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					                                                                                               J   A N U A R Y    2 0 0 6


 Research Insights:
 Is the U.S. Housing Bubble Over-inflated?
                                                                                               The US residential housing market has experienced
                                                                                               rapid price appreciation over the past several
                                                                                               years, driven by an improving economy, low
                        KEY FINDINGS                                                           interest rates and increased levels of home
                        s         While evidence suggests that the US housing                  ownership. The median price for existing homes
                                  market is slowing, the risk of a housing bust                nationwide increased 8% in 2003, 9.1% in 2004,
                                  seems low. We believe a gradual slowdown                     and will likely exceed 10% in 2005, a material
                                                                                                                                    1

                                  in the rate of appreciation in housing prices                increase from the 55-year average annual increase
                                  is a more likely scenario.                                   of 4.8% (see Exhibit 1). These outsized gains
                        s         Housing affordability is at historical lows, the risk        have enticed speculative investors to participate
                                  profile of borrowers has increased, and savings              in the US housing market and encouraged lenders
                                  rates have continued to decline, suggesting                  to market riskier financing products to prospective
                                  consumers are spending a meaningful portion                  buyers, with both parties increasingly using
                                  of their housing-related wealth.                             optimistic expectations for further price
                                                                                               appreciation to justify their investment decisions.
                        s         Offsetting these concerns, favorable
                                  demographics support steady housing demand,                  US homeowners borrowed $600 billion against
                                  stable vacancy rates in the rental market suggest            the growing equity in their homes in 2004, which
                                  that supply and demand for housing are                       has tripled in the past five years to represent
                                  relatively well-balanced, and upward resets on               approximately 7% of disposable personal income.2
                                  outstanding Adjustable Rate Mortgages (ARMs)                 Mortgage debt in mid-2005 totaled approximately
                                  will be fairly well-distributed in coming years.             $8 trillion, or 43.5%, of total US housing value
                        s         The UK experience suggests that a reversion to               of $18.4 trillion. Investors now represent
                                  normalized levels of annual home price appreciation          approximately 18% of home buyers through June
                                  could have a negative impact on consumer                     2005. With home prices significantly outpacing
                                  spending, which has been one of the key drivers              personal income, affordability has reached all-time
                                  of the US economy for the past several years.                lows, forcing buyers to take on more leverage with
                                                                                               a greater degree of interest rate risk to purchase
                                                                                               a home. How will this cycle end?


                                    16
            Exhibit 1
   Annual National                  14

House Price Growth
                                    12
               (Percent)
                                    10
                                                   4.8%: 1950-2004
   Source: E.H. Boeckh               8           Average Growth Rate
 and Associates, Bureau
     of Labor Statistics,
     US Census Bureau                6
      and Freddie Mac,
       November 2005                 4

                                     2

                                     0
                                         1950   1955      1960         1965   1970     1975        1980    1985      1990   1995    2000

                                                                                     Recession Year
                            (1)
                              National Association of Realtors
                            (2)
                              Greenspan, Alan and Kennedy, James, Federal Reserve Board. Estimates of Home Mortgage
                              riginations, Repayments, and Debt on One-to-Four Family Residences, September 2005.
Is the U.S. Housing Bubble Over-inflated?




           LOW RISK        OF A   HOUSING BUST                       a 30-year fixed rate 5.5% mortgage to an
                                                                     adjustable rate mortgage with a 1% teaser rate.
           While there is evidence that the US housing market        Yet the $500 out-of-pocket differential per month
           may be slowing, the risk of a housing bust,               carries significantly greater risk, namely that the
           characterized by a 10% or greater decline in              1% teaser rate could rise dramatically over the
           nominal house prices nationwide, appears low.             course of the loan. While the borrower in a 30-year
           Catalysts for such a decline could include an             fixed rate mortgage would feel no impact from
           oversupply of housing coupled with either a               rising rates, his monthly payment in an ARM would
           significant increase in unemployment, a sharp             increase by roughly $200 for every 1% increase in
           and unexpected spike in interest rates, or an             rates. If rates increase more than 2.5% over the life
           economic recession. None of these catalysts seem          of the ARM, the borrower would have been better
           to be on the horizon in the US economy: housing           off remaining in the 30 year fixed rate mortgage.   3

