of severity on HPA:
Faster prepayments arising

from high HPA also minimize
cumulative losses
Resale environment recovered properties are more easily resold in a strong

market, reducing upkeep and servicer corporate advances.
Process time the period from foreclosure to resale can typically require
anywhere from 6 to 18 months. Any home price appreciation during that
period applies directly to the homes value and diminishes severity
accordingly. In high HPA environments (e.g., recent California experience),
this can give rise to near zero severities.
Resolution method how the property is transferred and ultimately sold is

also influenced by home prices. Less costly methods such as a short sale or
deed-in-lieu of foreclosure make more sense to both borrowers and lenders in
a strong housing environment.
These factors prepayments, defaults, and severities interact and nonlinearly

contribute to cumulative loss. As higher HPA accelerates voluntary prepayments,
loans that would otherwise fail are able to refinance / payoff and thus make the
investor whole. Fewer loans default anyway and those that do experience lower loss
severities. We schematically show this compounded HPA sensitivity (Chart 6).
10
The underlying property is still near appraisal value.

The property has spent limited time on its way to foreclosure.
Total advances are lower.
Chart 6: A Schematic of Deal Losses and Home Prices

High HPA
Faster
Prepayments
Fewer
Defaults
Lower
Loss
Severity
Lower
Losses
Deal
Structure
Source: Merrill Lynch
We provide historical cumulative sub-prime losses by HPA and loan age in Chart
7. The underlying data are the same as those in Charts 4a and 4b.
Chart 7: Cumulative Loss versus Age by Home Price Appreciation
7
HPA=1.5%
Investors concerned about

losses should focus first on the
housing market.
Cum Loss (%)
HPA=5%
HPA=10%
HPA=15%
HPA=20%
3
2
1
0
3
12
15
18
21
24
30
36
48
60
82
Age (months)
11
4. Pricing Housing Market Risk Credit

Adjusted OAS (COAS)
Relating HPA Scenarios to ABS Spreads
We now turn to the critical
question: How do we relate
HPA to spreads?
The analysis in the previous section revealed that housing price appreciation
plays a major role in determining sub-prime cumulative losses prepayments,
and enabled us to quantify the relationship between the two. The next key
step is to relate these findings to an understanding of ABS spreads.
Because ABS prepayments and losses are directly related to home price
appreciation, there is validity in the concept of buying protection on ABS CDS as
a way of making a bet that home price appreciation will decelerate. However,
buying protection (shorting a bond) has a cost: the spread on the security must be
paid. In the Treasury market, at a given price, even bearish investors might be
induced to own a security for its yield. In the mortgage market even those who
believe that prepayments are increasingly efficient will take the convexity risk at
the right price. The same should be true for a sub-prime subordinate bond and
home price risk. Given any prior beliefs about the direction of the housing market,
there is some price or spread where a bonds expected value is acceptable. The
question before us, then, is how to value a subordinate security given its
exposure to home prices.
In one sense, this task is far more challenging than determining the impact of
interest rates on MBS. Interest rate risk has long been tamed quantitatively via
familiar financial tools such as term-structure models and OAS, both of which are
predicated on the existence of a liquid interest rate derivatives market. By contrast,
there has been no such market for home prices,10 though the Chicago Mercantile
Exchange will begin trading home price futures as of 2Q06.11
Three approaches to the

valuation question.
ABS CDS are indirect bets on

home prices their spreads
indicate implied home price
expectations.
Our approach is three-pronged:
First, we will use the information in the previous section to value ABS
securities under any given home price scenario. This allows investors with
a firm view of future home prices to choose bonds appropriately.
Second, we will use a distribution of these home price scenarios to price

