mortgages, bank loans

and structured credit

Contents
쐍 Introduction ..................................................................................... 1

쐍 Nuts and Bolts

• Mortgage-Backed Securities...................................................... 2
• Bank Loans ............................................................................... 10
• Structured Credit ........................................................................ 13

쐍 Conclusion ...................................................................................... 17

쐍 Behind the Industry Jargon ............................................................ 18

쐍 Learn More ..................................................................................... 24

 Introduction
Global fixed income markets are constantly evolving and have
doubled in size over the past ten years, now surpassing $28 trillion.
Since August 2007, investors have witnessed unprecedented
events, including a credit crisis, extreme Fed intervention and
market volatility. As a result, investors and policymakers are more
focused on the bond market than perhaps ever before.

Securitization has been a key driver of many events in today’s fixed

income markets. For investors seeking to successfully capitalize on
opportunities and best utilize risk in this dynamic asset class, an
understanding of securitization is critical. Securitization is the
process of pooling loans or other financial assets and converting
them into securities. It allows the cash flows and risks from the
underlying assets to be reallocated to different classes of debt,
which can be sold to investors with different risk and return
appetites. The resulting securities typically have a broader and
deeper investor base and better liquidity than the underlying asset
pool would have by itself.

This guide focuses on three key areas of the bond market relating
to securitization, including mortgage-backed securities, bank loans,
and structured credit:

쐍 Mortgage-Backed Securities (MBS): A security created

by pooling a group of individual mortgage loans with similar
characteristics. Monthly payments from the mortgage pool are
then passed through to investors in the mortgage security.

쐍 Bank Loans (leveraged loans): A tradable form of corporate

debt, usually backed by hard assets, that is senior to bonds in
the capital structure.

쐍 Structured Credit: A form of securitization that uses

underlying instruments, such as mortgages and bank loans, to
create new securities with specific credit risk and
return profiles.

Goldman Sachs Asset Management I 1

 Mortgage-Backed
Securities

What is a mortgage?
A mortgage loan is a debt instrument by which a borrower gives the
lender a lien on real property as security for a repayment of the loan.
The borrower has the use of the property and the lien is removed
when the obligation is fully paid.

What is a mortgage-backed security?

Mortgage-backed securities (MBS) are bonds that are secured by a
collection of underlying mortgage loans. The mortgage payments of
the individual real estate assets are used to pay interest and
principal on the bonds.

History and size of the US mortgage market

With $7.2 trillion in mortgage-related debt outstanding, mortgages
have developed into one of the largest capital markets in the world,
surpassing both the US Treasury and US corporate sectors.

Prior to the 1970s, the US mortgage market was largely a primary

market. Financial institutions, such as thrifts and commercial banks,
would make residential loans directly to individuals and then hold
these mortgages on their balance sheets until maturity. Due to the
lack of a robust secondary market, individual financial institutions
were limited in the number of mortgages they could extend, which
in turn, limited the size of the overall mortgage market. During the
1970s and 1980s, the US government, through its agencies and
enterprises, began to establish an active secondary mortgage market
by creating and selling securitized mortgage pass-through securities,
effectively introducing the concept of securitization to mortgages.

2 I Goldman Sachs Asset Management

The introduction of securitization provided great benefits to the
marketplace. On the supply side, it provided greater flexibility to
financial institutions originating mortgage loans by removing
constraints. On the demand side, it introduced many new investors,
such as pension funds, to the mortgage marketplace. These
benefits have helped the market grow significantly in size and in
diversity of securities. Alongside this growth, there have also been
significant developments in the investment technology used to
value these securities and to measure their risk.

The mortgage market has grown steadily

Mortgage-related securities outstanding1

8,000
7,210
7,000
6,504
6,000 5,917
5,456
5,239
5,000
$ billions

4,686
4,127
4,000
3,566
3,334
3,000

2,000

1,000

0
1999 2000 2001 2002 2003 2004 2005 2006 2007

Source: Securities Industry and Financial Markets Association.

1
Includes GNMA, FNMA, and FHLMC mortgage-backed securities and CMOs and
private-label MBS/CMOs.

Goldman Sachs Asset Management I 3

Who issues MBS?
MBS are issued and/or guaranteed by the US Government,
government sponsored enterprises (GSEs), or by a private entity.
Below is a description of the three major agencies responsible for
the majority of MBS issuance:

Year Tie to Federal

Formal Name Nickname Abbreviation Established Government

Government Ginnie Mae GNMA 1968 Backed by full

National Mortgage faith and credit of
Association the US Government

Federal National Fannie Mae FNMA 1938 Line of Credit to

Mortgage the US Treasury
Association

Federal Home Freddie Mac FHLMC 1970 Line of Credit to

Loan Mortgage the US Treasury
Corporation

It is important to note that Fannie Mae and Freddie Mac, while

generally referred to as “agencies,“ are technically GSEs given the
fact that, unlike Ginnie Mae, their obligations are not backed by the
full faith and credit of the US Government.

