Interest Rate Structured Notes Primer, Part 1

May 22, 2007

Benjamin Martens 212-526-6566 [email protected]

EXECUTIVE SUMMARY Over the past few years, U.S. interest-rate structured notes have become an increasingly popular vehicle for those targeting alpha, as they provide access to a variety of exposures that are not typically traded by real money accounts. This primer seeks to elaborate on the drivers of pricing, risks, and characteristics of a variety of the most popular notes: Part 1 focuses on LIBOR range accruals, noninversion notes, and leveraged steepeners. Part 2 focuses on CMT floaters, callable capped floaters and step-up callables, inverse floaters, targeted redemption notes, and BMA/LIBOR index spread notes.

PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 16

Lehman Brothers | Interest Rate Structured Notes Primer, Part 1

TABLE OF CONTENTS Introduction ...................................................................................................................... 3 LIBOR Range Accruals...................................................................................................... 4 Non-Inversion Notes .......................................................................................................... 8 Leveraged Steepeners....................................................................................................... 14

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Lehman Brothers | Interest Rate Structured Notes Primer, Part 1

INTRODUCTION Interest rate structured notes have become increasingly popular and important in the context of the broader fixed income market. We believe these products will become better institutionalized over time, particularly as long as the curve remains flat and interest rate volatility remains low. In such an environment, products that allow the expression of views in novel ways will be desirable as traditional avenues to alpha become less productive. Moreover, along with the increasing popularity of alternative investments, many funds are open to products that they have not purchased previously. Our purpose in this primer is to elaborate on the characteristics and risks of some of the most popular notes in the market and broadly address the question What do I need to be aware of before considering a significant risk position in a structured note? We attempt to give numbers and to quantify risks whenever possible. Because of the depth of the topic, the primer will be published in two partsthe first focused on range accruals, noninversion notes, and leveraged steepeners and the second focused on CMT floaters, callable capped floaters/step-up callables, inverse floaters, targeted redemption notes (TARNs), and BMA-LIBOR index spread notes. While this is a list of considerable size, even after discussing these notes, we will have explored only a small portion of the overall structured note market. However, our hope is that this primer will be a useful contribution in terms of improving dialogue in the space.

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Lehman Brothers | Interest Rate Structured Notes Primer, Part 1

LIBOR RANGE ACCRUALS 1 (LRAS) Background

What Are LRAs, What Is the View Expressed, and Why Have They Been Popular?

LRAs are notes in which an above-market coupon is paid contingent on 3- or 6-month LIBORs remaining below some above-market level. Each note has a LIBOR coupon knockout strike, and should LIBOR settle higher than the strike, the note would pay no coupon. As 3- and 6-month LIBOR are generally highly correlated with the overnight Fed funds rates, investors express the view that the Fed will not tighten interest rates through the area of a given notes LIBOR strike. LRAs have been popular because they have offered coupons higher than other fixed income instruments such as callables and mortgages, and accounts have been comfortable taking views on future Fed policy action.
Characteristics and Sizes Outstanding

LRAs are typically 10yNC6m Bermudan callables and have a digital coupon payment tied to either 3- or 6-month LIBORs remaining below a certain value. Over the past few years, this value has generally been 7%-9%. Approximately $50 billion has been issued in gross since the beginning of 2004 (Figure 1), and we estimate that net issuance outstanding is ~$20 billion. These structures gained press when the agencies began to issue them in 1H06. European banks have also been common issuers. Nuts and Bolts
How Does the LRA Coupon Calculation Work?

Coupons are paid quarterly based on daily accrual using the rate for 6-month dollar deposits that appears on Reuters page LIBOR01 as of 11:00AM London time. The interest accruals period begins and ends on the fifth business days prior to the respective interest rate payment dates.
How Does the Issuer Hedge the Risk Associated with the Note?

As with many other structured notes, the issuer generally swaps out the risks of the note with a broker dealer, and as such, the risks are typically managed off of major Wall Street derivative desks.
Figure 1. LRA Issuance over Time

Gross Issuance, $bn 10 8 6 4 2 0 Q1'04 Q3'04 Q1'05

Quarterly Range Accrual Issuance 3 Period Moving Average

Q3'05

Q1'06

Q3'06

Source: Lehman Brothers

1

Here we focus on LIBOR range accruals of the type Issued by the agencies in 2006-2007.

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Lehman Brothers | Interest Rate Structured Notes Primer, Part 1

LRA Market Risks and the Determination of Coupon and Price

Broadly, What Is the Risk That Investors Are Selling to Gain the High Coupon?