           supply has lagged job growth in most regions,
           unemployment rates are low, long-term interest
           rates are relatively unchanged while short-term           RISING INTEREST RATES HURT
           rates have been rising at a measured pace, and            HOMEOWNERS WITH ADJUSTABLE RATE
           US economic growth remains healthy. In fact,
           these factors could serve to alleviate a bust.            MORTGAGES
                                                                     Clearly, a rising interest rate environment will hurt
           What appears more likely is a gradual slowdown            homeowners with adjustable rate mortgages.
           in the rate of appreciation in housing prices going       To the extent that short-term interest rates
           forward. Overheated markets in coastal areas that         continue to rise and long-term bond yields remain
           have enjoyed strong double-digit appreciation may         low, the spread in yield between 2-year and
           experience a sharper decline. Such a slowdown             10-year Treasuries may continue to shrink. An
           could have a negative impact on consumer                  inverted yield curve, whereby short-term rates are
           spending, which has been one of the catalysts             higher than long-term rates, is often associated
           driving the US economy for the past several years.        with an economic slowdown or even a recession,
                                                                     which would be negative for home equity values.
           BUYERS TAKING          ON   MORE RISK                     While the Fed has historically eased monetary
                                                                     policy within a few months of a yield curve
           Affordability of US housing is at an all-time low.        inversion, the Fed’s apparent focus on achieving
           As home price appreciation has outpaced income            a neutral level of short-term interest rates and
           growth, prospective buyers have been forced               maintaining price stability could come at a cost in
           to take on greater interest rate risk to purchase         terms of slower economic growth in the near term,
           a home. While the more innovative financing               posing an additional risk to the US housing market.
           alternatives may look attractive to prospective
           buyers, many of them may not understand
           the underlying risks they are taking with
           these products.
           One example is the use of an adjustable vs.
           a fixed rate mortgage. There are several types
           of adjustable rate mortgages (ARMs), however,
           all share one feature: after an initial period of fixed
           payments with low rates, the loans adjust – usually
           to the prevailing yield of one-year Treasury bills plus
           a margin of one to three percentage points. Using
           reasonable assumptions, the monthly mortgage
           payment on a $230,000 home could decline by as
           much as $500 per month simply by switching from




           (3)
       2     Janus Research.
                          SAVINGS RATES CONTINUE                         TO   DECLINE          years, which may have contributed as much as
                                                                                               1% to US economic growth. If this wealth effect
                          As home equity values have made consumers feel                       were to diminish, consumer spending, and indeed
                          wealthier and supported higher levels of consumer                    economic growth, could be adversely affected.
                          spending, savings rates have continued to decline.
                          Savings rates fell to a record low of -1.5% in late
                          2005 from 2004’s already-low 1.7% average rate                       RISK PROFILE OF        BORROWERS
                          (see Exhibit 2). A slowing housing market would                      HAS INCREASED
                          dampen the positive wealth effect associated with
                          rising home equity values, driving consumers to                      Within the mortgage-backed securities market,
                          save a greater share of their incomes and returning                  the risk profile of borrowers has increased over
                          the savings rate to positive territory. While this                   the last several years. A brief snapshot of the prime
                          may be a healthy turn of events over the long                        mortgage subsection of the market, which includes
                          term, the hit to consumer spending in the near                       only non-agency jumbo loans, illustrates this trend.
                          term could be significant.                                           Prime borrowers have increasingly used ARMs to

           Exhibit 2        $320,000                                                                                                              10.0

                                                                   Personal Saving Rate
  New One-Family                                                   (percent: red line: rhs)
  Houses: Averege           $280,000                                                                                                              7.5
       Sales Price
       Compared
    with Personal                                                                                                                                 5.0
                            $240,000
      Saving Rate