While these three agencies account for the majority of MBS

issuance, private companies also issue MBS. The housing agencies
are limited to the types of mortgages they can securitize. Loans that
exceed a certain amount as well as loans that do not meet the
agencies’ strict underwriting standards are not eligible for
securitization by the agencies. “Private-label“ MBS, or non-agency
MBS, are typically issued by homebuilders or financial institutions
through subsidiaries and are backed by residential loans that do not
conform to the agencies’ underwriting standards. Non-agency
issued mortgage-backed securities are now a major component of
the MBS market.

4 I Goldman Sachs Asset Management

Securitization process: the creation of
mortgage pass-throughs
Agency mortgage pass-through securities are the most common
type of mortgage-backed securities and represent one of the largest
capital markets in the world. The agencies create pass-through
securities by securitizing residential mortgages. This process
involves pooling individual residential mortgage loans originated by
the private sector, issuing securities against the pool, and providing
some guarantee for the payments expected from these securities.
These newly created securities are called mortgage pass-through
securities. The diagram below illustrates this process:

Individual Mortgage Financial US Agency Investor

Home Deed Institution

쑺쑺 쑺쑺 쑺쑺 쑺쑺
Mortgages are Two mortgage Commercial GNMA, FNMA and Pools of individual
loans secured by loan structures banks, savings FHLMC are mortgages, now
real property. are most and loans and governmental packaged in a
common: insurance agencies that standard,
100% of the
Fixed Rate and companies provide liquidity diversified form,
collateral
Adjustable Rate. lend money and credit are sold to
consists of
collateralized enhancement in the institutional
residential real In both cases,
by the property mortgage market. investors. These
estate, with principal and
directly to the They purchase include pension
single family interest are
home owner. conforming funds, banks,
homes typically repaid in
mortgage collateral governments,
representing equal
and repackage it for corporations and
70% of the total. installments over
resale in the insurance
15-30 years.
securities market. companies.

Sources of risk:
Prepayment risk
• Borrowers of mortgages have an option to prepay their mortgages. Typically, they will
exercise this option to their advantage and the investor’s disadvantage.
• Unanticipated prepayments can change the value of some MBS.

Interest rate risk (Duration risk)

• Prices fall as interest rates rise due to fixed coupon rates.

Term structure risk

• Monthly principal cash flows cause a laddered structure.
• The value of securities can be affected by a steepening or flattening of the yield curve.

Negative convexity/volatility risk

• Embedded options cause the duration of most MBS to shorten in a rally and
lengthen in a sell-off.

Credit risk
• The agency market has little or no credit risk.
• The non-agency market has varying levels of credit risk.

Goldman Sachs Asset Management I 5

Credit enhancements
For agency MBS, the issuing agency guarantees investors that
they will receive timely payments of interest and principal,
regardless of the delinquency or default rates on the underlying
loans. Because non-agency MBS have no such guarantees, another
form of protection is needed to shield investors from borrower
delinquencies. Private-label MBS are rated by rating agencies
and often feature credit enhancements, such as subordination
and over-collateralization, which are designed to help protect
investors from delinquencies or losses on the underlying loans.

Subordination
Senior-subordinated credit structures are created with single or
multiple subordinated credit classes. The “junior“ tranches are
subordinated to the “senior“ tranches in terms of the prioritization
of principal cash flows. In addition, the subordinate tranches are
designed to absorb losses before they are allocated to senior
tranches. In other words, these designated junior securities
provide the credit support to the senior securities.

A typical capital structure (as shown in the exhibit below)

includes investment grade bonds, as well as “junk“ or unrated
bonds. The senior bonds are rated AAA and have first priority on
cash flow. The investment grade subordinates are rated AA to
BBB and have a lower priority on cash flow. At the bottom of the
credit structure are the non-investment grade subordinates.
These bonds are rated BB+ or lower and are significantly
exposed to losses from the underlying mortgage loans.

Typical mortgage pool structure

Cash Flow Mechanics
Mortgage Generic Deal Loss Principal
Loans Structure Priority Payments

AAA / Aa
Loss Position

Cash Flow

Pool of
Mortgage
Loans
AA / Aaa
A/A
BBB / Baa
BB / Ba
B/B
Unrated
First Loss

6 I Goldman Sachs Asset Management

Understanding mortgage collateral
Mortgage securities can be backed by a wide variety of loans with
different borrower characteristics, but the market is generally
divided into four main sectors: agency mortgages, prime jumbo
mortgages, Alt-A mortgages and subprime mortgages.

