Met West Overview
Met West Overview
I. TCW Overview
This publication is for general information purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy, any security. Any holdings of a particular company or security discussed
herein are under periodic review by the portfolio management group and are subject to change without notice. In addition, TCW manages a number of separate strategies, and portfolio managers in those
strategies may have differing views or analysis with respect to a particular company, security or the economy than the views expressed herein. An investment in the strategy described herein has risks,
including the risk of losing some or all of the invested capital. Before embarking on the described investment program, an investor should carefully consider the risks and suitability of the described strategy
based on their own investment objectives and financial position. Past performance is no guarantee of future results.
The information contained herein may include estimates, projections and other “forward-looking statements.” Due to numerous factors, actual events may differ substantially from those presented herein.
TCW assumes no duty to update any such forwardlooking statements or any other information or opinions in this document. Any information and statistical date contained herein derived from third party
sources are believed to be reliable, but TCW does not represent that they are accurate, and they should not be relied on as such or be the basis for an investment decision.
Any issuers or securities noted in this document are provided as illustrations or examples only, for the limited purpose of analyzing general market or economic conditions, and may not form the basis for an
investment decision. TCW makes no representation as to whether any security (or the security of any issuer) mentioned in this document is now or was ever held in any TCW portfolio. TCW is not
recommending the purchase, sale or holding of any security and is making no representation or indication of its own holdings of any securities. TCW may in fact be currently recommending the purchase of a
security or the sale of a security regardless of any statement made in this document about that security or whether TCW owns it or not. Discussion of securities in this document are strictly for educational
use only and are not intended to serve as investment advice. Any statement made in this document, including any statement or implication drawn from any discussion of individual securities, is subject to
change at any time, without notice.
Copyright TCW 2010
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I. TCW Overview
TCW Overview
• Over $115 billion under management or committed to management as of December 31, 2010
• TCW staff of 614 individuals, including 378 investment and administrative professionals***
• The TCW Group, Inc. is an indirect majority-owned subsidiary of Société Générale, S.A.
• TCW offers strategies that invest in major world equity, fixed income and alternative markets, with offices in Los Angeles and New York
* Investment advisors registered with the Securities and Exchange Commission under the Investment Advisers Act of 1940. Other registered investment advisor entities are also included in the TCW Group.
** Number reported semi-annually, as of December 31, 2010.
***Assistant Vice President and above.
3 PREShgf386 1/19/11
TCW Assets Under Management – By Products Offered
or Committed to Management as of December 31, 2010
Total Assets: $116.2 Billion U.S. Fixed Income Assets: $64.6 Billion
Government/Corporate
Investments ($1.7)
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Fixed Income Products
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Fixed Income Team History & Evolution
• Robert A. Day founder • Headquartered in Los Angeles, California • 614 Total Employees
• Acquired by Société Générale in 2001 • Grows to $50+ Billion in Fixed Income assets under management • 149 Investment Professionals
• 618 Employees
• 57 Fixed Income Investment
• Fixed Income team established in 1976 • 192 Investment professionals Professionals
• Broad capabilities in mortgage-backed securities, • 76 Fixed Income Investment professionals
government, corporate, emerging markets, and
non-dollar debt
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Fixed Income Expertise
As of December 31, 2010
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Representative Client List
As of September 30, 2010
The clients listed are invested in one or more investment strategies and are selected either because of their inclusion in the 2010 Money Market Directory or with express written consent by the client. Inclusion on this list
should not be considered an endorsement of the investment advisor or services rendered.
8 PREShgf386 1/19/11
II. Fixed Income Investment Philosophy
U.S. Fixed Income Investment Philosophy
Philosophical Tenets:
• Fixed income markets/securities are mean reverting
• Technical factors can temporarily drive pricing away from fundamentals
• Persistent inefficiencies in fixed income market can be exploited through disciplined research and bottom-up
issue selection
10 PREShgf386 1/19/11
Investment Process
Long-Term Quarterly
Economic Outlook
Mean reversion
Patience
• Duration Management Monthly
Discipline
• Yield Curve Management
Understanding of macro risks
• Sector Management
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Duration Management
Duration Strategy
Defensive Outlook Index Positive Outlook
Fast Growth Trend Growth Slow Growth
Higher Rates Rates Stable Declining Rates
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Yield Curve Management
Yield
– Expectations versus forward curve
Barbell
6%
– Yield versus convexity trade-off Return
Barbell 6.17%
– Total return analysis 5%
Maturity
Flattening Scenario
8% Bullet
Current Return
7% 7.39%
Yield
One Year
Barbell
6%
Return
7.97%
5%
Maturity
Steepening Scenario
8% Bullet
One Year
Return
7%
Current 7.39%
Yield
6%
Barbell
5% Return
5.49%
4%
Maturity
Scenarios presented do not represent current conditions and are illustrative only.
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Sector Management
Average Annual Return by Investment Horizon Average Annual Return by Investment Horizon
(Looking Back from 2008) (Looking Back from 2009)
15% 13.74% 60% 58.21%
Source: Barclays Capital Live Fixed Income Indices as of 12/31/08 Source: Barclays Capital Live Fixed Income Indices as of 12/31/09
“Investors should be greedy when others are fearful and fearful when others are greedy.”
– Warren Buffett
– Returns of each sector can be highly divergent in the short-term but revert to the mean in the long-term
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Issue Selection: Treasuries
– Measures roll-downs
– Values convexity/volatility
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Issue Selection: Corporates
– Asset quantification
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Issue Selection: Mortgage-Backed and Asset-Backed Securities
Shown is a print screen from our loan level database, which aggregates information on all of the loans backing this particular deal
and compares it against the average for the cohort.
1 Deal Information – Basic information about the deal structure
2 Geographic Distribution – Aggregated from zip code data
1 3 Loan Characteristics – Average loan details, and a breakdown
of loans by type (fixed, adjustable, interest only, etc.)
