Jp Morgan Housing Bubble Skepticism

Fixed Income Research J.P. Morgan Securities Inc. New York December 1, 2004

ABS and CDOs: Record Performance Continues

Chris FlanaganAC (1-212) 260-6515 [email protected] The certifying analyst(s) is indicated by a superscript AC. See last page of the report for analyst certification and important legal and regulatory disclosures.

www.morganmarkets.com

US Fixed Income Markets

2005 Outlook ABS and CDOs: Record Performance Continues Chris Flanagan [email protected] 212-260-6515

December 1, 2004

2005 key points – ABS and CDOs „ Multi-year tight spread environment, the result of extremely accommodative monetary policy of

past few years, enters year 2.

„ Record year for US ABS in 2004, with close to $600 billion in issuance. Spreads are at historic

tights.

„ Repeating 2004, home equities should continue to dominate. $375 billion in issuance anticipated

for 2005 – down slightly from 2004’s $400 billion pace.

„ Heavy issuance and excessive concerns about housing bubble continue to create some spread

volatility for home equities – and one of the best relative value opportunities in fixed income market, especially seniors. New rating agency Libor stress scenarios provide additional conservatism and support for home equities.

„ Former benchmark ABS sectors, credit cards and autos, remain at historically tight spreads with

minimal volatility. The same holds for Student Loan ABS and Global RMBS.

US Fixed Income Markets 2005 Outlook

„ 2004 was an unequivocally positive year for the CDO market, with increased supply and tightening

spreads. „ CDOs continued their transformation into a core asset class in the fixed income market. „ More spread tightening likely, best value in mezzanine cash and “second senior” synthetic paper.

„ Global structured credit bid for assets will remain huge. „ Close to $115 billion in cash CDO issuance anticipated for 2005 (85/15 US/European asset split,

50/50 Corporate/ABS split). „ $600+ billion estimated synthetic “issuance” in 2004 growing to close to $800 billion in 2005 (50/50 US/European, 90/10 Corporate/ABS).

1

US ABS supply US public ABS supply US public ABS supply

2002

US Fixed Income Markets 2005 Outlook

Collateral Credit Cards Autos Home Equity Dealer Floorplan Equipment Student Loans Global RMBS Other Total

2003

$ Billions % Floating $ Billions 65.8 84% 64.8 88.2 23% 77.2 159.0 76% 220.3 3.0 100% 8.9 5.5 28% 6.8 19.5 98% 30.7 18.9 96% 31.7 9.4 32% 3.8 $367.9 65% $444.2

% Floating 76% 19% 85% 100% 33% 98% 100% 20% 73%

2004 YTD $ Billions % Floating 45.7 78% 59.8 5% 365.9 90% 12.9 100% 5.1 34% 41.2 100% 34.8 100% 4.6 24% $573.3 81%

2005 Projected $ Billions 55 75 375 10 5 40 35 5 $600

Note: Other includes deals backed by Manufactured Hpousing, Stranded Asset, RV, Boat, Consumer, EETC, Aircraft Leases and Small Business Loans. Global RMBS, backed by non-US collateral, are registered and sold in the US public markets. Source: JPMS, MCM CorporateWatch, Bloomberg.

2

ABS spreads – AAA and BBB 3 3 year year AAA AAA spreads spreads Spread Spread to to LIBOR LIBOR (bps) (bps)

Cards (3-year)

60

Auto (3-year)

HEL ARMS (3-year)

Global RMBS (3-year)

40

29

20 9

0

2

11/98

6/99

1/00

8/00

3/01

10/01

5/02

12/02

7/03

2/04

9/04

US Fixed Income Markets 2005 Outlook

5 5 year year BBB BBB spreads spreads Spread Spread to to LIBOR LIBOR (bps) (bps)

Credit Card ABS

350 300 250 200 150 100 50 0 11/98

HEL ABS

UK RMBS 175 60 50

6/99

1/00

8/00

3/01

10/01

5/02

12/02

7/03

2/04

9/04

Source: JPMS.

3

What bubble? Home prices up, but payments, the key driver, still very low Housing Housing and and disposable disposable income income (Ratio) (Ratio)

Purchase price

0.90 0.85

8%

9.0

6%

8.5

0.80 0.75

8.0

0.70

7.5

0.65

7.0

0.60

6.5

0.55

6.0 Q1.1983 Q3.1984 Q1.1986 Q3.1987 Q1.1989 Q3.1990 Q1.1992 Q3.1993 Q1.1995 Q3.1996 Q1.1998 Q3.1999 Q1.2001 Q3.2002 Q1.2004

0.50

US Fixed Income Markets 2005 Outlook

9.5

Monthly Payment (av erage payment relativ e to per capita disposable income) Purchase Price (av erage purchase price relativ e to per capita disposable income) Sources: Federal Housing Finance Board, JPMS.