the ABS securities. This is a risk-based pricing approach that allows us to
balance the spread and the risk on these securities. We will show how
choosing the mean and standard deviation of the distribution plays a major
role in subordinate valuation, and discuss the concept of viewing subordinate
ABS as options struck on home prices.
Finally, we will examine the concept of using the ABS CDS market to
imply a distribution of home prices. In purchasing protection, an investor is
buying insurance. The spread paid is therefore the price of risk. We can find
the distribution of home prices which best fits the observed pricing of
subordinate CDS. We can then use this distribution to derive a rich/cheap
relationship across the credit spectrum.
A Reference Deal
In order to be concrete, we choose a reference deal that is representative of recent
sub-prime production in terms of collateral, structure, originator-servicer
reputation, and ratings coverage. Ameriquest 2005-R5 is triple rated by Moodys,
10
As such, housing market risk has not been diversifiable a risk that is readily measured and is
explicitly hedgable. In economics, an investor is not compensated for taking such risk. To illustrate, a
Agency CMO buyer might compare bonds on an OAS basis and then use swaps to dynamically hedge
the purchased bond. A subprime BBB buyer, on the other hand, has had no simple way to hedge home
price exposure and accordingly could not price the risk.
11
http://www.cme.com/trading/prd/env/housingover16250.html
12
S&P, and Fitch for all classes in the deal. We detail the lower mezzanine structure
and collateral backing it in Tables 1a & 1b.
Table 1a: Ameriquest 2005-R5 Mezzanine Structure
Class
Senior Classes
M6
M7
M8
M9
M10
Subordinate Classes
Moodys
Coupon (bp) Cash (bp) ABS CDS (bp)
A3
Baa1
Baa2
Baa3
Ba1
70
122
135
175
300
80
140
185
300
725
80
135
190
300
765
Initial Size
C/E
1.26%
1.01%
0.96%
0.55%
0.55%
4.70%
3.70%
2.75%
2.20%
1.65%
Market spreads as of 11/24/05

Source: Ameriquest, INTEX, and Merrill Lynch
Table 1b: Ameriquest 2005-R5 Collateral

ARM / Fixed
Owner Occ
SF / PUD
Avg FICO
Orig LTV
Full Doc
IO
CA
Avg Loan Size
81% / 19%
98%
90%
613
77%
75%
9%
15%
$150k
Source: Ameriquest, Bloomberg
Focus on lower mezzanine

classes.
We restrict our attention to the lower mezzanine (A3 and below) capital structure
because the performance of these classes is most sensitive to home price
appreciation in the region of common interest. Home prices would have to drop
dramatically in order for the A1A (Aaa rated) class to incur a loss a possible,
albeit very unlikely, event. The lower mezzanine classes, on the other hand, are
more sensitive to future home prices.
Having chosen our example transaction, we are now ready to discuss our three
approaches to valuation.
Capital Structure Valuation Under Static Pricing

Our first approach (which will also be used as a stepping stone for the later
approaches) is to value each security under the spectrum of possible HPA
outcomes. To do this, we use the collateral models from the previous section;
specify the HPA scenario and interest rate assumptions along with a discount
margin to statically price a given bond.12
12
Its imperative that one not confuse the various components involved in pricing. The external drivers
(interest rates and home prices) represent the risks. The models (prepayment, default, delinquency, and
loss severity) are predetermined functions that map rates and home prices into collateral cashflows.
Finally, the deal structure (fully determined and available via INTEX) allocates these cashflows among
the bonds contingent on rates and collateral performance.
13
Chart 8: Pricing using HPA, Interest Rates, and a Discount Margin
DM
HPA
Prepayments
Defaults
Delinquencies
Int Rates
Deal
Structure
Price
Loss Severity
Throughout this approach, we discount cash flows at LIBOR flat (discount

margin = 0). At first glance, this might seem surprising given that subordinate
ABS offer significant margins. However, if we were to use the bonds stated
margin, we would find that in scenarios where the bond does not incur a loss, the
price is todays market price, but the price is significantly lower at times when the
bond incurs a loss. In other words, prices would have nowhere to go but down.
We believe this is not only awkward but also misses the point: subordinate ABS
investors earn handsome margins by accepting the risk of losses. In scenarios
without losses, the value of a L+300 security should be greater than its initial
market price in order to balance those in less favorable scenarios.13
In Chart 9, we calculate the prices of the various securities in the capital structure
as a function of HPA assuming a fixed LIBOR of 4.5%.
Chart 9: Bond Price versus HPA for fixed LIBOR
140
120
Bond Price
100
How does the capital structure

stand up to home prices?
80
M6 (A3)
M7 (Baa1)
M8 (Baa2)
M9 (Baa3)
M10 (Ba1)
M11 (Ba2)
60
40
20
0
-15%
-7%
-3%
1%
5%
HPA
9%
13%
13
This approach is also analogous to interest rate derivatives, in which a term structure model is
adjusted so that each security has 0 OAS.
14
Chart 9 reveals the breaking point for each bond in the capital structure. The
more complex features arise from the interaction of the collateral model with the
deals structure.14
This simple approach significantly extends the usual first-loss coverage multiple
analysis. Rather than calculating just a single multiple of the default model at
which a bond incurs its first dollar of principal loss, we can size up precisely what
levels of HPA lead to bond price declines and principal losses. The impact of
structure is readily seen.
Dont go below Baa2 if you

expect flat home prices.
For example, if one anticipates flat home prices (HPA=0%), an investment

portfolio containing Baa2 and above credit is recommended.
Toward a Risk-Based Pricing Methodology