쐍 Agency mortgages – Must conform to the agencies’

standards in terms of size, the borrower’s credit score and
documentation, and the loan amount relative to the value of the
home. Other types of mortgages do not comply with these
standards for one or more reasons.

쐍 Prime jumbo – Exceed the agency maximum size (traditionally

$417,000 but the maximum was raised to $729,000 through 2008),
but borrowers generally have high credit scores.

쐍 Alt-A – Generally conform with agency standards in terms of

loan size and borrower credit score, but have other features that
do not conform, such as low documentation.

쐍 Subprime – Do not conform with agency standards primarily

due to lower credit scores (generally 605-640 out of a possible
850, compared to 680-730 for agency mortgages) and higher
borrower leverage (as measured by the debt-to-income ratio,
typically 40% for subprime borrowers). Documentation on
subprime mortgages also tends to be significantly lower than
agency standards, but may actually be higher than
documentation on an Alt-A mortgage.

Goldman Sachs Asset Management I 7

Different types of MBS
Pass-throughs are the most basic type of mortgage-backed securities.
One of the unique aspects of the mortgage market is the diversity of
instruments and products available to market participants. Below are
some other types of residential mortgage-backed securities:

쐍 Adjustable Rate Mortgage (ARM) – A pass-through

security that has predetermined adjustments of the interest
rate at specific intervals. Mortgage payments are tied to
varying indices, such as the interest rate on US Treasury bills,
London Interbank Offered Rate (LIBOR) or the average national
mortgage rate. Adjustments are made regularly, usually at
intervals of one, three, or five years. Different types of ARMs
include Hybrid ARMs, where the interest rate on the note is
fixed for a period of time, and then floats thereafter; as well as,
Option ARMs, where the borrower has the option to make
minimal payments, which allow for negative amortization, or to
make fully amortizing payments.

쐍 Collateralized Mortgage Obligations (CMOs) – A type

of mortgage security created by redirecting the cash flows from
underlying pools of mortgages to different classes of bonds
called tranches. The redistribution of scheduled principal,
unscheduled principal and interest from the underlying
mortgage pool to different tranches creates securities with
different coupon rates, average lives and price sensitivities.
Consequently, these instruments can be used to match an
investor’s particular risk and return objectives more closely.

8 I Goldman Sachs Asset Management

Other sectors
So far, this guide has focused on residential mortgage-backed
securities. However, there are other sectors of the market that are
interesting in the current environment. These include:

쐍 Commercial Mortgage-Backed Security (CMBS) –

Bonds backed by pools of mortgages on commercial and
multi-family real estate.

쐍 Asset-Backed Security (ABS) – One of the most

diverse sectors in the global fixed income markets, yet
with one common trait: they are backed by a pool of
homogeneous assets.

Unique characteristics of the mortgage market:

Market size
Market comprises approximately one-third of the US fixed income
aggregate indices.
Enhanced diversification
Investment opportunities vary by product type, geography and borrower.
Derivative components
Substantial risk “customization“ is made possible through deep and
sophisticated structuring markets, like CMOs.
Leverage
Investors can implicitly or explicitly lever investment bets due to
structuring capability.
Credit quality
Agency market is AAA, and senior/subordinated credit enhancement allows
AAA creation from non-agency/whole loans.
Credit depth
While the bulk of the mortgage universe is highly rated, equity-like risk is
available from credit tranching whole loans and commercial mortgages.
Diversity of participants
Most broad fixed income portfolios participate actively in the mortgage market.

Goldman Sachs Asset Management I 9

 Bank Loans
What is a bank loan?
The bank loan market consists of floating rate senior secured loans
made by banks or other financial institutions to corporations. Loans
are generally classified as “leveraged“ if the company to whom the
loan is being made has outstanding debt rated below investment
grade (i.e., less than BBB-). Unlike traditional bonds, which pay fixed
interest over a specific period of time, bank loan interest rates “float“
or reset periodically (usually 30, 60 or 90 days) based on LIBOR.

