Current Portfolio Position and Strategy

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Q2 2012 Investment Strategy
Sample Bank
Anywhere, US

Economic and Fed Overview
The US economy has enjoyed modest strength since the beginning of the year and Portfolio Mar 31, 2012
continued improvement in general conditions. First quarter growth is expected to
have come in close to 2%, and leading indicators point toward acceleration in the Book Value $54,000,000
second quarter. Portfolio/TA 54%

Employment data in particular have been encouraging as monthly payrolls growth $ Gain/(Loss) $1,242,000
has averaged 245K the last three months and the size of the labor force appears to % Gain/(Loss) 2.3%
have stabilized. Despite this good news, US economic performance as we begin the
Tax Equiv. Yield 3.21%
second quarter remains extremely weak in relative terms given the point in the
recovery cycle. Household deleveraging, continued weakness in home prices, fiscal Proj Avg. Life 3.75yrs
austerity, and a variety of external risks are likely to keep US growth slow and Eff. Dur/Conv 2.30/(0.6)
sluggish for the foreseeable future.
+300bp Risk (9.5%)
There continues to be a good news/bad news theme to the economic data. Recent
strength in retail sales growth is encouraging, though consumption growth in the
first quarter will struggle to match the 2.1% posted in the fourth quarter of last
year. Household balance sheets are on a firmer footing, but current consumption
appears to have drawn down savings, something that is not sustainable. Income
growth has been notably weaker than consumption. This pushed the personal
savings rate down to 3.7% in February, the lowest level since August 2009. Motor
vehicle sales and housing market activity (not prices) have improved, but rising
gasoline prices threaten to dampen consumer confidence in coming months.

Overall GDP growth for the year appears to be slogging along at a 2 - 2.5% pace,
still far below the average of comparable periods in prior cycles. The US output
gap remains large, and this fact seems to be a primary consideration for Fed
policy.

Inflation & Fed Policy
Inflation continues to be generally well behaved with the notable exception of
gasoline. The recent jump in gas prices will offset expected declines in other items,
but core inflation levels should remain around 2%, staying in line with the Fed's
target.

As for Fed policy, Chairman Bernanke, speaking to the National Association of
Business Economists, pointed to the relationship between the unemployment rate
and GDP growth (Okun's law) to show that labor market conditions remain far
from normal and that the recent pace of improvement may weaken. Bernanke
noted that this will probably require "continued accommodative policies" to
support demand. This leaves open the door for a third round of so-called
"Quantitative Ease".

The Fed's pledge to leave rates at near-zero until at least late 2014 remains valid
based on current conditions, although money markets currently discount a sooner
start to the tightening cycle. One likely reason for Bernanke's caution is the
prospect of severe fiscal tightening in 2013.

Bond yields can be expected to continue the "Great Range Trade" for the balance
of this year and beyond. The 10yr T-Note yield will likely fluctuate in the 2 - 2.75%
range in the near term. Any test of the upper end of that channel should be viewed
as particularly good value.

Fed Funds Futures – Current Market Expectations for FUTURE levels (as of 3/31/12):

Current Portfolio Position and Strategy

The Federal Reserve’s pledge to keep rates low through 2014 has helped to anchor Sector Distribution
Treasury yields at the lower end of their 4 year trading range. That has led to
some of the largest gains in the portfolio but also the lowest reinvestment rates in
recent history. As a result, portfolio yield fell another 12bp to 3.21% even as
Other,
extension risk and depreciation potential both rose during the quarter. Today’s CMO, 2%
13%
Agency
16%
extended low rate environment will continue to entice investors to “chase yield” in
higher risk securities, whether that risk comes from credit, liquidity or interest Muni,
25%
rate risk. Long periods of low rates typically lead to the introduction of many non- MBS,
40%
Tax
Muni,
traditional “alternative” investments as a way to pick up yield. The Bank will resist 3%

the temptation to take on unnecessary risk in these types of investments and will
instead focus on the traditional Agency, Municipal and MBS/CMO sectors to build
the portfolio. There is a real risk that an extended low rate environment combined
with a flat yield curve will continue to erode earnings and move the portfolio yield
closer to the Bank’s cost of funds. The best way to fight margin erosion without
taking on unnecessary risk will be to fully deploy idle funds. If Treasury yields
continue to trade within a narrow range during the 2nd quarter as expected, the
Bank will consider every market selloff (rise in yields) as an opportunity to
reinvest funds at higher rates. Security selection will be based on the best relative
value to take advantage of selloffs in certain sectors such as the unusually large
drop in municipal prices at the end of the 1st quarter. Being prepared to take
advantage of these types of opportunities may allow the Bank to further slow

margin erosion while continuing to avoid the pitfalls of higher risk securities. The
Bank will continue to maintain a cash flow barbell using short-end MBS/CMO
products for cash flow, along with longer tax-free Municipal bonds for income -
this will supply the Bank with necessary liquidity without sacrificing too much
yield. The Bank also expects to maintain duration and not be tempted to chase
yield in the wrong sectors, especially as the yield curve has flattened.