4 Income Documentation – Loans to borrowers with
documented income are less likely to default
5 Loan-To-Value Ratios – Measure of the size of the loan relative to the
value of the property; higher LTVs generally translate to higher loan delin-
3 5 10 14 16 quency. Two methodologies are used to enhance our understanding of
the impact of distressed markets
6 FICO Scores – Limited importance to security analysis in today’s
environment
7 Servicer – Each servicer is independently rated based upon
a proprietary scoring system
6
13 8 Current Loan Performance – Current Credit Enhancement, delinquency,
default, and prepayment rates allow us to
compare this bond to similar bonds in the same cohort
9 Servicing Metrics – In addition to a broad servicer level score, servicing
metrics such as cash flow velocity, advancing, cure rates, severities and
15 8 timelines are tracked at the bond level and compared to the cohort averages
10 Modifications and Recidivism – We track the percentage of the bond level
collateral that has been modified and compare these to the cohort. We
4 9 also break out the modification type and measure what percentage of
seasoned modifications re-default through the recidivism metric.
11 Negative Amortization – For those loans that allow negative amorti-
11 zation, we track what percentage of each negam sleeve
is current and the percentage of each sleeve approaching the negam cap
12 Subsequent Performance of Serious Delinquent Loans – Tracks the
number of payments made by loans that were seriously delinquent 3
months prior and have yet to liquidate. Good indicator of future transi-
12 tions from serious delinquency to default.
13 Current Consumer Credit Data – Knowledge of current borrower credit
2 activities helps forecast delinquencies, defaults and severities as well as
7 shifts in the overall credit quality of the pool.
14 Alpha/Negative Alpha Pricing – Using the TCW loan level default, severity
and prepayment models, the price at which the bond is likely to
outperform (Alpha Px) or underperform (Neg Alpha Px) versus it’s peers.
15 Roll Rates – Tracks the trend of previously current loans transitioning to
the delinquency pipeline.
Result: There is a wealth of information that is gathered, organized, and analyzed 16 Delinquency Analytics – Detailed delinquency statistics covering all
stages of delinquency and default for both the primary pool backing the
through the proprietary loan database. This information has been critical in bond as well as any cross collateralized pools. Additional metrics provide
navigating the difficult environment of the last two years. information on loans that have never been delinquent or are reper-
forming giving an even more detailed view of the health of the pool.
17 PREShgf386 1/19/11
III. Corporate Bond Investment Philosophy and Process
Corporate Bond Investment Philosophy
• Add value throughout the credit cycle via multiple strategies • Take advantage of modest asset base
– Adjust the overall corporate exposure (basis) – Nimbly trade into/out of issuers and sectors
as valuations change over the credit cycle
– Position sizes are not limited by size of market
– Implement intensive credit research process
– Make use of relatively small, but often compelling
to identify undervalued securities
areas of the corporate bond market
– Make modest duration and yield curve shifts
• Project debt
st
• 1 mortgage debt
• Control risk through
• Secured bank debt
– Limited basis when spreads are tight
• SPVs, e.g. EETCs
– Intensive credit analysis that focuses on asset
coverage/downside protection
• Look for value across
– Emphasis on companies with proven management
and strong balance sheets – Capital structure
– Diversification by industry and issuer – Term structure
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Credit Research
U.S. Fixed Income Resources
Information Services
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Credit Research
Fixed Income Roles, Responsibilities & Process
Follow up
questions
Brief Credit
Some Fundamental Review Credit Some
Investment Investment Ideas Committee Ideas Investment
Idea Advance Analysis Analysis Advance
Discussion Discussion
Process • Trader(s) continually • Director of Credit, • Industry & • Analyst(s) presents • Evaluate investment • Trader(s) implement
monitor real-time trader(s) and competitive initial analysis/opinion merits Investment axe
relative value analyst(s) initially dynamics to Director of Credit
• Trader(s) present • Analyst(s) conduct
discuss investment
• Analyst(s) • Financial analysis • Evaluate whether relative value vs. ongoing credit
merits
periodically review & projections idea merits credit opportunity set monitoring
comparable • Evaluate relative committee discussion
• Liquidity review • Identify further credit
universe value to decide if full
• Analyst(s) prepares questions for follow-up
credit review • Read indenture &
• Generalist(s) also analysis for credit
analysis is credit agreements • If approved, develop
evaluate relative committee discussion
appropriate use of trading axe targets
value across fixed • Asset value analysis
resources & parameters
income sectors
• Discussions with
management &
rating agency
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Credit Research Evaluation
• TCW/MetWest’s credit analysts conduct rigorous fundamental assessments to evaluate tangible asset value, claim structure and
management quality
Credit Opportunity
• Tangible asset valuation • Cash and undrawn credit facilities • Capital structure
• Cash flow assessment/forecast • Two year quarterly forecast • Organizational structure
• Industry trends • Restrictive covenants • Restrictive covenants
• Economic trends • Unencumbered assets/value • Management’s ability to execute
• Management skill of growing • History of liquidity management within restrictive capital structure
business/cash flow • Bondholder friendliness history
Credit Opinion
Merits vs. Risks
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Credit Process
Anchored in Asset Value
• Asset “coverage” measured both on the face value and market value basis.
Asset Value
Less: Debt
$800m
$1b
$800m
$300m1
Critical
Asset sale value } Most relevant
in times of
market stress
24 PREShgf386 1/19/11
Critical Credit Research Aspects
What Are They & Why They Are Important?
• Understand competitive dynamics of companies, • Highlight industry trends that may include
Sector
Cash Flow Generation • Identify business model drivers and forecast future • Can business internally generate cash via
expected cash flows business operations?