Characteristics of a sample bank loan

Coupon Floating
Typical Maturity 7-8 years
Callability Anytime @ 100
Effective Duration Short
Capital Structure Senior
Security Secured Lien
Covenants Yes
Recovery Rates 73.2%

Bank loans are at the high end of the capital structure

Seniority Type of Capital Security Types

High Senior Debt Secured Bank Loans

Subordinated Unsecured
Debt High Yield Bonds
쑺쑺

Low Equity Private Equity

10 I Goldman Sachs Asset Management

History and size of the bank loan market
The bank loan market emerged from two trends: the leveraged
buyout trend of the 1980s, and the tightening of bank capital
requirements that began in 1998 under the first Basel Accord.
Companies fund leveraged buyouts by borrowing from a bank or a
syndicate of banks. As the leveraged buyout trend emerged in the
1980s, demand for bank loans to fund LBOs increased sharply. Then,
in 1998, the Bank for International Settlements’ Basel Accord
increased the capital that banks were required to hold against their
loans. As a result, banks that had traditionally held loans on their
own balance sheet increasingly began to sell those loans to investors.

Over time, the secondary market has matured significantly as

investors came to recognize the potential of these loans as
investment vehicles. The first bank loan fund was launched in 1989
and, since then, trading volume has soared from $8 billion in 1991
to over $900 billion as of December 2007. The size of the market
today is estimated at $1.5 trillion.

The bank loan market has grown significantly

Leveraged Loan Market Size ($ billion)
1,800 900
New Leveraged Loan Volume ($ billion)

New Leveraged Loan Volume ($bn)

Leveraged Loan Market Size ($bn)

800
1,500
700
1,200 600
500
900
400
600 300
200
300
100
0 0
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

CLOs, hedge funds and high yield make up most of the

primary bank loan base
Securities Firm 2.4%
Asian Bank 2.3%
Canadian Bank 1.2%
Domestic Bank 5.5%
European Bank 5.8%
Finance Company 3.8%
Insurance Company 1.8%
CLOs & Prime, Hedge 77.2%
& High Yield Funds

Source: Credit Suisse, Standard & Poor’s

Goldman Sachs Asset Management I 11

Risk of buying bank loans
The most notable risk factors that all lenders contend with in buying
loans are credit risk, price risk and interest rate risk. While bank
loan funds have very low interest rate risk (due to the floating rate
structure of the loans), they carry the risk of default. Non-
investment grade fixed income securities are often issued in
connection with a corporate reorganization or restructuring, or as
part of a merger, acquisition, takeover or similar event. Such issuers
are often highly leveraged and, at times, less able to make
scheduled payments of principal and interest.

The market value of non-investment grade fixed income securities

tends to reflect individual corporate developments to a greater
extent than that of higher-rated securities, which react primarily to
fluctuations in the general level of interest rates. Issuers of non-
investment grade fixed income securities may not be able to make
use of more traditional methods of financing. Additionally, their
ability to service debt obligations may be more adversely affected
by economic downturns, specific corporate developments or the
issuer’s inability to meet specific projected business forecasts than
issuers of higher-rated securities. Negative publicity about the junk
bond or leveraged loan market and investor perceptions regarding
lower-rated securities, whether or not based on fundamental
analysis, may also depress the prices for such securities.

The secondary market for leveraged loans is less liquid, and more
volatile than the secondary market for higher-rated securities. In
addition, market trading volume for high yield fixed income
securities is generally lower, and the secondary market for such
securities could shrink under adverse market or economic
conditions, independent of any specific adverse changes in the
condition of a particular issuer. These factors may have a negative
effect on the market price and a fund’s ability to dispose of
particular portfolio investments. A less liquid secondary market also
may make it more difficult for a leveraged loan fund to obtain
precise valuations of the high yield securities in its portfolio.

12 I Goldman Sachs Asset Management

 Structured Credit

What is structured credit?

Structured credit is a term used to describe securitizations of
diverse portfolios of credit-related debt instruments, such as bank
loans, high yield bonds, investment grade corporate debt and
consumer asset-backed securities. Collateralized Debt Obligations
(CDOs) and Collateralized Loan Obligations (CLOs) are examples of
structured credit transactions. These transactions issue different
classes of securities, or tranches, with a variety of ratings ranging
from AAA down through Unrated (also known as “equity“). The
underlying debt instruments can be in either cash or synthetic form,
as can the issued tranches for that matter.

Structured credit securitizations are different from static

securitizations in that they tend to be managed transactions with
reinvestment periods. Collateral managers typically earn a fee to
reinvest principal paydowns and selectively trade in the underlying
portfolio. That said, the most liquid structured credit transactions –
the index tranche markets – are actually static (i.e., there is neither
a manager nor a reinvestment period, and hence, the underlying
individual credits cannot change over time). For example, the
investment grade index tranche market is carved out of a static pool
of 125 investment grade credits – the investment grade index itself.