Historical U.S. Treasury Yield Curves

Sector Strategies
Agencies
Agency spreads to Treasuries tightened further in Q1 as treasury yields rose; 2-
Agency %
year bullet agencies are +5 basis points to treasuries and 5-years are +19 basis
points. The Bank will continue to moderate sector duration by primarily Curr/Last Target
purchasing securities with 3- to 7-year maturities. Favored structures will
16%/18% 15-25%
continue to be premium one-time callable securities with at least one year of call
protection. Step-ups with 1x-call, 1x-step structures will also be utilized when the Eff. Duration / Convexity
step coupon provides sufficient probability of call. The Bank will also look to add Curr/Last Target
multi-step structures with mid-term maturities when the step coupon schedule
provides ample cushion and the yield pickups warrant. Step-up issuance remains 2.0/(0.8) 1.5-
high and with a varying range of structures. The Bank will avoid chasing yield and 1.8/(0.8) 2.5/(0.5)-
(1.0)
refrain from buying longer maturity bonds in favor of shorter maturity 1x-step,
and 1x-callable bonds with higher back-end coupons. The Bank will continue to
look for opportunities to sell short maturities and deploy the proceeds on the
intermediate portion of the curve. In general, the Bank will look to take advantage
of market fluctuations by adding slightly longer duration instruments when rates
rise, and focusing on premium 1x-calls in the lower part of the trading range.

CDs
The bank’s CD sector remains quite small. However, with Agency yields and
spreads near all-time lows, the Bank will add to the sector as appropriate
securities become available. The Bank will focus on buying short-to-mid-term
marketable FDIC-insured CDs, where it can expect to pick up 10-35 bps vs. 2-year
maturity and 15-60 bps vs. 5-year maturity bullet agencies. Like agencies, the
Bank will avoid longer-maturity, option-heavy structures. FDIC insurance covers
up to $250,000 per issuer (by FDIC Certification #), including accrued interest.
The bank will limit holdings of CDs under these constraints per issuer. The
supply of unique issuers remains limited, so the Bank will look to take advantage
quickly when new opportunities arise.

Municipals

Municipals rallied in the first quarter as demand outpaced issuance and this trend Municipal %
should continue in the future. The percentage ratio between 10 year municipals
Curr/Last Target
and treasuries is 100%. The historical ratio is 80% and the Bank will purchase
municipals when the ratio is above 80%. The Bank has made an extensive effort to 25%/24% 20-30%
analyze and monitor the credit metrics of all municipal holdings and will be very
Eff. Duration / Convexity
diligent in reviewing the creditworthiness of all future purchases. Given prudent
credit analysis, the environment continues to offer excellent opportunities to add Curr/Last Target
to the Municipal sector. As the Bank continues to employ a barbell strategy, the 3.4/(0.4) 3.5-4.0/0-(0.5)
Bank will maximize longer municipal holdings and explore opportunities to swap 3.4/(0.4)
out of shorter maturities and deploy the proceeds out on the preferred range of
the curve.
Taxable Municipal %
The Bank will continue to buy general obligation municipals and will purchase
essential-purpose revenue municipals with a minimum of 1.25x coverage and Curr/Last Target
preferring a 1.50x or higher coverage. The Bank will also purchase BABs with 5-
10 year maturities, preferring shorter maturities because they do not have the 3%/3% 5-10%
same reduced duration benefit as the tax-free issues. The Bank will carefully
Eff. Duration / Convexity
review the creditworthiness of all municipal issuers in addition to assessing the
strength of the bond insurer. Preferred insurers of municipal holdings will be the
Curr/Last Target
Texas PSF, State Aid Withholding and Qualified School Bond Funds, and issues
rated A or better on their own. The Bank will purchase municipals with AGM or 5.8/0.1 5.0-7.0/0.3-(0.3)
Assured Guaranty insurance that have an A or better underlying rating. 5.9/0.1