In an LRA, investors are selling the risk that the Fed will tighten rates further or, more generally, that additional rate hikes will be priced in. As LRAs have plain vanilla callable characteristics, investors are also selling the risk that the level of yields will change significantlyas would be true for any callable security.
Factors Driving an Existing LRAs Pricing and Rough Sensitivities

New-issue LRAs have exposure to a number of market variables. We will consider the exposures for a new-issue Bermudan callable 10yNC6m with an agency credit. The structure we have in mind has a fixed 6.80% coupon as long as 6-month LIBOR sets below 7.20%. Figure 2 summarizes the statistics. DurationFor a new-issue LRA of this type, the PV01 is approximately 450, implying that a 1 bp shift in yields shifts the price by 4.5 cents. As the note is callable, this PV01 increases as the note becomes less callable and vice-versa. CurveLRAs have fairly little exposure to curve movements. The option on LIBOR is a short-end option, while the notes call feature is a longer-end option. The two approximately net out to zero in terms of curve risk. Vega Associated with the LRAs Callability and Embedded OptionalityThe amount of vega/gamma exposure in an LRA is noteworthy in the context of the broader market because LRAs are occasionally issued in large, multi-billion dollar blocks. We calculate that each $ billion of range accrual issuance supplies about $3.0-$3.5 million in vega to the market and that the exposure breaks down roughly as shown in Figure 3. It should also be noted that much of this vega is associated with high-strike cap skew, and the idiosyncratic valuation of this cap vega relative to other forms of vega will have a disproportionate effect on the pricing of LRAs.
Statistics as of May 8, 2007, FNM 6.0 30-Year Mortgage Price at 100-23
PV01 (Rates) 10NC2 Agency Callable CC 30y Mortgage 10yNC6m LRA 7.20% 6m LIBOR Knockout 368 255 450 PV01 (Curve) Rate Vega (bp) -19 -14 -10 Qualitative Short Gamma Exposure Moderate Moderate Very High

Figure 2.

Data: Simulations on Lehman Brothers analytics, unchanged implied vol surface Source: Lehman Brothers Note: PV01 of 340 implies that a 1 bp change in rates will result in a 3.4 cent change in the notes price.

Figure 3.
Vega

Vega Supply Breakdown from a Typical LRA Structure

Effect of $1.0 bn Issuance $1.6 mn vega $1.2 mn vega $0.4 mn vega $0.1 mn vega

High Strike Digital Cap Skew 1y10y (50-high) 3y7y 5y5y

Data: Simulations on Lehman Brothers analytics Source: Lehman Brothers

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Lehman Brothers | Interest Rate Structured Notes Primer, Part 1

Other Factors Driving an LRAs New-Issue Coupon

The coupon of a specific LRA is sensitive to a number of variables. One must start with the market variables listed above, but also consider the following: The Credit Backing the NoteA note backed by the fully guaranteed KFW agency may trade at L-20, while a note backed by a AA-rated U.S. corporate may trade at L+20. Moreover, there may be a multiplier effect on the coupon, as the expected value of coupons for a note with L+20 credit must be 40 bp higher than for a note with L-20 credit. Consider a note that pays out either a large coupon (e.g., 10.00%) or 0.00%, with 50% probability. The note coupons expected value is 5.00%. If one switches from L-20 credit to L+20 credit, the coupon expected value must increase by 40 bp, to 5.40%. This requires an 10.80% high coupon on the hypothetical notea credit multiplier effect. The Nature of the Call FeatureOn any given Bermudan-callable note with a lockout, the shorter the lockout, the higher the coupon available. In the case of agency callables, a new-issue 10yNC2y today trades 55 bp above a 10-year bullet, while a 10yNC6m today trades 75 bp above a 10-year bullet. The mark to market of a 10yNC6m LRA is approximately 30% more volatile than a similar tenor/expiry agency callable; hence, its call feature is worth 30% more than the 10yNC6m figure cited above, or 100 bp on the LRA coupon. If an LRAs lockout is extended, this yield pickup relative to bullets will decrease, just as it would with any callable note. The LIBOR Knock-out on the NoteAn LRA can be thought of as a standard Bermudan callable with an additional short of a digital high-strike LIBOR payer swaption. As such, when the LIBOR strike is moved, the payer will be further in/out of the money. For the structure we have been examining, moving the 6-month LIBOR strike 50 bp higher results in a mark to market that is 85 cents higher. The coupon of such a note would be 45 bp lowera 6.35% coupon for a 7.70% LIBOR knockout, versus 6.80% for the original 7.20% LIBOR knockout.