The structured credit market provides investors with access to a

range of risk versus reward exposure to diverse portfolios of credit
assets. For example, the more senior tranches tend to embody
exposure to systematic credit risk, while the more junior tranches
tend to embody exposure to idiosyncratic credit risk.
Special
Portfolio Purpose Vehicle Investors

Proceeds Investment
Primarily
Senior CLO-AAA 70%
Secured CLO Debt and
Leveraged Equity
Loans Investors

(100+ Names) Principal Principal

& Interest CLO-AA 8% & Interest
CLO-A 6%
CLO-BBB 4%
CLO-BB 4%
CLO-Equity 8%
CLO Manager
Trustee
History and size of the structured credit market
The first CDOs were extensions of the securitization model to new
types of assets that had not been securitized before. Previously,
securitizations were static vehicles without the ability to reinvest,
and backed mostly by mortgage loans, auto loans, and credit card
receivables. Starting in the mid-1990s, the concept was extended to
diverse pools of credit assets such as high yield bonds, high yield
bank loans, investment grade corporate debt and consumer asset-
backed securities. The concept of managed transactions, with
collateral managers and reinvestment periods, was also introduced.
It is this more recent evolution of securitization that is known today
as the structured credit market.

CLO and CDO markets have grown significantly

The boom in CLO issuance over the past three years has been
driven by a combination of:

쐍 The imposition of higher regulatory requirements on banks,

which caused a shift from banks owning bank loans to
becoming distributors of bank loans
쐍 A boom in the supply of bank loans driven by private equity
demand to acquire companies via leveraged buyouts
The global CLO market now stands at approximately $400 billion
USD outstanding.

Growth of CLO issuance

35,000

30,000

25,000

20,000
$ millions

15,000

10,000

5,000

0
1999 2000 2001 2002 2003 2004 2005 2006 2007 1Q
2008

Source: Standard & Poor’s

14 I Goldman Sachs Asset Management

The boom in investment grade corporate CDO issuance over the last
five years has been fueled by the rise of credit default swap (CDS)
contracts as the preeminent vehicle for trading single-name
corporate credit risk. With the arrival of CDX indices and index
tranches, the first standardized “liquid“ CDO market was born.

The global investment grade corporate CDO market now stands at

approximately $200 billion USD outstanding.

Growth of CDO issuance

250
Mezz Issuance ($ billion)

200
Delta Equivalent CDO

150

100

50

0
1H 05 2H 05 1H 06 2H 06 1H 07 2H 07 1Q 08E

Source: Standard & Poor’s

Goldman Sachs Asset Management I 15

Structured credit is only a subset of the
securitization market
The securitization process begins with a borrower – a home owner
or a corporation – who borrows money in the form of a mortgage
loan or corporate debt instrument. This loan or debt instrument is
then packaged into a securitization, which issues different classes
of securities (tranches) of various ratings ranging from AAA down
through Unrated (also known as “equity“).

The term Level 1 means the first time a portfolio of loans or

corporate debt is packaged into a securitization (see exhibit below).
Level 1 securitizations are relatively straightforward to analyze.
Level 2 securitizations, on the other hand, are far more complex and
difficult to analyze because they are securitizations of securities
issued by Level 1 securitizations, each of which is backed, in turn,
by its own portfolio.

Level 1 Level 2
Borrower Credit Assets Securitization Securitization

Home 쑺쑺 Mortgage 쑺쑺 RMBS 쑺쑺 MBS CDO

Owner Loan

High Yield 쑺쑺 Bank Loan 쑺쑺 CLO

Corporation

Investment 쑺쑺 Corporate 쑺쑺 Corporate

Structured
Grade CDS CDO
Corporation Credit
products

Level 1 Securitization Level 2 Securitization

Assets Liabilities Assets Liabilities

AAA AAA
Securities
AA AA
Credit From
A A
Assets Level 1
BBB BBB
Deal
BB BB
Equity Equity

16 I Goldman Sachs Asset Management

 Conclusion

The changing dynamics of the global fixed income markets in recent

years have been fueled, in large part, by financial engineering.
Securitization, which has made much of the proliferation of
innovative products possible has, in essence, provided the liquidity
necessary to broaden the opportunity set for an expanding pool of
market participants. A solid understanding of these securities is
critical in navigating the complex fixed income markets and
effectively assessing new opportunities.

Goldman Sachs Asset Management I 17

 Behind the
Industry Jargon

Adjustable Rate Mortgage (ARM): A pass-through security that

has predetermined adjustments of the interest rate at specific
intervals. Mortgage payments are tied to varying indices, such as
the interest rate on US Treasury bills, LIBOR or the average national
mortgage rate. Adjustments are made regularly, usually at intervals
of one, three, or five years.