MBS
The role of the MBS portfolio continues to be to provide steady cash flow while MBS %
maximizing risk/reward benefits. Over the first quarter, while MBS holdings
declined 2% towards the low end of the target, sector duration extended from 1.5 Curr/Prev Target
to 1.9, as a result of slightly higher rates. The recent back-up in rates reinforces
our strategy to balance both contraction and extension risk in all mortgage related 40%/38% 35-45%
investments. On one hand, the White House continues to push simulative packages Eff. Duration / Convexity
to allow more homeowners to refinance, at the same time as private mortgage
lending remains non-existent and the FHFA continues to raise fees for government Curr/Prev Target
mortgage insurance. The Federal Reserve has continued quantitative easing (QE)
measures by reinvesting portfolio cash flows into Agency MBS securities under 1.6/(0.8) 1.5-2.0/(0.7)-
the strategy known as “Operation Twist”. This program is expected to continue 1.5/(0.7) (1.3)
throughout the second quarter. Additionally, on October 24th, the White House
issued notice that it would be implementing a new and improved Home Affordable
Refinance Program (HARP 2). As expected, while the program has taken a few
months to gain traction, a certain segment of homeowners are beginning to take
advantage of a tremendous opportunity to obtain an artificially low cost mortgage.
Specifically, borrowers with no delinquencies over the past 12 months and an
underwater loan (>80LTV) originated before June 1, 2009, has the opportunity to
streamline refinance through Dec 31, 2013. Over the past quarter, the Bank
reviewed all holdings in the MBS portfolio and liquidated all securities deemed to
be negatively impacted by these changes. Specifically, the portfolio was filtered to
find longer-term instruments with >80% estimated current LTV. Of those
securities, pools with longer terms (e.g. 30yr), higher loan balances (>$150k),
higher FICO scores (>700) were considered for liquidation. More recently, the
FHA has announced a similar refinancing program to provide incentives to
refinance borrowers with loans also originated prior to June 1, 2009. The Bank
will perform a similar review of all GNMA holdings to determine if any items
should be liquidated prior to the program’s inception in august of this year.
Over the past few years of elevated refinance activity, the #1 loan attribute to
curtail fast prepayments, and also provide higher base case turnover rates,
continues to be pools comprised of lower loan balance mortgages. These loan
holders have less economic incentive to refinance into lower rates when they are
low but have increased mobility due to smaller loan sizes when rates are higher.
To balance extension and prepayment risks, the Bank will continue to focus on
shorter-term (<=20yr) and higher coupon (>=4.0%) specified agency MBS pools.
Pools will be selected with one or more of the following loan characteristics
that should provide prepay protection: 1) low loan balance, 2) investor and
vacation properties, 3) NY, TX, NJ, FL geographic concentrations, 4) FHA Loans
(GNMAs).

MBS ARM
The Bank’s MBS ARM sector continues to be quite small. However, with fixed rate MBS ARM %
MBS yields continuing to fall over the first quarter, the Bank will evaluate
opportunities to increase holdings of newer GNMA 3x1 and 5x1 Hybrid ARMs. Curr Target
The yield differential between fixed and floating rate instruments has continued to 4% 5-10%
narrow significantly, leading to potential opportunities to enhance future rate
sensitivity with minimal yield give up. GNMA hybrids will be the primary focus of Eff. Duration / Convexity
the ARM strategy, as the underlying FHA loans have shown to provide similar Current Target
prepayment protection to FHA 30yr fixed mortgages (GNMA MBS). Longer first
resets provided by these structures, 24-60 months, could coincide well with the 0.61/(0.2) 1.5-
FOMC stated bias toward keeping short term rates low through the end of 2014. 1.5/(0.2)-
(0.75)

CMO
After peaking at 15% allocation in Q3 2011, the CMO sector has declined 2% to CMO %
stand at 13% of investments to close out Q1 2012. Similar to the MBS sector, the
CMO portfolio experienced a duration extension at the end of Q1 to 1.7 from 1.1 at Curr/Prev Target
the end of Q4, 2011. Given the growing impact of HARP 2, CMO structures must be 14%/15% 10-20%
evaluated with heightened scrutiny towards faster prepayment rates over the
Eff. Duration / Convexity
near term. The Bank will continue to pursue CMO structures that have 3-5 year
projected average lives with limited extension risk. Additionally, very short Current/Prev Target
average life CMOs (1-2yrs) will be utilized to provide a spread to cash alternatives
over the next 24-30 months while the Fed keeps the Funds rate anchored. To 1.1/(0.7) 1.0-
0.9/(0.8) 1.5/(.75)-
diversify mortgage prepayment exposure and take advantage of the more stable (1.25)
prepayment characteristics of FHA loans, GNMA MBS will be the preferred CMO
collateral. Foremost, FHA loans originated after June 1, 2009 are not eligible to
refinance under the FHA HARP program. Additionally, GNMA MBS originated
prior to April 2011 have provided excellent prepayment protection as the FHA has
increased the annual Mortgage Insurance Premium by 60bps since Q4 2010. The
increased premium results in an additional 50-60bp rate incentive for an FHA
borrower to have any Net Tangible Benefit to refinance. Furthermore, GNMA
collateral can offer superior extension protection as base case turnover should
remain brisk due to ongoing buyouts of lesser credit FHA borrowers.
Alternatively, preferred FNMA/FHLMC collateral will have underlying loan
attributes that should provide prepay protection (low loan balance, investor and
vacation properties, NY, TX, NJ, FL geographic concentrations, etc.). As with the
MBS portfolio, the Bank reviewed the CMO portfolio to determine if any securities
might be impacted by changes to the Government’s HARP program. Specifically,
the portfolio will be filtered to find instruments with >80% estimated current
LTV. Of those securities, pools with longer terms (e.g. 30yr), higher loan balances
(>$150k), higher FICO scores (>700) were considered for liquidation prior to the
implementation of HARP 2 throughout 2012. All CMO’s will be prudently analyzed
for both extension and call risks and will pass all FFIEC stress tests.