Risks to Consider

With LRAs, the main risk is stubbornly rising inflation, which would require an aggressive Fed response. Such an event need not be volatilefrom 2006 through early 2007, the U.K. economy has experienced the type of event that would lead to significant extension risk in range accrual structures. Other Statistics on LRAs
Survival Probabilities/Expected Life

We show data for our 10yNC6m 7.20%-strike LRA in Figure 4. As should be evident, expected life (and mark to market) is much more sensitive to the level of rates than it is to curve slopeat least locally. The bull flattener should be the best scenario for LRAs.
Historical Coupons

We discussed factors that drive the new-issue coupon on the previous page. As a result of movements in the underlying market factors, the history of the coupon on a new-issue 10yNC6m is shown in Figure 5.

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Lehman Brothers | Interest Rate Structured Notes Primer, Part 1

Figure 4.

Expected Life (Years) for a 10yNC6m 7.20% 6m LIBOR-Strike LRA versus Instantaneous Shocks to Rates/Curve Immediately Subsequent to Issuance
Parallel -50 -25 2.05 Change in 0 3.26 1.77 3.34 3.45 4.23 5.28 Forward Curve 25 50

Changes In 2s10s Curve Slope

5 bp Flatter Unchanged 5 bp Steeper

Data: Simulations on Lehman Brothers analytics, unchanged implied vol surface Source: Lehman Brothers

Figure 5.

Historical Coupon of 10yNC6m LRA, 7.20% 6m LIBOR Strike, Agency Credit

Coupon Available, %

8.0 7.5 7.0 6.5 6.0 Feb-06

10nc6m Range Accrual w ith 7.2% LIBOR Cap

May-06

Aug-06

Nov-06

Feb-07

May-07

Source: Lehman Brothers

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Lehman Brothers | Interest Rate Structured Notes Primer, Part 1

NON-INVERSION NOTES (NINs) Background

What Are NINs, What Is the View Expressed, and Why Have They Been Popular?

NINs are structures in which an above-market coupon is paid contingent on a given segment of the swap curve remaining steeper than some value (often 0 bp). Many believe that a 0 bp slope on the swap curve is a unique boundary and that it is unlikely for the curve to trade inverted. The rationale often given is that it is difficult to convince investors to bear an additional unit of duration risk without some extra yield compensation; hence, the curve should rarely invert because buying in the long end should dry up as the curve flattens. In any case, empirically, 2s-10s has been inverted only 3% of the time since 1987 (Figure 6); since 1992, 2s-30s has been inverted less than 1% of the time. The popularity of NINs has been driven by the availability of above-market coupons, contingent on a willingness to express the view that the curve will remain steep. NINs have also been viewed as a vehicle with which to target a form of alpha that is fairly uncorrelated with the more common views that real money investors take on rates, curve direction, butterflies, and volatility (through mortgages and callables).
Characteristics and Sizes Outstanding

The most frequently issued NIN is a 15yNC3m2 Bermudan callable on either 2s-10s or 2s-30s, and net issuance of these notes has totaled approximately $15-$16 billion since 2004 (Figure 7). Much of the earliest issuance was on the 10s-30s slope, while most 2006-2007 issuance was of the 2s-10s and 2s-30s varieties. It is not uncommon to see 10yNC1y and NC2y (2s10s) structures. Bullets are rare, but they do exist, although they typically offer lower coupons. European banks are the common issuers; the U.S. agencies have not issued NINs. Nuts and Bolts
How Does the NIN Coupon Calculation Work?

Coupons are usually paid based on daily accrual of CMS (constant-maturity swap) rates using the fixings that appear on Reuters screen ISDAFIX1 at 11am EST each day.
Figure 6.
bp 350 300 250 200 150 100 50 0 -50 -100 Jul-87 US 2s10s Sw ap Curve Slope

2s-10s in Swaps Has Been Close to 0 bp Recently, Flatter than Its Historical Average

Figure 7.

NIN Issuance over Time

$mn Notional Outstanding 24 20 16 12

$mn Notional Issuance 5 4 3 2 1 0

Jul-92 Jul-97 Jul-02 Jul-07

Gross Issuance by Quarter (LHS) Est for Total Outstanding Issuance (RHS)

8 4 0 1Q04 3Q04 1Q05 3Q05 1Q06 3Q06 1Q07

Source: Lehman Brothers

2

Source: Lehman Brothers 5- and 10-year tenors also trade frequently.

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Lehman Brothers | Interest Rate Structured Notes Primer, Part 1

What Are CMS Rates?

CMS implies a swap rate with a floating coupon. A given swap, once struck, has convexity associated with it, as would any fixed-strike fixed-income instrument. Because CMS implies a floating coupon, CMS rates have no convexity. This is key, because the forward swap rates that are observed in the market do have convexity. Hence, in order to derive future expectations of CMS 2s-10s from the forward 2s-10s spread that trades in the market, one must perform a convexity adjustment.
What Is the Nature of This Convexity Adjustment?