ALT-A: A type of US mortgage that, for various reasons (e.g., low or

no documentation), is considered riskier than “prime“ and less risky
than “subprime,“ the riskiest category. Alt-A interest rates, which
are determined by credit risk, tend to be between that of prime and
subprime home loans.

Assignment: A form of contract to purchase a loan and to have

the rights as a lender under the credit agreement.

Asset-backed security (ABS): Is essentially the same as a

mortgage-backed security, except that the collateral is more
diverse. The range of assets used in ABS deals as collateral has
been very wide, and includes ABS backed by auto loans, credit card
receivables, home equity loans, manufactured housing loans and
utility stranded costs.

Collateralized Bond Obligation (CBO): A securitized pool of

investment-grade bonds backed by a large number of junk bonds. It
is broken into tiers with varying degrees of risk and interest rates.

Collateralized Debt Obligation (CDO): Special-purpose vehicles

that invest in a diversified pool of assets in either cash or synthetic
form, financed with several tranches of debt (typically a ‘AAA’
tranche, a ‘AA’ tranche, a ‘BBB’ tranche, and a mezzanine tranche)
that have rights to the collateral and payment stream in descending
order. The funded form invests in actual cash assets such as
mortgage pass-throughs and bank loans. The unfunded form
invests in credit derivatives such as credit default swaps.

Collateralized Loan Obligation (CLO): Similar to CDO except it is

securitized by pools of leveraged loans.

18 I Goldman Sachs Asset Management

Collateralized Mortgage Obligations (CMOs): A type of mortgage
security created by redirecting the cash flows from underlying pools
of mortgages to different classes of bonds called tranches. The
redistribution of scheduled principal, unscheduled principal and
interest from the underlying mortgage pool to different tranches
creates securities with different coupon rates, average lives and
price sensitivities. Consequently, these instruments can be used to
match an investor’s particular risk and return objectives more closely.

Commercial Mortgage-Backed Security (CMBS): A type of

mortgage-backed security that is secured by pools of mortgages on
commercial property. These loans are typically secured by such
commercial property as apartment buildings, shopping malls,
warehouse facilities, hotels and office buildings.

Conforming Mortgage: A residential mortgage that conforms to the

loan purchasing guidelines set forth by the Government Sponsored
Enterprises (GSE), e.g., FNMA/FHLMC. Criteria include debt-to-
income ratio limits and documentation requirements. There is also a
maximum loan amount, which changes based on the mean home
price (above which a mortgage is considered a “jumbo loan“).

Covenant: A commitment in a loan agreement, which certifies

that certain activities may be carried out. There are several
examples of loan covenants, but the purpose is to give the lender
more security protection.

Credit Default Swap: A financial instrument designed to transfer

the credit exposure of fixed income securities between parties. It is
essentially an insurance contract that enables a seller to protect
against the risk of default on debt obligations.

Credit Derivative: Contracts that are based off credit assets such
as corporate bonds and mortgage bonds. They are over-the-counter
and are designed to customize the risk taking/hedging.

Credit Enhancement: Securities generated in a securitization deal

are “credit enhanced,“ meaning that their credit quality is increased
above that of the originator’s unsecured debt or underlying asset pool.

Credit Support: Refers to the amount of collateral available to

absorb losses.

Current Yield: Annual income (interest) divided by the current price

of the loans.

Discount Margin: The return earned above the index underlying a

floating rate security.

Goldman Sachs Asset Management I 19

FICO (Credit Score): A measure of a borrower’s credit-worthiness.
The lower the FICO score, the higher the likelihood of default. Generally
a FICO score of 630 or lower corresponds to a subprime borrower.

First Lien: A lien that takes priority over all other liens or claims
over the same property in the event of default.

Floating Rate: Moves up and down with the market, or along with
an index, in contrast to a fixed rate, which does not vary over the
duration of the debt obligation.

Full Documentation (“Full Doc“)/Low Documentation (“Low Doc“):

Full doc refers to a loan where all income and asset information is
documented. Low doc refers to a loan where income and/or asset
information is not fully documented.

Government Sponsored Enterprises (GSEs): A group of financial

services corporations created by the US Congress to assist groups
of borrowers in targeted sectors by enhancing the flow of credit to
these sectors. Targeted sectors include: agriculture, home finance
and education. The two housing government-sponsored enterprises,
Fannie Mae and Freddie Mac, were chartered by Congress to create
a secondary market for residential mortgage loans.

Home Equity Line of Credit (HELOC): A revolving line of credit with

an adjustable interest rate, whereas a home equity loan is a one-
time lump-sum loan, often with a fixed interest rate.