Introduce an option framework
to price risk.
While Chart 9 gives us the value of each security in a given home price scenario, it
makes more sense to value a security across a range of possible home price and
interest rate scenarios, just as we value interest rate options or mortgages using a
distribution of interest rate scenarios.
To do this, we combine the calculation of the bonds price under each scenario
(we did this in the previous section) with a probability of such a scenario
occurring. The option-adjusted price of the bond will then be the probabilityweighted average of the prices across the various scenarios. We therefore require:
a prescribed interest rate distribution
a prescribed home price appreciation distribution
a correlation between these two15
We present a schematic of the option adjusted pricing method in Chart 10.

Chart 10: Option Adjusted Price From Rate and HPA distributions
Forward HPA
probability distribution
Either we specify or
infer from ABS CDS /
ABX.HE
Calculate option adjusted price

from HPA and interest rate
probability distributions.
Correlation
Option
Adjusted
Price
Forward interest rate

probability distribution
(already known from
usual term structure)
Each scenario
uses modeled
cashflows

14
With lower HPA, losses increase and prepayments decline causing bonds to extend and rely on
overcollateralization when available. Ultimately, under sufficiently weak HPA, write-downs ultimately
extinguish the bonds.
15
Home prices and rates may be inversely correlated, at least locally. As rates rise, homes become less
affordable and demand accordingly wanes. As rates fall, demand increases. This correlation is relevant
because typical deal structures involve moving parts that are codependent on rates and collateral
prepayments and defaults, both of which depend on home prices. Because home prices are a direct
input in this approach (instead of estimating them from interest rates using the correlation), correlation
specification is less critical.
15
One of the two risk dimensions in Chart 10 is already known. Forward LIBOR and
its volatility (probability shape) are well determined by the familiar capital
markets instruments and can be applied directly. The home price distribution can
either be specified a priori or inferred from ABS CDS (next section).
Investor Beliefs and Pricing
A housing Bull and Bear
We now consider two hypothetical investors: a housing Bull and a housing

Bear. The Bear anticipates a distribution of housing prices centered around 4%
HPA per year, while the Bull more optimistically predicts a distribution centered
around 11% HPA per year a continuation of recent trends. Both claim a
reasonably modest uncertainty of 7%. Chart 11 compares HPA expectations.
Chart 11: Housing Bear and Bull HPA Outlook
Expected Home Price Appreciation

Bullish HPA
7%
Bearish HPA
6%
Probability
5%
4%
3%
2%
1%
0%
-15
-5
5
HPA (%)
15
25
will have different views of

whether spreads are attractive.
How would these two interpret the actual market portrayed in Table 1a? Given
their different projected home price distributions, each would calculate a different
fair value price for the securities. In other words, while the two investors may
agree on the price of the security under any given home price scenario, they
weight those scenarios quite differently and as a result arrive at very different fair
value (or option-adjusted) prices. We can translate these fair value prices into a
breakeven or fair value spread at which each investor finds the market cash
prices fair. We show the actual spread along with the Bears and Bulls
breakevens in Table 2.
Table 2: Housing Bear and Bull Breakeven Spreads (Volatility=7%)16
Class
M6
M7
M8
M9
M10
Moodys
Market Cash
Market ABS CDS Bull B/E Spread Bear B/E Spread
Price $
Spread (bp)
(bp)
(bp)
10
137
A3
99-21
80
Baa1
99-19
135
24
236
Baa2
98-04
190
82
481
Baa3
95-25
300
184
778
359
1170
Ba1
86-02
765
Rich
Cheap

16
16
as of November 29, 2005
When the breakeven spread is above (below) the cash spread, the bond appears
rich (cheap). In this example, the Bull finds all bonds cheap while the Bear finds
all bonds rich.
Impact of Volatility: Thinking of Subordinate Bonds as Options
Volatility (uncertainty) is an
essential component in risk
valuation.
In the above example, we found that the Housing Bear believes that all of the
bonds are expensive at current levels. Yet, under a 4% HPA scenario (Chart 9)
the Bears mean HPA the Baa2 and even the Baa3 security incur no decline in
price. Why then do they appear so rich according to the Bear? The answer lies not
in the Bears mean of 4%, but in the significant tail of the Bears distribution
(Chart 11, left side). The significant probability that HPA could be lower than 4%
is what makes the Bears distribution indicate that spreads are too tight.
This implies that we need to consider not only the mean of the distribution,
but also its standard deviation. In the prior example, we used a standard deviation
of 7%. What would happen if we reduced this to 4%, thus tightening both
distributions?
The Bull now finds the Baa3 extremely cheap, as it is trading at DM of 300 bp, but
its fair value is 24 bp. Even the Bear, who previously thought that the Baa3
should be trading at 778 bp, would now be content with a spread of just 562 bp
(Table 3).
Holders of subordinate ABS are