For any fixed-coupon bond, convexity value increases rapidly as tenor increases approximately with the square of duration, as shown in Figure 8. In Treasuries, for instance, 30s have ~5X the convexity value of 10s. Given the scaling of convexity, longer tenors pick up convexity faster than shorter tenors in forward space; hence, 10yfwd 2s-10s curve slope will have a convexity value that is much larger than the value for spot 2s-10s and must be adjusted in order to extract future expectations. This explains why long-dated forward 2s-10s is much flatter than 1yfwd 2s-10s; indeed 10yfwd 2s-10s is typically flat to inverted (Figure 9). This flatness/inversion in the forwards does not imply that the market actually expects 2s-10s to be inverted in the distant future; it is merely a symptom of convexity and has little to do with future expectations. In terms of NINs, the notes coupon is usually specified to accrue daily based on future realizations of 2s-10s. Hence, it is the convexity-adjusted future expectations of 2s-10s that are relevant for pricing. It is possible to calculate the value of this convexity for any forward rate by shifting eurodollars futures and determining the pricing effect on long tenors, but in general, the convexity-adjusted forward curve slope is calculated with the same convexity calculation procedure used for any fixed income product.
How Does the Issuer Hedge the Risk Associated with the Note?

Most typical issuers of NINs, such as KFW or other European banks, are not interested in managing the exotic risks associated with the NIN coupon. Most issuers will swap out the exotic risk to a broker dealer, and as such, the risks are typically managed off of major Wall Street derivative desks. Typically, the actual issuer of the note is left only with bullet funding that it perceives to be attractive.
Figure 8. Convexity Scales Approximately with the Square of Duration for Spot-Starting Instruments
Convexity (2nd Derivative of Price Relative to Yield) 400 350 300 250 200 150 100 50 0 0 5 10 15 Duration of Bonds in Treasury Universe y = 1.61x 2 - 2.84x + 3.52 R2 = 0.999

Figure 9.

Future Expectations of 2s-10s Are Actually Much Steeper than Forward 2s-10s Would Suggest

bp 40 35 30 25 20 15 10 5 0 Jun-07 2s10s Spot and Forw ard Sw ap Curve 2s10s Conv-Adj Spot and Forw ard Sw ap Jun-09 Jun-11 Jun-13 Jun-15 Jun-17

Source: LehmanLive

Source: LehmanLive

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Lehman Brothers | Interest Rate Structured Notes Primer, Part 1

NIN Market Risks and the Determination of Coupon and Price

Broadly, What Is the Risk That an Investor Is Selling to Gain the High Coupon?

Investors are selling the risk that the yield curve will invert, on both a spot and a forward basis. As NINs also have plain vanilla callable characteristics, investors are also selling the risk that the level of yields will change significantly; the call feature causes the note to be short both rate gamma and vega, although exposure to the slope of the curve remains the dominant risk factor.
Factors Driving an Existing NINs Pricing and Rough Sensitivities

New-issue NINs have exposure to a number of market variables. We will focus on a newissue 15yNC3m 2s10s NIN, with a KFW credit. Statistics are summarized in Figure 10. DurationFor a new-issue 15yNC3m 2s-10s NIN, the PV01 is approximately 340, implying that a 1 bp shift in yields shifts the price by 3.4 cents. Because the note is callable, this PV01 changes as the note becomes more or less callable. CurveNINs will benefit as the curve steepens, because the probability of an inversion falls. For notes with 5-year maturities or greater, most of the notes value is tied up in future expectations of 2s-10s. Hence, while the active coupon is dependent on spot 2s-10s, the NINs mark to market is more sensitive to changes in future expectations of 2s-10s. 2yfwd 2s-10s has typically moved 50% as much as spot 2s10s, while 5yfwd 2s-10s typically moves only 6%-7% as much as spot. Assuming these betas for a new-issue 2s-10s 15yNC3m NIN, the spot 2s-10s PV01 is ~1100. Gamma Associated with the NINs Callability and Embedded Optionality NINs are often structured as Bermudan callables, and just as with any callable, there is a yield pickup (relative to a bullet) associated with the call feature. For a 15yNC3m agency callable, the yield pick is ~100 bp over a 15-year agency bullet. Given the NINs duration and curve PV01s and duration/curve realized volatilities, one should expect the value of the NINs call feature to be approximately 80% higher than the value of a vanilla callable call featurea ~180 bp yield pickup over a 15-year agency bullet for our NC3m structure. Because rates and the curve are key drivers of the notes price, the value of this callable feature will have exposure to both implied rate volatility and implied curve volatility (Figure 10). Correlation Vega (Advanced Topic)Investors who buy NINs are implicitly selling a zero-strike digital floor on future realizations of the slope of the curve. As such, they are short gamma on curve slope and will benefit if the curve ceases to move or is priced to move less as reflected in the markets option pricing. Expected 2s-10s curve volatility over a long horizon (say, five years) is given by the implied pricing of 5y2y swaption vol (5-year expiry) relative to 5y10y vol and an implied correlation factor. Movements in this volatility ratio thus are important in setting the
Statistics as of May 8, 2007, FNM 6.0 30-Year Mortgage Price at 100-23
PV01 (Rates) 10NC2 Agency Callable CC 30y Mortgage 10yNC6m LRA 7.20% 6m LIBOR Knockout 15yNC3m 2s10s NIN 368 255 450 340 PV01 (Curve) 1100 Rate Vega (bp) -19 -14 -10 -15 Qualitative Short Gamma Exposure Moderate Moderate Very High Very High