Home Equity Loan (HEL): A type of loan in which the borrower uses
the equity in their home as collateral. It creates a lien against the
borrower’s house and reduces actual home equity. Home equity
loans are most commonly second position liens (second trust deed),
although they can be held in first or, less commonly, third position.
There are two types: closed end and open end.

Hybrid Adjustable-Rate Mortgages (Hybrid ARMs): A type of

adjustable rate mortgage where the interest rate on the note is
fixed for a period of time, and then floats thereafter. The “hybrid“
refers to the blend of fixed rate and adjustable rate characteristics.
Hybrid ARMs are referred to by their initial fixed period and
adjustment periods (e.g., 3/1 for an ARM with a 3-year fixed period
and subsequent 1-year rate adjustment periods). The date that a
hybrid ARM shifts from a fixed-rate payment schedule to an
adjusting payment schedule is known as the reset date. After the
reset date, a hybrid ARM floats at a margin over a specified index
just like any ordinary ARM.

20 I Goldman Sachs Asset Management

LIBOR (London Interbank Offered Rate): Daily reference rate
based on the interest rate at which banks offer to lend unsecured
funds to other banks in the London Interbank market.

Loan-to-Value Ratio (LTV) or Combined Loan-to-Value Ratio (CLTV):

A way of measuring household leverage. LTV is a percentage ratio
of a first mortgage lien in relation to the total appraised value of
the property. CLTV considers additional loans on the property in the
calculation of the percentage ratio.

Market-Flex Language: Language within a prospectus which

allows arrangers to price a loan based on investor demand, in some
cases within a predetermined range, as well as shift amounts
between various tranches of a loan.

Mortgage: Debt instrument by which a borrower gives the lender a

lien on property as security for a repayment of the loan. The borrower
has the use of the property and the lien is removed when the
obligation is fully paid. A mortgage normally involves real estate.

Mortgage Pass-Through: A security created when an entity (e.g.,

GNMA, FNMA, FHLMC, commercial bank, thrift) forms a collection
(pool) of single family mortgages and sells shares or participation
certificates in the pool. The monthly cash flow of a pass-through
depends on the cash flow of the underlying mortgages and consists
of monthly mortgage payments representing interest, the scheduled
repayment of principal, and any unscheduled prepayments of
principal. The cash flow is less than that of the underlying
mortgages by an amount equal to servicing and any guarantor fees.

Negative Amortization Mortgage (“NegAm“) or Option ARM: A

type of adjustable rate mortgage security which applies an
amortization method in which the borrower pays back less than the
full amount of interest owed to the lender each month. The unpaid
interest is added to the unpaid balance of the mortgage. It could be
considered borrowing equity from yourself. The period of time the
NegAm is applicable is usually limited on each mortgage.

Non-Conforming Mortgages: Mortgage loans that do not meet the

Agencies’ underwriting standards due to one or a combination of
factors. Fannie Mae and Freddie Mac, “the housing agencies,“ are
limited to the types of mortgages they can securitize. Examples of
factors which would render a loan ineligible include large mortgage
loan balance, high LTV, and/or limited documentation.

Goldman Sachs Asset Management I 21

Non-Agency (Private-label) Mortgages: Banks and mortgage
bankers pool non-conforming mortgages and typically sell the
resulting non-securitized loan package to investors as “whole loans“
or as publicly registered securities.

Occupancy Type: Refers to whether the residence is owner-

occupied or is an investor property.

Prepayment Risk: Borrowers of mortgages have an option to

prepay all or part of their mortgage at any given time. The
uncertainty for the mortgage holder which results, as well as the
risk of receiving principal back at an inopportune time (i.e., a lower
rate environment), is called prepayment risk.

Prime Rate: The interest rate that commercial banks charge their
most credit-worthy customers (generally, large corporations).

Second Lien: Debt that is subordinate to the rights of other, more

senior debts issued against the same collateral, or a portion of the
same collateral. If a borrower defaults, second lien debts stand
behind higher lien debts in terms of rights to collect proceeds from
the debt’s underlying collateral.

Securitization: The process of pooling loans or other financial

assets and converting them into securities. Securitization allows the
cash flows and risks from the underlying assets to be reallocated to
different classes of debt which can be sold to investors with different
risk/return appetites. The resulting securities typically have a broader
and deeper investor base and better liquidity than the underlying
asset pool would have by itself. The process can encompass any
type of financial asset. Mortgage-Backed Securities are an example
of static securitization, while CLOs are “managed“ securitizations.

Subordination: A common type of internal credit enhancement.

Senior/ subordinated tranches are created where senior bonds have
first priority on cash flows and subordinated securities are designated
to absorb loan losses before they are allocated to senior securities.