                            $200,000                                                                                                              2.5
Source: Census Bureau,                      New One-Family Houses:
    BEA, Merrill Lynch,                     Average Sales Price
       December 2005                        (dollars: black line: lhs)
                            $160,000                                                                                                              0.0



                            $120,000                                                                                                              -2.5

                                       91      92       93      94       95    96      97     98   99    00     01    02    03     04    05




                          HOUSING WEALTH HAS BOOSTED                                           reduce their near-term mortgage payments,
                          CONSUMER SPENDING                                                    while exposing themselves to greater interest
                                                                                               rate volatility over the life of the loan. While
                          Consumers have extracted money from their homes                      representing only 36% of total mortgage
                          to increase spending levels over the past several                    originations, ARMs accounted for 71% of all
                          years, which has been an important driver of US                      prime originations by late 2005 (see Exhibit 3).
                          economic growth. One recent study suggests                           Innovative mortgages, such as interest-only
                          that the long-term wealth effects of housing                         ARMs and option ARMs, have also become
                          and equities are similar, but that 80% of housing                    a large portion of the prime, near-prime and
                          wealth finds its way into consumer spending                          sub-prime markets in the last several years.
                          within 12 months, while stock market gains
                          typically translate into consumer spending over
                          a five-year period. Using reasonable assumptions,
                          housing wealth has likely accounted for over 20%
                          of the growth in US consumer spending in recent




              3
Is the U.S. Housing Bubble Over-inflated?




                        Loan-to-value (LTV) ratios have increased,                        Assuming replacement demand of 20 million units
                        effectively reducing total home equity, and                       over that time period, the US will need to build
                        debt-to-income (DTI) levels have risen by roughly                 59 million new units between 2000 and 2030.6
                        9%. The percentage of prime mortgages sold to
                        investors has tripled during this period, and the                 Furthermore, in several desirable regional areas,
                        percentage of full documentation loans, which                     job growth has meaningfully exceeded housing
                        require borrowers to provide more information                     growth, which has put upward pressure on
                        to process the loan, has nearly halved, both                      housing prices. In the year ending March 2005,
                        indicative of greater risk in the sector.                         28,000 new jobs were created in Orange County
                                                                                          on the Southern California coastline, while only

         Exhibit 3            Origination Year       ARM%         FICO      Current LTV      Loan Size     Investor%     Full Doc       DTI
Prime Mortgages                    1998              9.0%         725            72.3%          330          0.6%         72.2%        25.5%
                                   2000              33.1%        723            74.5%          368          1.1%         64.0%        29.5%
 Source: Source: UBS,
            July 2005              2005              71.4%        731            73.5%          453          3.3%         38.6%        34.5%


                                                                                          8,200 new building permits were issued. In
                        NOT WORRIED ABOUT                    A                            Washington D.C., 66,400 new jobs were created
                        HOUSING BUST                                                      with only 30,300 new building permits issued.7
                        We identify five factors which may serve to offset                This supply/demand imbalance has resulted in
                        these concerns.                                                   significantly greater price appreciation in both
                                                                                          areas than in other parts of the country. As long
                        Favorable Demographics Driving US                                 as local employment remains healthy, strong
                        Housing Demand                                                    housing demand should create a pricing floor
                        First, favorable demographics are driving US                      in these markets.
                        housing demand nationwide. The US population                      Real Estate is a Local Business, not a
                        is projected to grow by approximately 2.7 million                 National One
                        people annually for the next 10 years, while Japan
                        and much of Western Europe will most likely                       Second, localized ”mini-bubbles” can burst
                        experience a notable decline in population. 4                     without necessarily throwing the national housing
                        Between 1990 and 1999, approximately 12 million                   market into a tailspin. Real estate is a local business,
                        new US households were created as a result of                     not a national one, and housing prices are largely
                        record numbers of immigrants entering the U.S.                    driven by the relative strength of the local job
                        over the past 2 decades and a growing number                      market. Historically, the volatility in home prices
                        of “non-traditional” – single-parent, single person,              experienced in desirable locations, such as Southern
                        unmarried couples, female-headed – households.                    California, has been materially greater than the
                        Another 14 to 15 million new households are                       nationwide average. Beginning in 1991, San Diego
                        expected to be added between 2005 and 2015.                       experienced 3 consecutive years of job losses and
                        Together, household growth and replacement                        existing home prices declined approximately 10%,
                        demand are expected to support the construction                   with national housing prices largely unaffected.
                        of another 20 million new homes over the next                     While home prices in the Northeast have
                        decade,5 which would require annual housing                       appreciated close to 70% over the past five years,
                        starts to remain at approximately 2 million.                      housing prices in Texas and other parts of the South
                        Looking further into the future, estimates suggest                have risen roughly 25% over the same period.8
                        that population growth will require nearly 39                     Annual increases in house prices in 2005 range
                        million new units between 2000 and 2030.                          from less than 5% to over 25% (see Exhibit 4).