Figure 10.

Data: Simulations on Lehman Brothers analytics, unchanged implied vol surface, Source: Lehman Brothers Note: PV01 of 340 implies that a 1 bp change in rates will result in a 3.4 cent change in the notes price

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Lehman Brothers | Interest Rate Structured Notes Primer, Part 1

NIN coupon and driving the mark to market of an existing note. Recently, 5y2y was priced 10% over 5y10y, implying that the forward curve was expected to steepen gradually in a rally and vice-versa. If 5y2y were to flatten to even versus 5y10y, then one would say that the forward curve was no longer priced to be directional with ratesa less volatile condition for the curve and a beneficial result for an investor in NINs. Therefore, an investor in NINs is said to be short short-tenor vega (5y2y) versus long long-tenor vega (5y10y). We mentioned earlier that 5y2y was currently priced ~10% over 5y10y; for each 1% that 5y2y richens relative to 5y10y (each 1% is approximately 0.75 bpvol currently), a new-issue 15yNC3m 2s-10s NINs mark to market should improve ~10 cents.
Other Factors Driving a NIN New-Issue Coupon

The coupon of a specific NIN is sensitive to many variables. One must start with the market variables listed above, but also consider the following variables: The Credit Backing the Note and the Nature of the Call FeatureOn any Bermudan-callable note, the shorter the lockout, the higher the coupon available. In the case of agency callables, a new-issue 10yNC2y today trades 55 bp above a 10year bullet, while a 10yNC3m today trades 80 bp above a 10-year bullet. Moreover, there is more value in an NC3m NIN than there is in a NC3m callable because the NIN inversion note carries more risk (and, hence, price volatility) than the vanilla callable because of the NINs embedded digital curve option. Given the pricing of the forward curve in early May 2007, a 15yNC2y 2s-10s NIN will have a coupon ~140 bp higher than a 15-year bullet, and a NC3m structure will have a coupon another ~50 bp higher than the NC2y structure. The Curve Spread that Underlies the NoteA 2s-10s NIN will have a different coupon than a 2s-30s NIN because 2s-30s is a more volatile slope spread and, hence, has a different implied curve volatility associated with it. The Strike on the NINMost of our focus on NINs has been limited to notes with a 0 bp strike on curve slope. Notes will sometimes be issued with other strikes, such as -5 bp or +25 bp. Depending on the slope of the forward curve in the market at issuance, a 5 bp shift in the strike of the note would change the coupon of a 15yNC3m by approximately 25-35 bp.

Event Risks to Consider

NIN investors are taking the view that the last 20 years of curve slope behaviora period in which the curve rarely invertedis the most likely outcome over the life of the new-issue non-inversion note. There are risks to consider associated with low-probability events. The following list is not exhaustive, but should be considered in step: Above-Target Inflation and Multiple Fed HikesThese were the drivers of the inverted curve that developed in the late 1970s. If the Fed gets behind the curve on inflation containment, punitive tightening may be required. If short rates are tightened to levels higher than long-term equilibrium rates are thought to reside, then the curve may invert. Significant Pension Fund Duration ExtensionPension fund liabilities are discounted relative to long-dated interest rate benchmarks, while assets are typically invested in shorter-duration indices and equities. As federal scrutiny of pension fundedness increases, there may be increasing incentive for pensions to extend assetside durations. We do not envision a long-end supply/demand crisis of the size seen
11

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Lehman Brothers | Interest Rate Structured Notes Primer, Part 1

in the U.K. government market, but moderate richening of the U.S. long end over the next several years cannot be ruled out. Re-elimination of Bond IssuanceWhile the Treasury seems committed to maintain 30-year issuance in the years ahead, were the budget picture to improve markedly, there lies the possibility that 30-year issuance might be re-eliminated at some point. In late 2001, elimination of the bond resulted in a 2-day 30 bp flattening of 2s-30s in swaps. Most of this move took the form of longer-dated forwards such as 5y5y idiosyncratically richening to 5-year ratesa rapid richening of term premium and the U.S. long end.