• Distill accounting “gimmicks” to identify actual cash • If not, business is dependent on external sources
generation and long-term viability could be in question
Claim Structure Priority • Detailed examination of legal/organizational • In a downside, recoveries result from asset value
structure and associated claims (debt) attributed to claim pool. Higher priority claims
• Identify structural and/or claim priority seniority have more favorable recoveries
Asset Valuation • Conduct various valuation approaches including cash • Abundant asset value and unencumbered assets
flow multiple, discounted cash flow percent of could be a potential source of cash
Credit Evaluation
Covenant Analysis • Identify and understand various covenants across • Are there limitations on management flexibility
capital structure via tight covenants?
• Loose covenants could indicate leveraging
potential via value shift to equity owners
Liquidity Assessment • Identify cash and undrawn credit facilities available • Defaults occur when external liquidity
• Detailed quarterly forecast of cash sources/uses for disappears. Can the company manage within
the next two years internal liquidity during a crisis?
Management Interaction • Evaluation of senior management via historical track • Does management have history and flexibility
record and regular interviews to expect leveraging?
• Assess bondholder friendliness and incentives to • How strong is management?
favor shareholders
25 PREShgf386 1/19/11
Credit Research
Other Current Considerations
• Bankruptcy Scenario
– Would a priming debtor in possession loan be necessary? If so, How much?
– Potential for undisclosed liabilities
– Implied recovery using claim priority
• Capital Structure Considerations
– Organizational structure and claim priority analysis
– Pressure of intercompany loans
• Supply Chain Considerations
– Sector excess capacity
– Ability to pass through commodity cost
– Customer concentration/health
• Pension/OPEB Obligations
– Funding requirements
– In downside, what priority and how large would claim be?
• Environmental Liabilities
– Potential capital requirements or demand response of carbon emissions regulation
– Asbestos liability
– Decommissioning liability
This list is not exhaustive but is designed to be indicative of the types of issues analyzed when researching credits.
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Credit Portfolio Tracking
Proprietary Credit/Index Monitoring System
• Idea generation
Source: TCW/MetWest
27 PREShgf386 1/19/11
Credit Monitoring
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Credit Research Example
Telecommunications Firm A
• Large U.S. wireless carrier with valuable spectrum positions, Parent Telecommunications Corporation
Revolver $0 0.1x
customer relationships, and long-haul wireless assets. Export Development Canada $750 0.1x
6.000% Senior Notes 2016 $2,000 3.4x
8.375% Senior Notes 2017 $1,300 3.4x
• Fallen angel that entered high yield universe due to operational 9.250% Debentures 2022
TowerCo Sale-Leaseback
$200
$697
3.4x
3.4x
Subtotal $4,947 3.4x
challenges from integration that caused subscriber losses. Total Subsidiary Debt $15,115 3.4x
Other Debt $239 3.4x
Consolidated Debt $20,301 3.4x
• This coincided with market deleveraging with irrational fears of
an impending default despite generating sizable free cash flow Holding Corporation Holding Corporation
Co-borrower under credit facility
while having substantial liquidity and moderate (~3.0x) 7.625% Senior Notes 2011* $1,650 3.4x 6.875% Senior Notes 2013** $1,473 3.4x
8.375% Senior Notes 2012* $2,000 3.4x 5.950% Senior Notes 2014** $1,170 3.4x
leverage. 6.900% Senior Notes 2019*
6.875% Senior Notes 2028*
$1,729
$2,475
3.4x
3.4x
7.375% Senior Notes 2015**
Total
$2,137
$4,780
3.4x
3.4x
8.750% Senior Notes 2032* $2,000 3.4x ** Guaranteed by Parent but can be waived
Total $9,854 3.4x in certain asset sale circumstances
• During crisis, fears of a split were overblown, in our opinion, * Unconditionally guaranteed by Parent
Other Subsidiary 1
causing over 30 points of price disparity between bonds. Other Subsidiary A
Subsidiary bonds traded as low as the 30s but still trade at a 5 Other Subsidiary 2
Other Subsidiary B
to 10 point discount to parent bonds.
Other Subsidiary 3
Recent Developments: Other Subsidiary C
Other Subsidiary 4
• The operational turn-around is now gaining traction with lower Other Subsidiary D
29 PREShgf386 1/19/11
IV. Structured Product Management
Structured Products – Team, Resources, Interactions
Structured Product Working Group
(Sector Allocations/Risk Weightings)
CIO
Generalist Portfolio Managers/Structured Product Specialists
Structured Product Analysts
Reviews relative value, risk budgets, sets trading targets and
approves new structures/trading programs
The processes described herein are illustrative only and subject to adaptation in any particular context.
31 PREShgf386 1/19/11
Non-Agency MBS Agency MBS
The unprecedented housing and sector dislocation has created the Persistent inefficiencies in the agency mortgage market can be exploited
opportunity for high loss-adjusted yields through a disciplined asset through disciplined research and bottoms-up issue selection.
selection process using: • Minimal credit risk of agency MBS
• Top-Down Analysis • Few competing high quality assets with yield advantage
– Regional and local property trends • Agency MBS cash flows modeled over a range of scenarios
– Local employment conditions for prepayments, interest rates, volatility and home prices
– National loan modification initiatives • Combine fundamental OAS and spread regression with technical
– Differentiating mortgage servicers methods market trends
• Bottom-Up Deal Analysis • Dedicated team seeking relative value opportunities
– Detailed collateral analysis
– In-depth structural analysis
– On-going surveillance of investments, strategies, and trends Structured Products
• Negative home equity is of particular focus
Philosophy and
Valuation Process
CMBS ABS
Historically wide credit spreads and stable cash flows can be captured Complex structures, esoteric assets, and unique idiosyncratic risks limit
through continuous evaluation of: investor participation but can also lead to cheap risk-adjusted investments.