OFHEO index deflated by CPI

4% 2% 0% -2% -4% -6% -8% Q3.1993 Q1.1995 Q3.1996 Q1.1998 Q3.1999 Q1.2001 Q3.2002 Q1.2004

Monthly payment

Q1.1983 Q3.1984 Q1.1986 Q3.1987 Q1.1989 Q3.1990 Q1.1992

0.95

Real Real national national average average home home prices prices (qoq (qoq % % change) change)

Sources: OFHEO, US Dept of Labor, Bureau of Labor Statistics

4

Home builders efficiently responding to demand – for bigger houses! (Where’s the speculative bubble here?) Nominalized Nominalized new new home home sales sales and and housing housing starts starts (Jan 1963 = 1, 3-month moving average) (Jan 1963 = 1, 3-month moving average)

Ratio Ratio of of housing housing starts starts to to new new home home sales sales (3-month moving average) (3-month moving average)

New Home Sales Housing Starts

3.00 2.75

2.00

4.0 3.5 3.0

1.75

2.50

2.5 2.0

2.25

1.50

1.5 63

2.00 1.25

1.75

73

78

83

88

93

98

03

Source: US Census Bureau, US Dept of Commerce.

Median Median price price of of new new homes homes

1.50 1.00

1.25 US Fixed Income Markets 2005 Outlook

68

1.00

0.75

0.75 0.50

0.50 63

68

73

78

83

88

Source: US Census Bureau, US Dept of Commerce.

93

98

03

Year 1975 1980 1983 1990 1992 1997 2000 2003

Median Price (2003 dollars) 161,634 196,585 183,191 177,046 169,334 174,401 182,297 195,000

Size (median Price per sq ft sq ft) (2003 dollars) 1,535 $105.30 1,595 $123.25 1,565 $117.05 1,905 $92.94 1,920 $88.19 1,975 $88.30 2,079 $87.68 2,126 $91.72

Source: Joint Center for Housing Studies of Harvard.

5

HEL ABS versus homebuilding index Spread Spread differential differential to to BBB BBB HEL HEL (bp) (bp)

300

HEL BBB minus Bank BBB JPM Homebuilding STW (Sw apped) minus HEL BBB

250

200

150

US Fixed Income Markets 2005 Outlook

100

50

0 1/03

4/03

7/03

10/03

1/04

4/04

7/04

10/04

Source: JPMS.

6

HEL ABS cheap – Irrational fears at work Spread Spread differentials differentials to to AAA AAA HEL HEL (bp) (bp)

HEL AAA (3Y) minus FNMA CC 30yr Libor OAS SF CDO AAA (7-9Y) minus HEL AAA 3Y

40 30

29

20 12

10 0 -10 10/00

4/01

10/01

4/02

10/02

4/03

10/03

4/04

10/04

Spread differentials differentials to to subordinate subordinate HEL Spread HEL (bp) (bp)

US Fixed Income Markets 2005 Outlook

300 200 100 0 -100 -200 -300

Single-A HEL ABS (6-year) minus Financial (5-year)

BBB HEL ABS minus Financial (5-year) 158 148

10/00 1/01 4/01 7/01 10/01 1/02 4/02 7/02 10/02 1/03 4/03 7/03 10/03 1/04 4/04 7/04 10/04 Source: JPMS.

7

New rating agency LIBOR stress – Prepared for the worst LIBOR LIBOR curves curves –– BBB BBB stress stress

7%

S&P

Moody's

Fitch

Forw ard Curv e (11/12)

6%

5%

4%

US Fixed Income Markets 2005 Outlook

3%

2% 11/04

8/05

5/06

2/07

11/07

8/08

5/09

2/10

11/10

8/11

5/12

2/13

11/13

Source: Moody’s, S&P, Fitch, Intex.

8

The Structured Credit bid for assets will remain significant Global Global Cash Cash CDO CDO issuance issuance by by sector sector ($bn) ($bn)

US Fixed Income Markets 2005 Outlook

120

SF

HY Loans

Corp Bonds

Total Total outstanding outstanding Global Global Credit Credit Derivatives Derivatives volume volume ($bn) ($bn)

Other

6000

100

5000

80

4000

60

3000

40

2000

20

1000

0

0 1997 1998 1999 2000 2001 2002 2003 2004

Source: JPMS, MCM, IFR Markets, Moody’s, S&P, Fitch, Bloomberg

Other Credit Deriv ativ es

Structured Credit

1997 1998 1999 2000 2001 2002 2003 2004 Source: JPMS, CreditFlux, British Banker’s Association, ISDA, McKinsey & Co., Bank for International Settlements