Other Statistics on NINs

Survival Probabilities/Expected Life

Figures 11 and 12 show data for two types of notesa new-issue 15yNC3m and a newissue 10ync2y. Expected lives for the structures are initially ~3.5 years and ~6.0 years, respectively. We also show how this expected life changes for instantaneous shocks to both rates and curve slope immediately subsequent to issuance. For NINs, one should expect the bull steepener to be the best environment and vice-versa.
Historical Coupons

We discussed factors that drive the new-issue par-value coupon on the previous page. As a result of movements in the underlying market factors, the history of the coupon on a newissue 10nc2y is shown in Figure 13. NIN coupons fell sharply in February-March 2007 as the forward curve steepened in response to subprime-related housing market risk.

Figure 11.

Expected Life (Years) for 15yNC3m NIN on 2s-10s versus Instantaneous Shocks to Rates/Curve Immediately Subsequent to Issuance
Parallel -50 -25 2.73 Change in 0 4.43 2.04 3.46 2.51 4.24 5.06 Forward Curve 25 50

Changes In 2s10s

5 bp Flatter Unchanged

Curve Slope 5 bp Steeper

Data: Simulations on Lehman Analytics, Unchanged Implied Vol Surface Source: Lehman Brothers

Figure 12.

Expected Life (Years) for a 10yNC2y NIN on 2s-10s versus Instantaneous Shocks to Rates/Curve Immediately Subsequent to Issuance
Parallel -50 -25 5.62 Change in 0 6.28 5.25 6.00 5.79 6.38 6.76 Forward Curve 25 50

Changes In 2s10s Curve Slope

5 bp Flatter Unchanged 5 bp Steeper

Data: Simulations on Lehman Brothers analytics, unchanged implied vol Surface Source: Lehman Brothers

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Lehman Brothers | Interest Rate Structured Notes Primer, Part 1

Figure 13. The New-Issue Par-Value 10nc2y Coupon Fell Abruptly in February-early March 2007; Has Recovered Somewhat Recently
Coupon Available on 10nc2y, % 10.0 9.5 9.0 8.5 8.0 7.5 7.0 6.5 6.0 Aug-05 Nov-05 Feb-06 May-06 Aug-06 Nov-06 Feb-07 10nc2y 2s10s Non-inversion Note Coupon Large Fw d-Curve Flattening Events Collapse in Q107

Figure 14. We Show that the Long-Dated Futures Slope Has Been Flatter than Usual of Late
bp 15 10 5 0 -5 -10 -15 Jan-94

Long-dated Futures Slope, per Year, Unexplained by Steepness of Shortdated Futures Slope

Jan-97

Jan-00

Jan-03

Jan-06

Source: Lehman Brothers

Source: Lehman Brothers

General Questions
What Drives the Valuation of Forward Curve Slope?

Although many factors drive the valuation of NINs, a variable to which they are very sensitive is the slope of the forward curve. In terms of understanding NIN exposure to the forward curve, it is first necessary to distinguish between forward curve slope, which is a breakeven, and convexity-adjusted curve slope, which is a future expectation (as demonstrated earlier, in Figure 9). Given the importance of the convexity-adjusted forward curve slope, we might ask what drives its pricing. This is not simple, and the answer touches on risk premium and longdated expectations of supply/demand for Treasuries. Such discussions are best left for another forum, but one may start by examining the history of term premium. In the U.S. rates market, term premium has averaged 15 bp on the futures curve for each additional year of duration risk taken; this factor explains why the convexity-adjusted forward 2s10s curve slope is steep even to long dates. As for rich/cheap around this 15 bp per year, Figure 14 shows a history of residual term premium per yearlong-dated future curve slope expectations (we use the 20th-40th eurodollar differential divided by 5) that cannot be explained by the slope of 2s-5s. Term premium has been richer than normal over the past 18 months, which is another way of saying that spot and forward 2s-10s has been flatter than usual over this period.
What Role can NINs Play in a Portfolio that is Benchmarked to the Aggregate Index?

Structured notes can be useful for investors that seek to outperform the aggregate index, as they allow novel ways to express views, but NINs and leveraged steepeners (described in the next section) may have special attraction for investors who are ultimately total return accounts. Insurance companies and pension funds typically have long-dated liabilities and tend to suffer when they must re-invest capital in the extended low-yield environments that are typically seen during recessions. However, low yields are often associated with an extended steep curve environment, and as such, adding steepening exposure through NINs or leveraged steepeners may actually help out in performance and improve Sharpe ratio. Moreover, for pension funds with significant equity positions, steep-curve recessionary periods have historically been some of the worst periods for equity performance.
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Lehman Brothers | Interest Rate Structured Notes Primer, Part 1

LEVERAGED STEEPENERS (LEVSTPS) Background

What Are LevStps, What Is the View Expressed, and Why Have They Been Popular?