            4           (4)
                           U.S. Census Bureau, Population Division, Interim       Opportunity To Rebuild America, The Brookings Institution
                           State Population projections, 2005.                    Metropolitan Policy Program.
                        (5)
                           Joint Center for Housing Studies of Harvard            (7)
                                                                                      John Burns Real Estate Consulting, Local Building Market
                           University, The State of the Nation’s Housing 2005.        Intelligence.
                        (6)
                           Nelson, Arthur C. Toward A New Metropolis: The         (8)
                                                                                     Housing Credit Market, Goldman, Sachs & Co., November 2005
                                                                                WA                                                                           NH ME
                                                                               16.1%                                                                   VT 12.5% 14.1%
            Exhibit 4                                                                           MT                                                   16.2%
                                                                           OR                  11.5%           ND                                                 MA 12.1%
Single Family House                                                       14.8%         ID                    9.5%       MN                                 NY
                                                                                                                        9.7%                             15.4%      RI 17.4%
                                                                                      11.9%                    SD                  WI
      Price Growth,                                                                                                               9.6%     MI                    CT 14.2%
                                                                                                  WY          9.3%                        4.9%          PA
       Q204 – Q205                                                             NV                10.9%                                                13.8%     NJ 18.7%
                                                                                                                           IA                  OH
                                                                              27.0%                             NE        5.6%            IN 5.4%              DE 17.4%
                                                                                         UT                    4.9%                  IL              WV VA     MD 23.7%
                                                                       CA               9.1%        CO                             10.1% 4.9%       8.9% 21.8%
                                                                      25.7%                        5.5%           KS          MO              KY
    Source: Freddie Mac                                                                                          4.9%        7.8%            6.0%      NC 6.1%
 Conventional Mortgage                                         AK                      AZ                                               TN 7.1%
      Home Price Index                                        11.9%                   28.0%       NM                 OK                              SC 7.1%
                                                                                                                    4.9%       AR
        Annual Growth,                                                                           11.9%                        7.4%                 GA
                                                                                                                                      MS AL       6.4%
              June 2005                                                                                                              4.4% 7.8%
                                                                                                               TX
                                                                                                              4.3%               LA
                                                                                                                               5.7%                       FL
                                                                                                                                                       24.5%

                                                                                    HI
                                                                                  24.7%



                            Adjustable Rate Mortgage Rates Will Reset                                           Build to Order Model Mitigates Risk of
                            Gradually Over Time                                                                 Housing Glut
                            Third, notwithstanding the growing concern                                          Fourth, the evolution of the build-to-order
                            about the rise in ARMs as a percentage of total                                     model within the homebuilding industry should
                            mortgage originations, these innovative mortgages                                   contribute to a more rational supply/demand
                            represent only 36% of total outstanding mortgage                                    environment as the housing market slows. In many
                            obligations, with the remaining 64% in fixed-rate                                   markets, over 50% of the homebuilder’s costs are
                            product. Additionally, over the next decade, no                                     not incurred until a buyer orders the home.
                            more than 6% of the mortgage market will                                            Because the majority of his costs are not exposed,
                            experience an ARM rate reset in any given year.                                     the builder has little incentive to construct unsold
                            The distribution of ARM resets should mitigate a                                    homes and create excess inventory. In addition,
                            high concentration of defaults in any given period.                                 the builder increasingly has the ability to option
                                                                                                                land, rather than purchase it outright.