9

CLO spreads grind to record tights, but premium to Cards has ended up unchanged AAA AAA CLO CLO Spread Spread to to LIBOR LIBOR (bp) (bp)

BBB CLO Spread to LIBOR (bp) BBB CLO Spread to LIBOR (bp)

65

325

60

300

55 50 45

250

40

225

35

200

30

175

10/00 4/01 10/01 4/02 10/02 4/03 10/03 4/04 10/04 AAA CLO CLO minus minus AAA AAA Card Card Spread Spread differential AAA differential (bp) (bp)

US Fixed Income Markets 2005 Outlook

275

10/00 4/01 10/01 4/02 10/02 4/03 10/03 4/04 10/04 BBB CLO CLO minus minus BBB BBB Card Card Spread BBB Spread differential differential (bp) (bp)

35

185

30

165

25

145 125

20 15 10 10/00 4/01 10/01 4/02 10/02 4/03 10/03 4/04 10/04

105 85 65 10/00

4/01

10/01

4/02

10/02

4/03

10/03

4/04

10/04

Source: JPMS.

10

Despite tightening, CDOs still offer a spread pick-up to like rated securities AAA AAA Spreads Spreads to to Swaps/Libor Swaps/Libor

53

39

33

5-7 Yr IG Syn

7-12 Yr SF

6-10 Yr HY

CDO

CDO

CLO

28

10 Yr CMBS

27

3-5 Yr HEL

18

13

5

10 Yr Floating

5 Yr UK

10 Yr

Cards

Sterling RMBS

Industrial

75

75

49

BBB BBB Spreads Spreads to to Swaps/Libor Swaps/Libor

300

315

US Fixed Income Markets 2005 Outlook

200

175 82

7-12 Yr SF CDO

5-7 Yr IG Syn CDO

6-10 Yr HY CLO

3-5 Yr HEL

10 Yr CMBS

5 Yr UK 10 Yr Floating Sterling RMBS Cards

10 Yr Industrial

As of November 18th, 2004 Source: JPMS.

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US Fixed Income Markets 2005 Outlook

Additional information is available upon request. Information herein is believed to be reliable but JPMorgan does not warrant its completeness or accuracy. Opinions and estimates constitute our judgment and are subject to change without notice. Past performance is not indicative of future results. The investments and strategies discussed here may not be suitable for all investors; if you have any doubts you should consult your investment advisor. The investments discussed may fluctuate in price or value. Changes in rates of exchange may have an adverse effect on the value of investments. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. JPMorgan and/or its affiliates and employees may hold a position, may undertake or have already undertaken an own account transaction or act as market maker in the financial instruments of any issuer discussed herein or any related financial instruments, or act as underwriter, placement agent, advisor or lender to such issuer. Clients should contact analysts at and execute transactions through a JPMorgan entity in their home jurisdiction unless governing law permits otherwise. This report should not be distributed to others or replicated in any form without prior consent of JPMorgan. This report has been issued, in the U.K. only to persons of a kind described in Article 19 (5), 38, 47 and 49 of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 (all such persons being referred to as “relevant persons”). This document must not be acted on or relied on by persons who are not relevant persons. Any investment or investment activity to which this document relates is only available to relevant persons and will be engaged in only with relevant persons. In other European Economic Area countries, the report has been issued to persons regarded as professional investors (or equivalent) in their home jurisdiction. JPMorgan uses the following recommendation system: Overweight. Over the next six to twelve months, we expect this bond to outperform the average total return of the bonds in the analyst’s (or analyst’s team’s) coverage universe. Neutral. Over the next six to twelve months, we expect this bond to perform in line with the average total return of the bonds in the analyst’s (or analyst’s team’s) coverage universe. Underweight. Over the next six to twelve months, we expect this bond to underperform the average total return of the bonds in the analyst’s (or analyst’s team’s) coverage universe. JPMorgan uses the following rating system: Improving (I) The issuer’s long-term credit rating likely improves over the next six to twelve months. Stable (S) The issuer’s long-term credit rating likely remains the same over the next six to twelve months. Deteriorating (D) The issuer’s long-term credit rating likely falls over the next six to twelve months. Deteriorating+ (D+) The issuer’s long-term credit rating likely falls to junk over the next six to twelve months. Defaulting (F) There is some likelihood that the issuer defaults over the next six to twelve months. This report should not be distributed to others or replicated without prior consent of JPMorgan.

12

Chris Flanagan (1-212) 260-6515 [email protected]

US Fixed Income Research 2005 Outlook – Special Report December 1, 2004

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