• Systematic Factors: • Hard asset or receivables valuation is the basis for which other forms
– Property Types and Geographic Region of credit protection can be evaluated
– Modification and Liquidation Trends • How these assets or receivables fit within the lessee or borrower’s
business model help us evaluate sponsorship and cash flow timing
– Availability of Financing in both Loan and Securities Markets
• Structural protections need to fill the “credit” gaps and anticipate how
– Transaction Volumes and Subsequent Price Discovery and where performance deterioration will impact bondholders
• Idiosyncratic Factors: • Any level of liquidity constraints are considered when determining the
– Close attention to Tenants and Occupancy proper cusip and portfolio exposure
– Payment Shocks can affect the borrower’s Ability to Pay
– Individual Loan Covenants such as Lockboxes can affect Cash Flows
to the trust
Ultimately our goal is to establish the projected Debt Service
Coverage Ratio
32 PREShgf386 1/19/11
RMBS Proprietary Research and Analytical Tools
Our systems allow us to understand the risks and opportunities of every MBS we purchase on behalf of our clients
The processes described herein are illustrative only and subject to adaptation in any particular context.
33 PREShgf386 1/19/11
TCW Proprietary RMBS Analytics
Shown is a print screen from our loan level database, which aggregates information on all of the loans backing this particular deal
and compares it against the average for the cohort.
1 Deal Information – Basic information about the deal structure
2 Geographic Distribution – Aggregated from zip code data
1 3 Loan Characteristics – Average loan details, and a breakdown
of loans by type (fixed, adjustable, interest only, etc.)
4 Income Documentation – Loans to borrowers with
documented income are less likely to default
5 Loan-To-Value Ratios – Measure of the size of the loan relative to the
value of the property; higher LTVs generally translate to higher loan delin-
3 5 10 14 16 quency. Two methodologies are used to enhance our understanding of
the impact of distressed markets
6 FICO Scores – Limited importance to security analysis in today’s
environment
7 Servicer – Each servicer is independently rated based upon
a proprietary scoring system
6
13 8 Current Loan Performance – Current Credit Enhancement, delinquency,
default, and prepayment rates allow us to
compare this bond to similar bonds in the same cohort
9 Servicing Metrics – In addition to a broad servicer level score, servicing
metrics such as cash flow velocity, advancing, cure rates, severities and
15 8 timelines are tracked at the bond level and compared to the cohort averages
10 Modifications and Recidivism – We track the percentage of the bond level
collateral that has been modified and compare these to the cohort. We
4 9 also break out the modification type and measure what percentage of
seasoned modifications re-default through the recidivism metric
11 Negative Amortization – For those loans that allow negative amorti-
11 zation, we track what percentage of each negam sleeve
is current and the percentage of each sleeve approaching the negam cap
12 Subsequent Performance of Serious Delinquent Loans – Tracks the
number of payments made by loans that were seriously delinquent 3
months prior and have yet to liquidate. Good indicator of future transi-
12 tions from serious delinquency to default
13 Current Consumer Credit Data – Knowledge of current borrower credit
2 activities helps forecast delinquencies, defaults and severities as well as
7 shifts in the overall credit quality of the pool
14 Alpha/Negative Alpha Pricing – Using the TCW loan level default, severity
and prepayment models, the price at which the bond is likely to
outperform (Alpha Px) or underperform (Neg Alpha Px) versus it’s peers
15 Roll Rates – Tracks the trend of previously current loans transitioning to
the delinquency pipeline
Result: There is a wealth of information that is gathered, organized, and analyzed 16 Delinquency Analytics – Detailed delinquency statistics covering all
stages of delinquency and default for both the primary pool backing the
through the proprietary loan database. This information has been critical in bond as well as any cross collateralized pools. Additional metrics provide
navigating the difficult environment of the last two years. information on loans that have never been delinquent or are reper-
forming giving an even more detailed view of the health of the pool
34 PREShgf386 1/19/11
TCW RMBS Cash Flow Models
The processes described herein are illustrative only and subject to adaptation in any particular context.
35 PREShgf386 1/19/11
Proprietary CMBS Research and Analytical Tools
Our systems allow us to understand the risks and opportunities of every CMBS we purchase on behalf of our clients.
The processes described herein are illustrative only and subject to adaptation in any particular context.
38 PREShgf386 1/19/11
Structured Products: Reporting and Tracking Exposure
Duration and liquidity positioning are Long term sector targets are set by the Sector construction and individual
constantly evaluated against both Structured Products Committee based security selection is delegated to the
target and current credit exposures. upon relative value against a myriad of Specialists.
economic scenarios.
These reports ensure that sub-sector
targets are achieved and done so with
consistency across similar accounts.
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Structured Products: Portfolio Tracking and Reporting Exposure
40 PREShgf386 1/19/11
Structured Products: Portfolio Tracking and Reporting Exposure
• Effective durations are run daily using Barclays Point System to compare MetWest Total Return strategy portfolios to the MBS portion
of the Barclays Aggregate Index
The processes described herein are illustrative only and subject to adaptation in any particular context.
41 PREShgf386 1/19/11
V. Outlook and Strategy
Economic Outlook
U.S. Economy Has Suffered An Immense Loss of Wealth
• The “illusion of wealth” effect brought on by the asset price bubble in housing led to:
– Personal net-worths are systematically mis-estimated
– Sharp elevation in consumption, remember “mortgage equity withdrawals”?