writing put options on home
prices.
In fact, with a 4% volatility, the Bear actually believes that the A3 and the Baa1
classes are cheap. Lowering the volatility materially reduces the likelihood of
these classes incurring losses. The Baa1 only begins to lose value at an HPA of
around -4% per year; with the lower volatility this scenario is two standard
deviations below the 4% mean of the Bear (Chart 11).17
Table 3: Housing Bear and Bull Breakeven Spreads (Volatility=4%)
Class
M6
M7
M8
M9
M10
Moodys
A3
Baa1
Baa2
Baa3
Ba1
Market Cash Market ABS CDS Bull B/E Spread Bear B/E Spread
Price $
Spread (bp)
(bp)
(bp)
1
-19
99-21
80
99-19
135
-2
2
98-04
190
0
208
24
562
95-25
300
86-02
765
101
1105
Rich
Cheap
We begin to consider
subordinate ABS as short
options on HPA.
Having introduced HPA volatility into the analysis, we can now think of
subordinate ABS as being short options on home prices. Remarkably, if we
review Chart 9 and consider the shape of the price distribution for any given class,
we find that it remarkably resembles a put option on HPA (with a few structural
nuances). Consequently, it makes sense that subordinate securities, as with interest
rate options, should be valued using a volatility assumption for home price
scenarios. Each bond in the capital structure corresponds to being short a put
option with a different strike in HPA space. The Ba2 class is struck closest to-themoney and accordingly offers the greatest spread in return for the greatest risk.
17
As volatility drops, there can even be scenarios in which the Bear would pay more for a bond than
the Bull; indeed, this is shown in the A3 pricing in Chart 9, where the Bear believes the bond is worth
L-19 while the Bull has L+1. The reason is that while both believe that writedowns are highly
unlikely, the expected price of this class is higher at 2% HPA than at 11%. This effect is due to bond
extension arising from lower prepayments and deal paydown rules. In other words, the Bear is
compensated for his HPA brinkmanship he expects HPA to be much lower than it is today but is
confident that it will not go negative by much under this volatility assumption.
17
Market Implied Home Prices

An Analogy With Swaptions: Using CDS to Derive an Implied HPA
Distribution
In the prior section, we imposed our own views of the distribution of HPA
scenarios and calculated fair value spreads, which we then compared with actual
market spreads. However, how are we to know the appropriate distribution of
HPA scenarios? In this section, we consider using the market itself to reveal the
implied distribution.
Readers familiar with interest rate derivatives will immediately recognize this
problem as very similar to the daily calibration of forward curves and implied
volatility to fit observed rate levels and swaption and cap prices. The implied
forward rate curve is not guaranteed to be realized rather it is a convenient
representation of the markets current price for interest rate risk.
The crucial step: infer the

market implied HPA
distribution from ABS CDS
spreads.
In order to apply a similar methodology to home prices, we simply need a family

of spreads referencing different bonds in a single deal, such as the one in our
example; this provides adequate information to deduce a market-implied HPA
distribution. By analogy to the Black model for interest rates, we employ a
normal distribution to model market implied HPA. Using forward interest rates
and volatility from the swaps market and fitting the HPA mean and standard
deviation accordingly, we arrive at an implied distribution of HPA scenarios that
best fits the current ABS spreads.
We label the option-adjusted framework that prices the risk arising from home
prices as well as that arising from interest rates as COAS Credit and (Rate)
Option Adjusted Spread. 18 Both home prices and interest rate expectations are
implied by market prices.
The ABS CDS market implied