The view expressed with LevStps is similar to the view expressed within non-inversion notes (NINs), which is that a steep yield curve is more likely than a flat or inverted curve. But whereas NINs pay a digital coupon contingent on the curves remaining steeper than some value (usually 0 bp), without additional upside if the curve steepens significantly, LevStps retain some upside exposure to steepening. Many LevStps pay out coupons that are calculated as 20x-50x the slope between two CMS points on the swap curve and floored at some lower value. This 20x-50x is termed a leverage factor. In the event of a rapid curve slope steepening (as in 1990-1992 and 2001-2003), coupon payments could potentially be large. Typical LevStp structures have offered a fixed above-market coupon for 1-3 years before the variable coupon becomes active, and some banks have found the notes attractive, with the view that the yield curve is currently in an abnormally flat state (bad for bank earnings) but will revert to a more typical shape in time. Many accounts that consider NINs also consider LevStps.
Characteristics and Sizes Outstanding

LevStps are frequently issued as 15yNC1y 3 Bermudan callables, and the most popular underlying curve slope has recently been 10s-30s. Approximately $5-$7 billion has been issued since the beginning of 2004. As with NINs, bullets are rare, but do exist; they generally offer lower coupons and leverage factors. Also as with NINs, European banks are the typical issuers; the U.S agencies have not issued LevStps. Nuts and Bolts
How Does the LevStp Coupon Calculation Work?

Coupons are paid quarterly using the CMS (constant-maturity swap) rate fixings that appear on Reuters screen ISDAFIX1 at 11am EST on the interest determination date. For information on CMS rates and the nature of the convexity adjustment in forward swap rates, please see the NIN section of this primer.
How Does the Issuer Hedge the Risk Associated with the Note?

As with NINs, most typical issuers of LevStps, such as KFW or other European banks, do not manage exotic risks associated with the LevStp coupon. Most issuers will swap out the exotic risk to a broker dealer, and as such, the risks are typically managed off of major Wall Street derivative desks. Typically, the actual issuer of the note is left only with bullet funding that it perceives to be attractive. LevStp Market Risks and the Determination of Coupon and Price
Broadly, What Is the Risk That Investors Are Selling to Gain the High Coupon?

In a LevStp, investors are generally long volatility associated with the slope curve (in contrast with non-inversion notes [NINs]), meaning that they will do better, other things being equal, if the curve is volatile, as this implies a greater chance of significant steepening. Nonetheless, investors are selling the risk that the curve will flatten or invert. As LevStps also have plain vanilla callable characteristics, investors are selling the risk that the level of yields will change significantly.

5- and 10-year tenors also trade frequently.

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Lehman Brothers | Interest Rate Structured Notes Primer, Part 1

Factors Driving an Existing LevStps Pricing and Rough Sensitivities

New-issue LevStps have exposure to many variables. We will consider the exposures for a Bermudan callable 15yNC1y LevStp with a broker dealer credit. The structure we have in mind has a fixed 8.25% coupon for the first year and a 50x 10s-30s coupon afterward. Statistics are summarized in Figure 15. DurationFor a new-issue 15yNC1y LevStp, the PV01 is approximately 340, which is, coincidentally, similar to the PV01 of the 15yNC3m NIN examined earlier. Because the note is callable, this PV01 is, of course, highly sensitive to price. CurveLevStps will benefit as the curve steepens, as the potential value of future coupons rises. Given the 50x leverage factor in this note, the curve PV01 relative to the 10s-30s slope is nothing short of hugeon the order of 4300. This easily qualifies as the primary risk exposure of the note. The sensitivity would be proportionally lower for a lower leverage factor. Gamma and Vega Associated with the LevStps Callability and Embedded OptionalityLevStps are often structured as Bermudan callables, and just as with any callable, there is a yield pickup (relative to a bullet) associated with the call feature. For a vanilla 15yNC1y agency callable, the yield pick is ~70-75 bp over a 15-year agency bullet. Given the LevStps large curve PV01 and typical curve realized volatility, the LevStps call feature is worth ~2.5x the value of a typical vanilla callable call featureapproximately 175-200 bp. The value of this call feature, as well as the value of the curve call option embedded within the LevStp itself, scales with implied volatility on curve options. The value of the call option will also be correlated with the level of implied rate volatility, though exposure to the level of implied rate volatility will be lower than in other structured notes. Correlation Vega (Advanced Topic)As noted above, the core option in LevStps is exposed to implied curve volatility. Long-dated 10s-30s curve slope volatility trades at ~16-18 bpvol. Each 0.8 bpvol decrease in this implied volatility (which represents a rather large 5% change in the implied level) will increase the mark to market of the LevStp in question by 60 cents.4 The best way to track changes in the value of this implied curve volatility is to monitor the vega ratio of 5y10y over 5y30y vol in bpvol terms. Currently, this vol ratio stands at ~112%. Each percent decrease in this vega ratio corresponds to a decrease of ~0.8 bpvol on long-dated 10s-30s implied curve volatility and 0.6 points on the LevStp in question. This vega ratio is driven by both structured note-related swaption flows and non-structured-note-related flows such as trust preferred vega supply and pension fund demand for swaptions in long-dated 30-year tails.
Statistics as of May 8, 2007, FNM 6.0 30-Year Mortgage Price at 100-23
PV01 (Rates) 10NC2 Agency Callable CC 30y Mortgage 10yNC6m LRA 7.20% 6m LIBOR Knockout 15yNC3m 2s10s NIN 15yNC1y 50X 10s30s LevStp 368 255 450 340 342 PV01 (Curve) 1100 4300 Rate Vega (bp) -19 -14 -10 -15 -11 Qualitative Short Gamma Exposure Moderate Moderate Very High Very High Moderately High