            Exhibit 5                              9-10

                                                   8-9
         ARM Resets
                                                   7-8
       as a % of the
                             Years in the future




                                                   6-7
       MBS Market*
                                                   5-6

                                                   4-5
    Source: Bear Stearns                           3-4
        December 2005
                                                   2-3
     *Includes Agencies,
   Jumbo's, Alt.-A’s, and                          1-2
    Subprime securitized                           <1
            product only
                                                         0%               2%                             4%                       6%                         8%
                                                                                        Percentage of universe that resets




                5
Is the U.S. Housing Bubble Over-inflated?




                           By putting most of the money down only when                    rates typically decline as potential home buyers
                           ready to start construction, builders can assess the           decide to rent instead. However, if vacancy rates
                           market and estimate their expected returns before              continue to fall, demand for rentals usually
                           committing more capital and creating more supply.              increases, driving up rental costs, and renters
                           If demand softens and estimated returns are too                may decide that buying a home is a more attractive
                           low, the builder may elect to sit on the land, to              investment. Double digit vacancy rates coupled
                           build fewer homes and accept a lower price for                 with strong home price appreciation might be
                           them, or to renegotiate terms with the land owner.             a cause for concern as buyers may be reaching
                           This flexibility should reduce the likelihood that             beyond what they can afford. Vacancy rates in the
                           builders will create an oversupply of unsold                   mid single digits historically suggest that owning
                           housing inventory. Inventory sale time for new                 and renting a home are both relatively attractive
                           homes has been remarkably stable over the past                 alternatives. After peaking in early 2005, apartment
                           five years at just under five months, suggesting               vacancy rates have stabilized at 6%, suggesting
                           that supply and demand have been better aligned                that while there may be some switching from
                           than in previous economic cycles.                              buying to renting on the margin, supply remains
                                                                                          relatively tight in the housing market.

           Exhibit 6             15
                                 14
Months Supply of                 13
  Homes for Sale                 12                              Existing Homes
                                 11
                                 10
        Source: Census
                                 9
  Bureau and National
Association of Realtors,         8
       November 2005             7
                                 6
                                 5
                                 4                               New Homes
                                 3
                                  1976   1978   1980   1982   1984   1986   1988   1990    1992   1994   1996   1998   2000   2002   2004

                                                                                Recession Year


                           Investors Increasingly Renting,                                HOUSING PRICES MORE LIKELY                  TO
                           Not Flipping Properties
                                                                                          LEVEL OFF
                           Finally, outside of overheated markets like Miami
                                                                                          Rather than experiencing a nationwide bust,
                           and Las Vegas, many investors in the housing
                                                                                          the housing market should level off, with annual
                           market are renting their properties rather than
                                                                                          nationwide home price appreciation slowing from
                           trying to sell them for a quick profit. With housing
                                                                                          10% to the low single digits. Overheated markets
                           investors earning a low single-digit annual return
                                                                                          in coastal areas where home prices have increased
                           by renting their properties, new homes purchased
                                                                                          20% per year may see a much sharper slowdown.
                           by investors that have entered the rental pool are
                                                                                          Notwithstanding the strength in consumer
                           less likely to come for sale in the open market,
                                                                                          spending and the decline in household savings
                           reducing the risk of a supply glut.
                                                                                          rates over the past several years, consumers have
                           One way to analyze the risk of a supply glut is                not spent 100% of the appreciated value in their
                           through demand for apartment rentals, which                    homes. In the event of a sharp fall in home equity
                           are effectively the substitute product for home                values, the past several years of appreciation will
                           ownership. As home prices appreciate, vacancy                  create a cushion for homeowners.9