HPA is centered about 8% per
annum.
It turns out that the distribution that best fits ABS CDS spreads in our example has
a mean of 8% and standard deviation of 7%, situating it right between our Bull
and Bear investors.19 The three distributions are shown in Chart 12.
Chart 12: Market Implied Home Price Appreciation
Implied Forward HPA
Bullish HPA
7%
6%
Bearish HPA
Probability
5%
4%
3%
2%
1%
0%
-15
-5
5
HPA (%)
15
25
18
Credit used in this context refers to home prices and all correlated drivers of borrower default. Note
also that we allow interest rates to vary as well as home prices. We also allow for correlation between
rates and home prices, with higher rates implying lower rates of growth for home prices, as has been
suggested by empirical evidence.
19
as of November 29, 2005.
18
This outcome is surprisingly reasonable. ABS CDS spreads are primarily

determined by the balance between synthetic CDO originators sourcing synthetic
collateral and, on the other side, macro hedge funds buying protection thereby
shorting the consumer. The true valuation of these spreads is quite complex: it
requires a model for prepays, defaults, and losses in terms of home prices and
interest rates as well as a model for translating those relationships into price terms.
Yet despite this complexity, the current market equilibrium appears to be at least
roughly in the realm of reasonableness. Of course, aggressive ABS CDS
protection buyers, including some macro hedge funds, might find an implied 8%
( = 6.8%) HPA distribution is far too optimistic. They, accordingly, may want
to purchase protection at todays levels.
Capital Structure Arbitrage
Capital structure relative value.
Once the market implied HPA distribution is determined and prices are generated
for each attachment point in the capital structure, comparison to actual prices
provides a natural relative value framework within the capital structure. In
particular, the residuals from the fits used to build the HPA curve provide a rich /
cheap analysis framework. This is because the HPA curve above is the best fit on
average across all the tranches. There remain residual errors on individual
tranches: some appear too tight (rich) while others appear too wide (cheap). We
identify arbitrage opportunities in Chart 13, using pricing (Table 1a) and implied
HPA distribution (Chart 12). The rich/cheap amount in basis points is on the left
hand y-axis and denoted by bars. The overall spread levels are denoted by the line
and presented on the right hand y-axis.
Chart 13: Quantitative Capital Structure Arbitrage
100
900
80
800
700
40
600
20
500
0
-20
-40
-60
A3
Baa1
Baa2
Rich / Cheap
CDS Spread
Baa3
Ba1
400
300
CDS Spread (bp)
Rich / Cheap (bp)
60
200
-80
100
-100
-120
0
Class
Sell Baa3, buy Ba1 or Baa1.
The Baa2 and especially the Baa3 classes appear rich. This is not a surprise given
the CDO bid for the two classes. At the same time, the Ba1/Baa3 swap appears
170 bp cheap.20,21 One could buy the Ba1 and buy protection on the Baa3 a
positive carry trade, albeit with financing considerations.
Another way to take advantage of the Baa3 richness would be to own Baa2s and
Ba1s versus Baa3s; this also is a positive carry trade which only loses in the
narrow band of scenarios in which the Ba1 incurs losses but the Baa3 remains
mostly whole.
20
We caution that AB CDS spreads were volatile during this analysis and marking an accurate Ba1
spread is difficult due to infrequent trading.
21
Due to funding issues, this cash swap should always be cheap. Typical repo haircuts for the Baa3
class are 15%-25% where as that for the Ba1 are closer to 30%-40%. In theory, one would execute both
legs synthetically by selling protection on the Ba1 and purchasing protection on the Baa3.
19

Housing Risk Metrics
The Greeks for housing?
Now that we have presented subordinate bonds as short options and derived an
implied distribution of HPA scenarios from current pricing, it makes sense to
consider the next step. In dealing with interest rate options, we usually consider
their risk in terms of duration, convexity, and vega. Suppose we applied a similar
approach to subordinates, but rather than calculate the exposure to interest rates,
we calculate the exposure to home prices. These metrics applied at the portfolio
level would provide a windfall of valuable exposure information to todays
investor.
We provide an example using our reference deal and the implied HPA distribution
determined in the previous section (Chart 12). The duration (delta) is the
percentage change in a securitys price for a 1% change of the mean of the
distribution, while the gamma represents the convexity associated with moving the
mean by 1% up relative to 1% down (Table 4).
As expected, the ABS are all long delta on HPA they all benefit from a rise in
HPA and all are negatively convex relative to HPA they lose more for a 1%
decline in HPA than they gain from a 1% rise. This is makes sense given that they
are effectively short put options.
Finally, the vega gives the percent change in option-adjusted bond price for a 1%
increase in the standard deviation; as can be seen, the Baa3 has the most vega as
well as the greatest gamma.
It is possible that the spread widening toward the end of 2005 reflected changing
investor views on both the mean and standard deviation of the HPA distribution:
as investors became more bearish on housing and more uncertain about its future,
the price of subordinate ABS declined.
Table 4: HPA Risk Measures
Class
M6
M7
M8
M9
M10
Moodys
A3
Baa1
Baa2
Baa3
Ba1
Price ($)
99-21
99-19
98-04
95-25
86-02
Spread (bp)
80
135
190
300
765
HPA Delta HPA Gamma