Figure 15.

Data: Simulations on Lehman Brothers analytics, unchanged implied vol surface Source: Lehman Brothers Note: PV01 of 340 implies that a 1 bp change in rates will result in a 3.4 cent change in the notes price
4 The effect would be large, but the long position in implied curve volatility is partially canceled out by the short implied curve volatility exposure embedded within the notes call option. Bullet LevStps should be expected to have larger exposure to implied curve volatility than callable LevStps.

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Lehman Brothers | Interest Rate Structured Notes Primer, Part 1

Other Factors Driving a LevStps New-Issue Coupon

The coupon of a specific LevStp is sensitive to many variables. One must start with the market variables listed above, but also consider the following variables: The Curve Spread That Underlies the Note, the Credit Backing the Note, the Nature of the Call FeatureSee the non-inversion note section for description of these factors, which are sufficiently general as to be valid for LevStps as well. The Leverage Factor The size of the leverage factor on a LevStp defines its coupon upside should the yield curve steepen significantly. For a given price, a higher leverage factor is always better for the investor. In the case of the 15yNC1y 10s-30s leverage steepener we have been discussing, the difference between a 50x leverage factor and a 45x leverage factor is worth ~1.2 points on the notes mark to market.

Unique Event Risks

LevStps carry some of the same risks as NINs (refer to the NIN section), but there is one unique risk: A Settlement of Yield Curve Slope at a Level Only Slightly Steeper than 0 bp In the NIN section, we discussed the idea that there may be something unique about the 0 bp level on the swap curve. However, as LevStp coupons are generally proportional to the slope of the curve, a curve slope settlement between 0 and 10 bp implies a very low coupon for LevStp notes, even though it provides for the full coupon to be paid on NINs. Early in 2006, it appeared that there was some risk that the yield curve slope would settle in fairly close to 0 bp. This differential NIN/LevStp behavior would be important in such an event.

Other Statistics on LevStps

Survival Probabilities/Expected Life

Figure 16 show data for our 15yNC1y 10s-30s 50x LevStp. The expected life for the structure is a little over five years at issuance, and we show how this expected life changes for instantaneous shocks to both rates and curve slope immediately subsequent to issuance. For LevStps, one should expect the bull steepener to be the best environment and vice-versa; however, the main sensitivity is to the curve component.
Figure 16. Expected Life for a 15nc1y New-Issue 50x 10s-30s LevStp versus Instantaneous Shocks to Rates/Curve
Parallel -50 Changes In 10s30s Curve Slope 5 bp Flatter Unchanged 5 bp Steeper 4.89 5.04 -25 Change in 0 6.49 5.20 3.44 5.49 5.82 Forward Curve 25 50

Data: Simulations on Lehman Brothers analytics, unchanged implied vol surface Source: Lehman Brothers

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Explanation of the Lehman Brothers Mortgage Model The Lehman Brothers Mortgage Valuation Model allows investors to analyze mortgage-backed (MBS), asset-backed (ABS) and commercial mortgage-backed securities (CMBS). The model collects pertinent and material information needed to evaluate and calculate the risk measures of the security. The model provides option-adjusted spreads and durations along with other risk measures using Lehman Brothers' Prepayment, Default, and Term Structure Models. Analyst Certification The views expressed in this report accurately reflect the personal views of Benjamin Martens, the primary analyst responsible for this report, about the subject securities or issuers referred to herein, and no part of such analyst's compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed herein. 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