              6              Greenspan, Alan and Kennedy, James, Federal Reserve Board. Estimates of Home Mortgage Originations, Repayments,
                           (9)

                             and Debt on One-to-Four Family Residences. September 2005.
                            While consumer liabilities are growing, assets have            times the median annual income.11 To the extent
                            grown substantially as well. Widespread defaults               that home prices level off and consumers feel less
                            are unlikely so long as home equity is still positive.         wealthy, overall consumer spending could be hurt,
                                                                                           which would in turn weigh on economic growth.
                            The negative wealth effect of lower home price
                            appreciation, however, may weigh on consumer
                            spending. While consumers have been feeling                    UK EXPERIENCE SUGGESTS SLOWER
                            wealthier and spending more, income growth                     CONSUMER SPENDING
                            has not kept pace with home price appreciation.
                            Between 2001 and 2004, home price appreciation                 The UK experience over the past several years is
                            exceeded income growth by an average of 6.5%                   illustrative in this regard. UK average home prices
                            on existing homes and 7.1% on new homes.                       have increased roughly fourfold in the past 20
                            Estimates suggest that this gap between home                   years. The majority of the UK mortgage market
                            prices and incomes increased to nearly 8% on                   is comprised of two-year ARMs. The mid-1990’s
                            existing homes and 12.6% on new homes in                       ushered in a period of strong double-digit annual
                            2003–2004. In the most expensive US cities,
                                        10                                                 home price appreciation, which has since leveled
                            the median home price now represents 8 to 9                    off with little to no appreciation in the past 2
                                                                                           years. Home equity values have not declined in
                                                                                           absolute terms. However, the negative wealth
            Exhibit 7              35
                                                                                           effect associated with financing an asset that
                                   30                                                      is no longer rising in value at higher interest rates
   U.K. House Price
                                                                                           is a factor that has sharply curtailed UK consumer
      Appreciation                 25
                                                                                           spending and increased the UK savings rate during
    (3 Mo. Avg. Y/Y %              20                                                      this period.
           Oct. 3.2%)
                                   15                                                      At the peak of the UK housing market in
                                   10
                                                                                           2003, annual home price appreciation reached
    Source: International                                                                  approximately 25% and retail sales had grown
Strategy and Investment,            5                                                      nearly 8% over the prior year. Today, UK home
         November 2005                                                                     prices are stable with annual appreciation of less
                                    0
                                                                                           than 5%, while retail sales growth has slowed
                                    -5                                                     to less than1%.
                                   -10
                                                                                           To put this in perspective, US housing prices in
                                         88   90   92   94   96   98   00   02   04        2003 and 2004 increased 8-9% per year, less than
                                                                                           half the UK’s peak annual increase of 20%. In
                                                                                           addition, the US housing market has experienced
            Exhibit 8              12
                                                                                           roughly half the appreciation that the UK market
       U.K. Nominal                                                                        has in the past 20 years. Furthermore, while ARMs
                                   10                                                      increased from 9% to 36% of the outstanding
         Retail Sales
                                                                                           mortgage universe between 2001 and 2005,
    (Y/Y % Oct. 0.2%)               8                                                      fixed-rate mortgages remain a much larger share
                                                                                           of the total loans outstanding in the US than in
                                    6                                                      the UK. Less dramatic price appreciation and more
    Source: International                                                                  modest exposure to rising interest rates together
Strategy and Investment,
                                    4                                                      suggest that the impact of slowing home price
         November 2005
                                                                                           appreciation on consumer spending appears likely
                                    2
                                                                                           to be more modest in the US than in the UK.


                                    0
                                         88   90   92   94   96   98   00   02   04




                7              Janus Research.
                            (10)


                               Standard and Poors, US House Prices: Even Pretty Bubbles Pop.
                            (11)
Is the U.S. Housing Bubble Over-inflated?