Special Purpose Vehicle (SPV): A vehicle established to acquire a

portfolio of credit assets such as mortgage-backed securities,
commercial real estate debt and corporate bonds. The SPV finances
the underlying assets by issuing different classes of securities with
different risk characteristics (tranches).

Spread: The risk premium on the loan paid over LIBOR.

Subprime: Borrowers who generally exhibit lower credit scores and

higher leverage (i.e., higher debt-to-income ratio).

22 I Goldman Sachs Asset Management

Syndicate: A group of investment banking firms who work together
temporarily on a large project, typically underwritings. Acting in a
group reduces the risk that each individual firm must assume.

Syndicated Loan: A loan provided by a group of lenders and is

structured, arranged, and administered by one or several
commercial or investment banks as arrangers.

Third Party Credit Enhancement: Includes insurance provided by

bond insurers, corporate guarantees and letters of credit.
Companies such as MBIA, FGIC, AMBAC, FSA are able to insure up
to AAA ratings. These entities typically insure investment grade-
rated cash flows to higher ratings desired by the issuer or the
underwriter for an upfront fee and or ongoing fee.

Tranche: A portion or piece of a deal of structured financing.

Underwritten Deal: A deal where the arrangers guarantee the

entire commitment and then syndicate the loan.

YTM (Yield to Maturity): The rate of return earned on a bond if it is

held to maturity.

Goldman Sachs Asset Management I 23

 Learn More

Following is a list of GSAM publications that can help you further

explore the intricacies of MBS, Bank Loans and Structured Credit, as
well as expand your understanding of fixed income investing.

쐍 Active Alpha Investing: Redefining the Role of Fixed Income

in a Portfolio

쐍 Closing the Gap: Addressing the Liability Challenge

쐍 Determining Value in Emerging Local Markets

쐍 Finding Opportunities in Mortgage and Credit Markets

쐍 Increasing Active Bond Risk: A Practical Guide to Implementation

쐍 A Primer on Mortgages

쐍 Using Derivatives to Enhance the Opportunity Set for Fixed

Income Investing

Please contact your relationship management team

to obtain a copy of these materials.

24 I Goldman Sachs Asset Management

This material is provided for educational purposes only and should not be construed as
investment advice or an offer or solicitation to buy or sell securities. Opinions expressed are
current opinions as of the date appearing in this material only. No part of this material may,
without GSAM’s prior written consent, be (i) copied, photocopied or duplicated in any form,
by any means, or (ii) distributed to any person that is not an employee, officer, director, or
authorized agent of the recipient.
This presentation is provided for informational purposes only and we are not soliciting any
action based on it. This information is not intended to be used as a general guide to
investing, or as a source of any specific investment recommendations and should not be
construed as research or investment advice. Accordingly, such information should not be
relied upon in whole or in part in making an investment decision.
Derivatives often involve a high degree of financial risk because a relatively small
movement in the price of the underlying security or benchmark may result in a
disproportionately large movement in the price of the derivative and are not suitable for all
investors. No representation regarding the suitability of these instruments and strategies for
a particular investor is made. The portfolio risk management process includes an effort to
monitor and manage risk, but does not imply low risk.
This material has been approved for issue in the United Kingdom solely for the purposes of
Section 21 of the Financial Services and Markets Act 2000 by GSI, Peterborough Court, 133
Fleet Street, London EC4A 2BB; by Goldman Sachs Canada, in connection with its
distribution in Canada; in the United States by Goldman, Sachs & Co.; in Hong Kong by
Goldman Sachs (Asia) L.L.C.; in Korea by Goldman Sachs (Asia) L.L.C., Seoul Branch; in
Japan by Goldman Sachs (Japan) Ltd; in Australia by Goldman Sachs Australia Pty Limited
(ACN 092 589 770); and in Singapore by Goldman Sachs (Singapore) Pte. This material has
been issued or approved for use in or from Hong Kong by Goldman Sachs (Asia) L.L.C. This
material has been communicated in the United Kingdom by Goldman Sachs Asset
Management International which is authorized and regulated by the Financial Services
Authority (FSA). This material has been issued or approved for use in or from Singapore by
Goldman Sachs (Singapore) Pte. (Company Number: 198602165W). With specific regard to
the distribution of this document in Asia ex-Japan, please note that this material can only
be provided, upon review and approval by GSAM AEJ Compliance, to GSAM's third party
distributors (for their internal use only), prospects in Hong Kong and Singapore and existing
clients in the referenced strategy in the Asia ex-Japan region.
Copyright © 2008, Goldman, Sachs & Co. All Rights Reserved.
9349 / MORTREF / 3K / 05-08