– Economic distortions, e.g., an excess of construction activity, too many mortgage brokers, record levels of car sales
• Since the 2006/2007 peak in housing, the U.S. has experienced a dramatic diminution in net worth
– Residential real estate down $7 trillion – some 28% from the 2006 peak
– U.S. equities down over 25% since 10/31/071
80%
20.0 70%
60%
15.0
50%
40%
10.0
Households Owners’ Equity in Real Estate 30%
5.0 20%
Owners' Equity as % of Household Real Estate
10%
0.0 0%
6% 2500
5%
2000
Billions ($)
4%
1500
3%
1000
2%
500
1%
0% 0
00 01 02 03 04 05 06 07 08 09 01
0 59 962 965 969 972 976 979 982 986 989 993 996 000 003 006 010
l-20 l-20 l-20 l-20 l-20 l-20 l-20 l-20 l -20 l -20 ul-2 19 1 1 1 1 1 1 1 1 1 1 1 2 2 2 2
Ju Ju Ju Ju Ju Ju Ju Ju Ju Ju J
Source: Bloomberg
45 PREShgf386 1/19/11
Meanwhile, the Rest of the Private Sector Continues to De-Lever
Commercial and Industrial Loans Outstanding Commercial Paper Outstanding: Financial and Asset-Backed
1600 1400
1400 1200
1200
Billions ($)
Billions ($)
1000
1000
800
800
600
600
400
400
200 200
88 89 91 992 94 995 997 999 000 002 003 005 007 008 010 01 001 002 03 04 04 05 6 7 7
00 200 200 -200 200
8 9 10
-19 g-19 r-19 ct-1 y-19 c-1 l-1 -1 -2 -2 -2 -2 -2 -2 r-2 -20 ct-2 ul-2 r -20 n-20 -20 g-20 y-2 - - - -20
n
Ja A u M a O Ma De Ju Feb Sep Apr Nov Jun Jan Aug Ma J a n
O J A p Ja N o v
Au M
a F e b
N ov
S e p
Ju
n
M
a r
Commercial and Industrial Loans at All Commercial Banks Financial Commercial Paper Outstanding (SA)
Commercial and Industrial Loans of Large Commercial Banks Asset-backed Commercial Paper Outstanding (SA)
46 PREShgf386 1/19/11
Leaving Labor Markets Deeply Stressed
Historical Unemployment (U-3) Historical Unemployment and Underemployment Rate (U-6)
16.0 18.0
14.0
16.0
12.0
14.0
10.0
8.0 12.0
6.0
10.0
4.0
8.0
2.0
0.0 6.0
Jan-1948 Mar-1953 May-1958 Jul-1963 Sep-1968 Nov-1973 Jan-1979 Mar-1984 May-1989 Jul-1994 Sep-1999 Nov-2004 Jan-2010 Jan-1994 Jan-1996 Jan-1998 Jan-2000 Jan-2002 Jan-2004 Jan-2006 Jan-2008 Jan-2010
40
35
30
25
20
15
10
5
0
Jan-1985 Oct-1988 Jul-1992 Apr-1996 Jan-2000 Oct-2003 Jul-2007 Jun-2010
Source: Bloomberg
47 PREShgf386 1/19/11
As the Loss of Wealth Was Severe, So Has Been the Economic Retrenchment
6.0%
5.0%
4.0% 3.7%
2.9%
2.0% 1.6%
Gross Domestic Product
0.6%
(Annualized)
0.0%
1.6%
-0.7% -0.7%
-2.0%
-4.0%
-4.0%
-4.9%
-6.0%
-6.8%
-8.0%
Q4 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008 Q1 2009 Q2 2009 Q3 2009 Q4 2009 Q1 2010 Q2 2010
• The technical ending of the Great Recession has not brought economic activity back to where it was pre-recession
• And, with all these negative forces, how has the economy stayed above water?
Source: Bloomberg
48 PREShgf386 1/19/11
America Goes for Broke:
Government “Levers Up” as Private Sector “Levers Down”
GDP = Consumer Spending (C) + Business Investment (I) + Government Outlays (G) + Net Exports (X – M)
• In classic fashion, government is “replacing” the loss of consumption from the private sector by implementing
“borrow and spend” stimulative programs
U.S. Public Debt Outstanding U.S. Total Public Debt Outstanding as a % of GDP
$13.2 Trillion 95%
$12.3 Trillion 8.2
90%
80%
$8.7 Trillion 5.0 5.1
75%
4.3 4.4
$5.7 Trillion 70%
3.2 65%
2.5
60%
55%
50%
Jan-2000 Jan-2007 Dec-2009 Jun-2010
96 96 97 98 99 99 00 01 02 02 03 04 05 05 06 07 08 08 09 10
19 19 19 19 19 19 20 20 20 20 20 20 20 20 20 20 20 20 20 20
Marketable Non-Marketable
49 PREShgf386 1/19/11
Government Spending Providing “Bridge Financing”
20%
18%
16%
14%
12%
10%
8%
6%
4%
• Do the Feds have the willingness and the ability to sustain the stimulus until private sector balance sheets recover
and growth resumes?
Source: Bloomberg
50 PREShgf386 1/19/11
Cost: Federal Debt Interest Payments
Interest-Bearing Debt
Rate*
T-bills 0.24%
Treasury Notes 2.74%
Treasury Bonds 6.23%1
TIPS 2.24%
Other 4.63%
Non-Marketable 4.37%
Total 3.21%
51 PREShgf386 1/19/11
Central Conundrum
National
Economy Public and
Non-Marketable
(GDP)
Federal Debt
• Public debt/GDP has risen from 55% to 90% over the ‘00s
– Trend is not sustainable unless private sector begins to grow substantially more rapidly
– Private sector must replenish the demand that will be “lost” when deficit spending moderates
52 PREShgf386 1/19/11
Fundamentally: How Do You Solve a Problem Like a Debt Burden?
2. Inflation: Reduce the debt burden over time via expansion of money and credit
– Allow the real adjustment to be “masked” by a nominal change in price level
– “Socializes” the costs of adjustment
3. Prosperity: Grow your way out: Fix private sector balance sheets
– Re-allocate labor/capital facilitating real GDP growth
– Not directly determined by policy makers in Washington
53 PREShgf386 1/19/11
Prognosis
• Keynesian stimulus will be pulled back – hence, growth will be very muted
– Exogenously: By global financial markets reducing its “preference” for U.S. Treasuries
Prematurely scaling back government spending would set the table for a “double-dip”
• Would the Fed then stand idly by – or would the Fed activate “QE-2” and inflate the economy?