           US IS MORE LIKE              THE    UK,                            FINANCIAL SERVICES LESS EXPOSED
           LESS LIKE JAPAN                                                    THAN IN PAST CYCLES
           While the recent UK housing cycle provides insight                 From a financial services perspective, where is all
           with respect to the potential range of outcomes                    this risk in the mortgage industry going? Certainly
           in the US, the Japanese real estate collapse is a                  the banking system is accepting its fair share with
           lessuseful analogy. While the UK and US real estate                mortgage portfolios exceeding $50 billion at Bank
           booms have been concentrated in the residential                    of America, Wells Fargo, Washington Mutual,
           housing market, Japan's real estate bubble was                     Countrywide and Golden West. Mortgages held
           concentrated in the commercial sector. A healthy                   by US commercial banks increased 160% from
           economic environment and strong job growth                         2001 through 2004.   12


           helped drive housing prices higher in the US, while
           the Japanese real estate boom was largely a result                 However, a real change in the mortgage industry
           of excessively loose lending standards on the part                 is the growth in the securitization market – where
           of the major banks, which provided companies                       an originated mortgage is packaged into a pool
           looking to invest in office space, golf courses                    of similar mortgages and sold as individual
           and other non-core activities with plenty of cheap                 securities with varying degrees of risk. Once
           capital. Unlike the gradual monetary tightening                    dominated by Government-Sponsored Enterprises
           by both the Bank of England and the US Federal                     (GSEs) Fannie Mae and Freddie Mac, this $5.6
           Reserve, the Bank of Japan increased interest rates                trillion secondary market has enabled financial
           rapidly and dramatically to curb speculative activity              institutions to remove some of the credit risk
           and pop the commercial real estate bubble in that                  from their balance sheets, while distributing
           country. Notwithstanding that many of these real                   that risk among a diverse set of investors seeking
           estate projects were financially under water, the                  higher-yielding fixed income securities. New
           banks who had lent the money refused to call in                    issuance of private-label Mortgage-Backed
           the loans they had extended to their corporate                     Securities (MBS) increased 40% in the first half
           borrowers, and the losses continued to mount.                      of 2005 over the same period in 2004. As Fannie
                                                                                                                       13



           The growing pool of non-performing loans on                        Mae and Freddie Mac have continued to lose
           bank balance sheets, coupled with significant                      market share, non-GSE mortgage securitizations
           overinvestment by Japanese manufacturers,                          have more than doubled as a percentage of the
           subsequently led to a sharp contraction in                         overall MBS securitization mix in the past 3 years,
           Japanese bank lending, and the Japanese                            accounting for 53% of all securitization activity.
                                                                                                                               14



           economy, in the years that followed.                               2004 saw a record $864 billion in non-agency
                                                                              issuance, a 47% increase over 2003. As a result
                                                                                                                    15


           In contrast to the Japanese experience, UK                         of this trend, while the mortgage portfolios at
           and US banks have remained relatively disciplined                  many banks have grown substantially in the past
           lenders in the context of rapidly rising home                      several years, their underwriting risk has been
           prices. US and UK banks have more robust cash                      mitigated somewhat. Exhibit 9 shows the
           provisioning practices, whereas Japanese banks                     percentage of outstanding bond market debt
           have always relied on collateral provisioning,                     invested in MBS as of March 2005.
           which is less liquid and more prone to murky bank
           lending and moral hazard. In addition, rather than
           keeping all the real estate exposure on their own
           balance sheets as the Japanese banks did, US
           financial institutions have aggressively used
           securitization as a tool to remove some of the
           mortgage exposure from their books. We discuss
           this topic in more detail in the next section.




       8   (12)
               Office of the Comptroller of the Currency Quarterly Journal,       JPMorgan Investor Presentation, October 2005.
                                                                               (14)

               Vol. 24, No. 3, September 2005.                                    Inside MBS & ABS.
                                                                               (15)

           (13)
               Bond Market Association.
           Exhibit 9
                                                                                  Municipal ($2.0)
MBS as a % of Total                                Corporate ($4.9)                    9%
                                                        20%                                                                  1. Interest-bearing marketable public debt.
  Outstaning Debt
            ($ trillions)                                                                                                    2. Includes FHLMC, FNMA, FHLBs,
                                                                                               Treasury ($4.1)1                 Sallie Mae, Tennessee Valley Authority
                                                                                                    17%                         and Farm Credit System.