0.6%
-0.19%
1.0%
-0.28%
1.9%
-0.38%
3.0%
-0.42%
4.0%
-0.36%
HPA Vega
-1.3%
-1.9%
-2.6%
-3.0%
-2.6%
These risk measures could be used in a number of different ways.
20
They represent the response of the security to changes in perceptions of the

housing market. In our view, the prices of subordinate bonds should move as
new housing data become available. Of course, changes in HPA are not as
apparent as changes in rates, but on days when home price information is
released, we believe subordinate prices should move. So far, we have not
seen this kind of response in the market, but perhaps that is no surprise as this
methodology is relatively new.
These exposures can be used for constructing trades which are durationneutral not only to rates but also to home prices. Eventually, we might want
to calculate similar measures for agency securities as well. For example,
agency IOs have negative HPA deltas a decline in HPA would slow down
speeds and raise the value of the IO. This immediately suggests that
subordinate ABS could be an appropriate hedge for agency IOs; calculating
accurate HPA deltas and gammas would be critical for determining a hedge
ratio.
5. Final Thoughts and Direction for

Future Work
Final Thoughts
Our main findings concerning this new approach to understanding and valuing
subordinate ABS securities are summarized below.
Sub-prime prepayments, defaults, and loss severities are all highly correlated
with home price appreciation. Consequently, cumulative losses for a given
pool are driven in large part by HPA. Using these relationships, we can value
subordinate securities under different HPA assumptions.
Imposing a weighting on HPA and interest rate scenarios generates an optionadjusted fair value price for each security. This price, in turn, implies a fair
spread on the security for the chosen distribution.
We explore the impact of different distribution means and standard deviations

on valuation, and suggest that investors begin thinking of subordinate ABS as
being short options on home prices.
As a further step, letting the market imply an HPA distribution is similar to

the approach taken with other types of options. An implied distribution
captures the markets pricing of risk and, to some degree, its expectations.
These techniques readily lend themselves to quantitative relative value

recommendations.
This approach naturally sheds light on capital structure arbitrage and relative
value across different tranches. It also allows the calculation of risk exposures
to the housing market.
We hope this discussion and analysis has helped investors gain a better
understanding of ABS subordinates. We plan to work on putting this analytical
framework into automated production in order to track and value a wide variety of
ABS. The recently introduced liquid benchmark ABX index is likely the best
source for calibrating an implied HPA distribution. In addition to these goals, we
believe that there remain a number of possible avenues for further research, and
we now turn to a discussion of these.
Directions for Future Work

There are many possible avenues for further work along these lines. Here we
explore five: i) ABS relative value; ii) cross-sector opportunities; iii) further study
of implied and actual HPA distributions; iv) the prospect of a full Monte Carlo
simulation; and v) exchange traded HPA futures and options.
ABS Relative Value
In this paper, we have developed a new methodology for the valuation of ABS
spreads in a single transaction. By considering collateral, structure, HPA, and
interest rates in an unified framework, we back out an implied home price
distribution given market spreads. As we continue to build our capabilities in this
area, we would like to apply the same technique to a wider variety of structures,
seasoning, and collateral. We suspect that this approach will illuminate some very
interesting relative value opportunities.
A good application is the calculation of fair payups for seasoned bonds, say
between 2004 and 2005 vintage deals. The more seasoned bond would have lower
current LTV and greater subordination, but slightly less structural integrity given
tighter rating agency 2005 rate stresses. Credit-Adjusted OAS would capture the
impact of each in a form that is most appropriate, namely price. It would also
provide a quantitative window on the impact of rating agency guidelines.
21