• Meanwhile, government intervention has impeded economic adjustments – including slowing the re-pricing of the
stock of residential real estate, thereby delaying recovery
54 PREShgf386 1/19/11
Investment Approach in Uncertain Times
• Recovery faces deleveraging headwinds • Treasury rates near historical lows (0.5-3%)
• Housing stabilizing • Agency MBS at 3-4%
• Corporate balance sheets improving • Senior non-agency RMBS 5-11%
• Government stimulus will eventually fade • Senior commercial MBS 4-5%
• Heightened risk for deflation (near-term) • IG Corporates 3-5%
and inflation (long-term) • HY Corporates 8-9%
• Equities: Function (GDP, earnings, production, rates)
Conclusions
55 PREShgf386 1/19/11
Corporate Market Outlook
Barclays Credit Spreads – Index OAS
As of December 31, 2010
900
800
700
600
OAS (bps)
500
400
300
200
100
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
57 PREShgf386 1/19/11
Current Portfolio Positioning
Objective
• Position portfolio for challenging economic environment, focusing on companies that are:
– Government–sponsored
– Non-cyclical
– Backed by good management and flexible balance sheets
• Achieve corporate basis exposure above market/index
Strategy
• Corporate basis greater than index
• Duration short index
• Overweight/Emphasize
– Senior debt of large money center banks
– Regulated pipeline companies
– Secured project debt
– Well-capitalized telecommunications companies
– Well-managed, asset-rich companies
– Insurance companies (Senior)
– REITs (Healthcare; frontend)
• Underweight
– Industrials
– Retailers
– Technology
– Media
• Opportunistic allocation to Super-Senior CMBS
Opinions expressed are current only as of the time made; are subject to change without notice.
58 PREShgf386 1/19/11
Opportunities in the Corporate Bond Market
Financials:
Financials bonds offer compelling valuation on both absolute and relative basis, trading at nearly 2x the spread of single A-rated
industrials and at nearly 2x historical pre-crisis means.
• Money-center banks – relatively stable funding profile (deposit-heavy) and diversification by business line and geography. Long-term
ramifications of FinReg are credit friendly while balance sheets continue to rehabilitate. Expect financials spread to mean revert over time.
– Large money center bank senior debt @ ~+220-230bps
– Floating rate TRUPs/hybrids – due to FinReg (Collins amendment), regulatory capital credit will phase between 3-5 years from
passage. Likely to cause incentive to call/refinance structures while quasi inflation-hedge. Currently trade in low 70s and yield 7-8%
• Insurance – favor operating company level securities. Well capitalized and generally have lower problematic loan balances than banks.
– Secured paper at ~+200–300bps
– Opco surplus notes @ ~+300–400bps
– Callable hybrid securities @ ~8-9% to likely call
• Real Estate Investment Trusts (REITs) – asset-heavy sector where bonds offer strong covenant protection that limit debt incurrence
ability, both on secured and unsecured basis. Favor healthcare REITs and shorter maturities.
Opinions expressed are current only as of the time made; are subject to change without notice.
59 PREShgf386 1/19/11
Opportunities in the Corporate Bond Market (cont’d)
Opinions expressed are current only as of the time made; are subject to change without notice.
60 PREShgf386 1/19/11
Opportunities in the Corporate Bond Market (cont’d)
Technology/Retail – due to asset-based lending philosophy, tend to be cautious on asset-light sectors and industries where rapid
technological evolution could cause diminution of intellectual property. Underweight both sectors
Opinions expressed are current only as of the time made; are subject to change without notice.
61 PREShgf386 1/19/11
Structured Product Outlook
Treasury Rate & Agency MBS Yield Moves In 4Q 2010
Conclusion: Rates backed up significantly in 4th quarter and the curve steepened.
MBS Agency yields rose 75 bps and average lives extended.
63 PREShgf386 1/19/11
Agency MBS Duration Changes In 4Q 2010
• While price payups for Loan Balance pools compressed, their more stable durations due to better convexity as well
as higher current yields offset the loss in payups during the rate backup in the 4th quarter
64 PREShgf386 1/19/11
Agency MBS Fundamental Valuations
2008financialcrisis
300
250
FNMACurrentCouponNominalSpread
200
150
100
Min 103
Max 293
50 Last 146
Average(10yr) 156
Average(5yr) 150
Source:Bloomberg
65 PREShgf386 1/19/11
Agency MBS Fundamental Valuations (cont’d)
AgencyMBSLOAS
100
Min Ͳ41
Max 82
80 Last 15
Average(10yr) Ͳ4
Average(5yr) Ͳ5
60
FNCLCurrentCouponLOAS(bps)