                                      Money Market ($3.0)5                                                                   3. MBS include GNMA, FNMA and FHLMC
   Source: Bond Market                       12%                                                                                mortgage-backed securities, CMOs, and
                                                                                                                                non-agency MBS/CMOs.
Association, March 2005
                                                                                                Agency Debt ($2.7)2
                                                                                                                             4. Includes public and private placements.
                                                                                                      11%
                                                               4                                                             5. Includes commercial paper, bankers’
                                            Asset-Backed ($1.8)
                                                                                                                                acceptances, and large time deposits.
                                                    8%
                                                                            MBS ($5.6)3
                                                                              23%




                            MORTGAGE-BACKED SECURITIES LIKELY                                           This trend appears to have already begun,
                                                                                                        as investors in lower credit-quality MBS products
                            TO SEE SPREAD WIDENING                                                      have begun to demand more compensation for
                            Within the fixed income markets, the yield                                  heightened credit risk. For example, spreads on
                            spread between mortgage-backed securities                                   BBB-rated subprime MBS widened by 153bps
                            and US Treasuries will likely widen if housing price                        from October through mid-December 2005,
                            appreciation slows to a more "normal" rate. Agency                          bringing yields to 2-year highs (see Exhibit 10).
                            MBS, which have the guarantee of timely payment                             In contrast, spreads on agency-wrapped MBS
                            of interest and principal by Fannie Mae, Freddie                            widened by only 40bps over the same period.
                            Mac or Ginnie Mae, should experience less spread                            A similar “tiering” or credit risk would most likely
                            widening than the other sectors of the mortgage                             occur within the entire MBS market should the
                            market. The initial impact would probably be felt                           housing market continue to show signs of slowing.
                            in the subprime and innovative mortgage sectors
                            of the MBS market, which would likely experience
                            higher defaults and more severe losses in an
                            economic downturn.


                                      330
          Exhibit 10                                                                                                                                                       last=303
                                      300
   BBB Fixed Rate                     270
 Sub-Prime Spread
                             Spread




                                      240
           History
                                      210
                                      180
    Source: Bloomberg,                150
       Janus Research,
       December 2005                  120
                                        12/12/03    2/12/04   4/12/04   6/12/04    8/12/04   10/12/04   12/12/04   2/12/05     4/12/05      6/12/05      8/12/05     10/12/05




              9
Is the U.S. Housing Bubble Over-inflated?




                                                                                  CONCLUSION
                                                                                  While there is clear evidence that the US housing
                                                                                  market is slowing, the risk of a housing bust
                                                                                  appears low. A gradual slowdown in the rate
                                                                                  of appreciation in housing prices going forward
                                                                                  appears to be a more likely scenario. While
                                                                                  overheated markets in coastal areas, which have
                                                                                  enjoyed strong double-digit appreciation, may well
                                                                                  experience a sharper decline, this would be unlikely
                                                                                  to throw the national housing market into
                                                                                  a tailspin. The UK experience suggests that
                                                                                  a reversion to normalized levels of annual home
                                                                                  price appreciation could have a negative impact
                                                                                  on consumer spending, which has been one of the
                                                                                  factors behind the US economy for the past several
                                                                                  years. Financial services companies with large
                                                                                  mortgage portfolios are likely to be somewhat
                                                                                  insulated by the removal of some of this credit
                                                                                  risk through securitization activity. Fixed income
                                                                                  markets are likely to experience spread widening
                                                                                  in the lower-quality sub-prime and innovative
                                                                                  sectors within the MBS market.




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           management or advisory services, other than pursuant to an agreement in compliance with applicable laws, rules and
           regulations. Nothing herein is intended to amount to investment advice.

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           FM-0206(1)0806 Global(ex US) Q/D



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