Cross Sector Possibilities
Beyond the realm of just ABS, there are possibilities for the extension of this
framework to other areas of the MBS market. Thus far, residential ABS CDS
trading has been restricted to sub-prime transactions. However, home price
information gleaned from spreads using sub-prime models could be useful in
valuating other sectors as well. As an illustration, one could use the implied HPA
distribution extracted from ABS CDS spreads and apply to non-agency
subordinate MBS. In theory, investors could also use the implied HPA
distribution to project a distribution of prepayments on agency pass-throughs or
derivatives. In either of these endeavors, there would certainly be challenges, as
different models could give rise to biases, and the two markets have very different
participants. Nevertheless, adapting and transferring housing market information
embedded in ABS CDS to other sectors may be well worth pursuing.
Further Study of the Implied and Historical HPA Distribution
In calculating the implied HPA distribution from ABS spreads, we made the
simplified assumption of a normal distribution. This could potentially be
incorrect. After all, interest rate traders and researchers still debate over normal or
log-normal rate distributions, even with a quarter century of data and wisdom. We
did test a few other distributions and found few differences in the resulting
valuations.
An even more interesting topic, in our view, is the relationship between the
implied HPA distribution and the actual, historical distribution. Chart 14 shows
the historical distribution of home price appreciation rates for the U.S. since 1980.
The data are recorded quarterly and represent year-over-year HPA.
Chart 14: Historical HPA for the United States (1980 2005)
20
USA
USA Fit Normal
# Periods
15
10
= 5.7%
= 2.8%
20%
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
-2%
-4%
-6%
Year-over-Year HPA
Source: Merrill Lynch, OFHEO
Comparing the historical distribution to the implied in Chart 12, we find that
todays implied HPA volatility of 7% is more than twice the historical average
over the past 25 years. The implied mean of 8% is also higher that the historical
average of 5.7%. This makes sense: the nation has just enjoyed a sustained period
of high HPA and is at a juncture characterized by uncertainty.
Generally speaking, when implied volatility exceeds actual volatility one
considers selling options, e.g., buying subordinate ABS in our case. However, we
also see that the historical mean of 5.7% is below the implied 8% in Chart 12; this
suggests the opposite trade. The risk measures presented in Table 4 can help
quantify these issues, but we plan to develop this analysis further in future work.
22
It may also be important to consider differences in home price behavior across

geographical regions. As we discussed in earlier, regional differences have
dominated home price behavior across the U.S. The historical standard deviation
of home price appreciation rates in California over the past 25 years has been far
greater than that of the Midwestern states. This may be due to many factors, but
one of them is almost certainly the fact that the supply of land in many areas on
the coasts is limited. Consequently, changes in demand associated with variables
such as income, rates, or consumer confidence will have a greater impact in these
areas than in areas where land is more readily available. We compare year-overyear historical HPA volatility for Ohio and California in Chart 15.
Chart 15: Historical HPA for Ohio and California (1980 2005)
40
OH
Ohio
= 4.5%
= 1.3%
35
# Periods
30
25
CA
OH Fit Normal
CA Fit Normal
California
= 7.1%
= 8.6%
20
15
10
30%
27%
24%
21%
18%
15%
12%
9%
6%
3%
0%
-3%
-6%
Year-over-Year HPA
Source: Merrill Lynch, OFHEO
These types of comparisons and the exposure of the different tranches to both the
mean and the standard deviation could also create some interesting opportunities
for relative value. For example, Ba1 securities are particularly sensitive to the
mean of the distribution because even some low level of positive HPA could bring
these closer to losses. On the other hand, Baa1 securities are more exposed to the
standard deviation, because it is only in the tail of the distribution that they incur
losses, and a lower standard deviation suggests a lower likelihood of a negative
HPA regime. Perhaps one should look for Baa1 and higher-rated securities with
higher concentrations in the low volatility Midwest areas of the country.
Toward a Full Monte Carlo Simulation?
Although we have moved toward a probabilistic HPA approach, we are still using
only static interest rate and HPA scenarios. A stochastic implementation, on the
other hand, would allow home prices and rates to vary over time. It would include
valuable whip-saw scenarios in which both risks vary in time and interact with
bond structures. This would be more analogous to the standard Monte Carlo
simulation approach used for OAS in MBS and CMOs.
Although there are certainly advantages to moving to a Monte Carlo approach,
there are some reasons not to leap to this stage as well:
First, our current approach is more transparent, easier to understand, and

better adapted to the manner in which ABS trade today: static spreads and
speeds. Given that a probability-weighted HPA approach is completely new
to the ABS market, we might not want to go for the full black box approach in
which the results are sometimes more difficult to grasp intuitively.
23
Second, the calibration of a home price term structure model is likely quite
difficult. After all, unlike interest rate derivatives, existing ABS CDS (or for
that matter existing cash ABS) are not available for an arbitrarily chosen
forward time period. Different models could yield quite different results; for
example, whether HPA is mean reverting or not could become an important
question. Another question is whether one should run HPA series purely on a
national level or on a regional level; if we choose the latter there will be
issues of the correlation between the regions and their individual volatilities.
Nonetheless, a Monte Carlo simulation could be a reasonable next step at some