40
20
20
Ͳ20
Ͳ40
Ͳ60
Source:Yieldbook
66 PREShgf386 1/19/11
Agency MBS Fundamental Valuations
Refinancabilityof30yrFixedConventionalUniverse
4.0s 4.5s 5.0s 5.5s 6.0s 6.5s
• Expectations for
400 voluntary prepayments
Marginally Fully remain muted for 2011
350 Refinanceable Refinanceable
=~64% =~42% despite the historically
300 WillingandAble low rate environment,
UnwillingorUnable which will bode well
250
for collecting carry in
<18%ofuniverseisboth
OutstandingBalance($bn)
utstandingBalance($bn)
150
• After accounting for
100
credit, mark-to-market
50
LTVs, and loan balances,
only about 18% of the
0 outstanding Agency
mortgage market is
GrossWACBucket currently “refinanceable”
Willing: Sufficientmortgagerateincentiveonlargeenoughloansize(>$150,000)toovercomeupfrontcostsofrefinance
Ͳ50bpsis"marginallyrefinancable"
Ͳ100bpsis"fullyrefinancable"
Able:Unconstrainedbycredit(LTV<80%,FICO>720)
Source:FTNFinancial
67 PREShgf386 1/19/11
Risks to Fundamental Valuations
• Government policy changes are unpredictable and often a catalyst to higher mortgage spread volatility
• Delivered volatility has recently trended above implied volatility
ImpliedSwaptionVolatilityversusDeliveredVolatility
300
3Yrby10YrImpliedVolatility(bp)
Volof3Yrby10YrSwapRate,20Ͳdayaverage(bp)
250
200
If delivered volatility
remains elevated, implied
150
volatility is likely to rise,
reducing LOAS
100 valuations for Agency
MBS and pressuring
spreads wider
50
Source:Bloomberg
68 PREShgf386 1/19/11
Agency MBS Technical Valuations
Millions
(Existing)
MonthlyHomeSales Millions
(New) • Net supply of Agency MBS will be low
7
ExistingSingleFamilyHomeSales(ls)
1.6 due to:
Buyersrushedtotake
6.5
NewSingleFamilyHomeSales(rs) advantageofexpiring
federal taxcredits 1.4
1. continued low levels of new home
sales (see graph)
6 1.2 2. muted or negative home price
appreciation (HPA)
5.5 1
3. higher mortgage rates
5 0.8 4. tighter underwriting guidelines
5. higher loan fees charged by GSEs
4.5 0.6
(see table below)
4 0.4
3.5 0.2
Credit Score <= 60% 60 - 70% 70 - 75% 75 - 80% 80 - 85% 85 - 90% 90 - 95% 95 - 97%
=> 740 -0.25% 0.00% 0.00% 0.25% 0.25% 0.25% 0.25% 0.25%
720 - 739 -0.25% 0.00% 0.25% 0.50% 0.50% 0.50% 0.50% 0.50%
700 - 719 -0.25% 0.50% 0.75% 1.00% 1.00% 1.00% 1.00% 1.00%
680 - 699 0.00% 0.50% 1.25% 1.75% 1.50% 1.25% 1.25% 1.00%
660 - 679 0.00% 1.00% 2.00% 2.50% 2.75% 2.25% 2.25% 1.75%
640 - 659 0.50% 1.25% 2.50% 3.00% 3.25% 2.75% 2.75% 2.25%
620 - 639 0.50% 1.50% 3.00% 3.00% 3.25% 3.25% 3.25% 3.00%
< 620 0.50% 1.50% 3.00% 3.00% 3.25% 3.25% 3.25% 3.25%
Source: Fannie Mae
69 PREShgf386 1/19/11
Agency MBS Technical Valuations
10YrUSTͲ 2YrUST(bps)
cautious on economic
recovery prospects and loan
2YrUST(b
0 100
demand is weak
– Basel III rules favor low risk- Ͳ100 50
weighted, highly liquid asset
allocations
Ͳ200 0
CommercialBankGovtSecuritiesHoldings,$changeYoY(LHS)
Ͳ300 CommercialBankC&ILoans,$changeYoY(LHS) Ͳ50
2Ͳ10Spread(RHS)
Ͳ400 Ͳ100
Source:FederalReserve,Bloomberg
70 PREShgf386 1/19/11
Agency MBS Technical Valuations
• Demand from money managers should be steady as Agency MBS valuations appear attractive
to other high quality assets such as investment grade corporates
MBS Index
Sector Duration Yield Yield Pickup
U.S. MBS Index 4.31 3.69 –
Intermediate AAA Corporates 3.54 1.72 197 bps
Intermediate AA Corporates 4.00 2.57 112 bps
Intermediate A Corporates 4.41 3.27 42 bps
71 PREShgf386 1/19/11
Risks to Technical Factors for Agency MBS
72 PREShgf386 1/19/11
Non-Agency MBS Review and Outlook
3,000,000 30,000
2,500,000 25,000
2,000,000 20,000
1,500,000 15,000
1,000,000 10,000
500,000 5,000
0 0
Jan-2008 Apr-2008 Aug-2008 Dec-2008 Apr-2009 Aug-2009 Dec-2009 Apr-2010 Aug-2010 Dec-2010
74 PREShgf386 1/19/11
Non-Agency MBS Review and Outlook
Loan Fundamentals
75 PREShgf386 1/19/11
Non-Agency MBS Review and Outlook (cont’d)
Loan Fundamentals
40%
• Delinquencies are between 25% to 50%
20%
• Market assumes cumulative defaults of
10% to 40% of the remaining loans 15%
76 PREShgf386 1/19/11
Non-Agency MBS Review and Outlook (cont’d)
Loan Fundamentals
• Loss Severity
– Largest factor in determining loss severity is the
depreciation of home value 70%
72.2%
• House prices have been stable recently 65%
• Risks to lower home prices remain due to large 60%
shadow inventory of homes 55%
57.7%
• Distressed/Depression-like pricing conditions of late ‘08/early ‘09 have remediated to “stressed” pricing
– Market continues to discount very severe defaults, loss severities, and prepayments:
* 2005-2007 vintages. Source: Calculations based on security prices from Bloomberg and major banks.