point in the future.
Potential for Using Traded HPA Futures; The Analogy to MBS
In this paper, we derived an implied HPA distribution from the market prices of
ABS CDS, making an analogy to the common practice of calculating implied
interest rate volatility from the market prices of caps and swaptions. It would be
even more convenient, however, if we could obtain the implied HPA distribution
not from ABS CDS, but rather from an external source that directly references
home prices. When the Chicago Mercantile Exchange begins to trade home price
futures, this may become a real possibility if that market becomes sufficiently
deep and if an options market develops.
If this does become reality, then the treatment of housing risk and interest rate risk
would be nearly symmetric. We would derive both from their respective derivative
markets.
This would greatly enhance the current methodology. Given only one source of
securities which depend on HPA distribution, we are forced to choose between
imposing our own distribution (based on view or history) or using the CDS
spreads themselves to imply a distribution. Neither approach allows us to take an
independent, market implied distribution and assess the Credit-Adjusted Spread of
the ABS based on that distribution. This, in fact, is the standard approach in
valuing MBS, and would be a very exciting development in our view.
The authors would like to thank Tim Isgro for his valuable contributions to
this work.
Analyst Certification
We, Kamal Abdullah, Akiva Dickstein, Shaolin Li, Sarbashis Ghosh and Jonathan
Braus hereby certify that the views each of us has expressed in this research report
accurately reflect each of our respective personal views about the subject
securities and issuers. We also certify that no part of our respective compensation
was, is, or will be, directly or indirectly, related to the specific recommendations
or view expressed in this research report.
24
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and liquidity in the fixed income markets.
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ASSET-BACKED SECURITIES

Valuing Subordinate ABS

Sub-prime mortgages are particularly sensitive to the rate of home price

By reversing the approach and using observed market spreads to derive an

Refer to important disclosures on page 25. Analyst Certification on page 24.

Fixed Income Strategy

Valuing Subordinate ABS 3 February 2006

Todays Housing Market

Home Prices and the Sub-prime Borrower

Pricing Housing Market Risk Credit-Adjusted OAS

Final Thoughts and Direction for Future Work

Refer to important disclosures on page 25.

Valuing Subordinate ABS 3 February 2006

Home prices have a major

We can calculate the fair price

Market spreads can also be

Refer to important disclosures on page 25.

Valuing Subordinate ABS 3 February 2006

Refer to important disclosures on page 25.

Valuing Subordinate ABS 3 February 2006

2. Todays Housing Market

Five-Year Cumulative HPA

Is the Housing Market Slowing?

Refer to important disclosures on page 25.

Valuing Subordinate ABS 3 February 2006

Chart 2: NAR Affordability Index: Declining Affordability

Could a negative media effect

Hard evidence of a slowdown

Refer to important disclosures on page 25.

Valuing Subordinate ABS 3 February 2006

Chart 3: Even Seasonally Adjusted, Home Price Growth Has Flattened

Source: NAR, Merrill Lynch

Refer to important disclosures on page 25.

Valuing Subordinate ABS 3 February 2006

3. Home Prices and the Sub-Prime Borrower

The sub-prime sector is

With home prices mainly rising,

We are interested in quantifying the relationship between prepayments and

Use a horizontal analysis to

Refer to important disclosures on page 25.

Valuing Subordinate ABS 3 February 2006

Chart 4a: Historical Subprime Prepayments by Age and HPA

Chart 4b: Historical Subprime Defaults by Age and HPA

Defaults are defined as 90+ days delinquent

Subprime performance goes

The sensitivity of sub-prime loan performance to home prices is astounding. A

High HPA low loss severity.

Loss severity, like prepayments and defaults, is a crucial ingredient when

Refer to important disclosures on page 25.

Valuing Subordinate ABS 3 February 2006

Chart 5: Loss Severity versus Home Price Appreciation

Loss Severity (%)

HPA < 2.5%

The are several reasons for this dependence of severity on HPA:

Faster prepayments arising

Resale environment recovered properties are more easily resold in a strong

Resolution method how the property is transferred and ultimately sold is

These factors prepayments, defaults, and severities interact and nonlinearly

The underlying property is still near appraisal value.

Refer to important disclosures on page 25.

Valuing Subordinate ABS 3 February 2006

Chart 6: A Schematic of Deal Losses and Home Prices

Source: Merrill Lynch

Investors concerned about