** Source: TCW Loan Level database and Intex. 2005-2007 vintages.
78 PREShgf386 1/19/11
2010 Non-Agency Sector Return Attribution
80 PREShgf386 1/19/11
The Layering of Old and New Metrics on Non-Agency MBS
Price
Old Metrics
Base Case
+ 3 Month
Timeline Extension
55.00 9.83 9.53
56.00 9.51 9.21
57.00 9.20 8.91
58.00 8.90 8.61
59.00 8.61 8.33
60.00 8.33 8.05
61.00 8.06 7.78
62.00 7.79 7.52
63.00 7.53 7.26
64.00 7.28 7.01
65.00
66.00
7.03
6.79
6.77
6.54
67.00 6.56 6.31
68.00 6.33 6.08
69.00 6.11 5.87
70.00 5.90 5.65
71.00 5.69 5.45
72.00 5.48 5.24
73.00 5.28 5.05
74.00 5.09 4.85
75.00 4.90 4.66
Total Defaults 67% 67%
Voluntary Prepayment Rate 1% 1%
Severity Rate 60% 62.5%
81 PREShgf386 1/19/11
The Layering of Old and New Metrics on Non-Agency MBS (cont’d)
Price
Old Metrics
Base Case
+ 3 Month
Timeline Extension
+ Increasing Interest
Rate Modifications
+ Increasing Stop
Advancing %'s
55.00 9.83 9.53 9.10 8.61
56.00 9.51 9.21 8.79 8.31
57.00 9.20 8.91 8.49 8.01
58.00 8.90 8.61 8.20 7.73
59.00 8.61 8.33 7.92 7.46
60.00 8.33 8.05 7.64 7.19
61.00 8.06 7.78 7.38 6.93
62.00 7.79 7.52 7.12 6.67
63.00 7.53 7.26 6.87 6.43
64.00 7.28 7.01 6.63 6.19
65.00
66.00
7.03
6.79
6.77
6.54
6.39
6.16
5.96
5.73
67.00 6.56 6.31 5.93 5.51
68.00 6.33 6.08 5.71 5.30
69.00 6.11 5.87 5.50 5.09
70.00 5.90 5.65 5.29 4.88
71.00 5.69 5.45 5.09 4.68
72.00 5.48 5.24 4.89 4.49
73.00 5.28 5.05 4.69 4.29
74.00 5.09 4.85 4.50 4.11
75.00 4.90 4.66 4.32 3.93
Total Defaults 67% 67% 67% 68%
Voluntary Prepayment Rate 1% 1% 1% 1%
Severity Rate 60% 62.5% 62.5% 62.5%
82 PREShgf386 1/19/11
The Layering of Old and New Metrics on Non-Agency MBS (cont’d)
Price
Old Metrics
Base Case
+ 3 Month
Timeline Extension
+ Increasing Interest
Rate Modifications
+ Increasing Stop
Advancing %'s
+ Improved Defaults
and Prepayments
55.00 9.83 9.53 9.10 8.61 10.41
56.00 9.51 9.21 8.79 8.31 10.06
57.00 9.20 8.91 8.49 8.01 9.72
58.00 8.90 8.61 8.20 7.73 9.39
59.00 8.61 8.33 7.92 7.46 9.08
60.00 8.33 8.05 7.64 7.19 8.77
61.00 8.06 7.78 7.38 6.93 8.47
62.00 7.79 7.52 7.12 6.67 8.18
63.00 7.53 7.26 6.87 6.43 7.89
64.00 7.28 7.01 6.63 6.19 7.62
65.00
66.00
7.03
6.79
6.77
6.54
6.39
6.16
5.96
5.73
7.35
7.09
67.00 6.56 6.31 5.93 5.51 6.84
68.00 6.33 6.08 5.71 5.30 6.59
69.00 6.11 5.87 5.50 5.09 6.35
70.00 5.90 5.65 5.29 4.88 6.12
71.00 5.69 5.45 5.09 4.68 5.89
72.00 5.48 5.24 4.89 4.49 5.67
73.00 5.28 5.05 4.69 4.29 5.45
74.00 5.09 4.85 4.50 4.11 5.24
75.00 4.90 4.66 4.32 3.93 5.04
Total Defaults 67% 67% 67% 68% 55%
Voluntary Prepayment Rate 1% 1% 1% 1% 3%
Severity Rate 60% 62.5% 62.5% 62.5% 62.5%
83 PREShgf386 1/19/11
CMBS Review and Outlook
Despite Strong Rally, Opportunity Remains In Super-Senior Tranches
• The CRE market has seen prices decline roughly 40% from the
peak of the cycle in October of 2007
Opinions expressed are current only as of the time made; are subject to change without notice.
84 PREShgf386 1/19/11
CMBS Review and Outlook (cont’d)
Despite Strong Rally, Opportunity Remains In Super-Senior Tranches
The Opportunity
• Value to be gained in CMBS due to the structural protections of the super-senior tranches
• Best risk-adjusted value in senior last cash flow sequential payers bearing 30% credit enhancement at issuance
• The original credit enhancement of 30% would protect the nominal yield up to a 40% default rate and 75% severity
(or, alternatively 50% default at 60% severity)
• Focused on large, well-diversified pools that are not concentrated in a few large loans
• Emphasizes those CMBS that are expected to hold up even in a process of continued deleveraging
• Avoiding exposure to deals with significant forecasted declines in debt service coverage ratios
• Capital has returned to new issue CRE lending albeit at conservative underwriting standards
Opinions expressed are current only as of the time made; are subject to change without notice.
85 PREShgf386 1/19/11
Asset-Backed Securities (ABS) Review and Outlook
On-the-run Sectors
Credit Cards
• Stricter underwriting standards enacted by issuers over the last two years have resulted in steadily improving master trust metrics
• Several trusts continue to employ the discount option, which will continue to lend stability to excess spread measures
• Chargeoffs and delinquencies continue to decline, although softness in the overall employment situation could challenge this trend
Autos
• Overall better performance in the auto industry has resulted in better execution levels for new issuance, across all pieces of the capital
structure
• The more conservative guidelines prescribed by rating agencies have produced very solid, well-protected structures and historically
active purchasers have returned to provide support to the sector
Specialized Sectors
• The low interest rate environment, net decrease in outstanding supply and large amounts of cash to deployed have spurred issuers to
tap the markets
• Transportation stalwarts such as rails and containers have been able to access the markets, aircraft-related securitizations are in the
queue, and even highly-specific revenue streams should be able to issue in the near term
Opinions expressed are current only as of the time made; are subject to change without notice.
86 PREShgf386 1/19/11
Asset-Backed Securities (ABS) Review and Outlook (cont’d)
Specialized Sectors
Shipping Container 225 dm 3.25% Tighter Scarcity of assets and
limited new issuance will
continue to drive spreads
Opinions expressed are current only as of the time made; are subject to change without notice.
87 PREShgf386 1/19/11