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4Q 2009 Investment Strategy Sample Bank Anywhere, US Market Comments / General Overview Sep 30, 2009 Portfolio Book $41,000,000 Portfolio/TA 41.00% $830,000 Even as it appears the Fed has achieved its goal of restoring a sense of $ Gain/(Loss) normalcy to credit markets and Chairman Bernanke declaring an end to the % Gain/(Loss) 2.3% recession in early September, Treasury yields pushed 20 basis points lower 4.62% across the curve while the S&P 500 jumped almost 19% over 2Q 2009. In the Tax Equiv. Yield September policy statement, the FOMC did upgrade its economic outlook but Projected Avg. Life 3.30 yrs reinforced its belief that conditions continue to warrant generous policy 2.17/(.63) support and exceptionally low levels of the federal funds rate for an extended Eff. Dur/Conv period of time. It is clear that policymakers will not allow higher borrowing +300bp Risk (9.33) rates to derail the recovery in housing or the economy. Despite the clear signals from the FOMC, the Fed Funds futures market predicts a potential rate hike in 1Q 2010. However, many economists argue that the Taylor Rule (which evaluates current output to potential output vs. inflation projections) more accurately points to the Fed staying on hold through 2010 and even into 2011. Additionally, to provide continued support to mortgage lending and housing markets, the Fed announced they would purchase the entire approved allotment of $1.45tn of Agency debt and Agency MBS and extend purchases through the end of 1Q 2010. As the Government grows its balance sheet, the massive supply of Treasury debt has been easily absorbed by the market, with longer maturity auctions actually the performing very well. Foreign demand has accounted for almost 50% of the purchases. The simultaneous strength in the stock and bond markets (gold too) over the 2nd quarter belies historical precedent that one would expect to see one market start to sell off or soften as the other one rallies. Close attention will be paid to employment and consumer data over the next several months, with “cash for clunkers” having expired and tax credits for home purchases ending in November these data points could tell us if we are in the clear or potentially face a “double dip” recession. General Strategy The spread tightening theme of the 2nd Quarter continued through 3rd Quarter. Strong performance across all sectors pushed the portfolio’s unrealized gain from less than 1% to over 2.3% at the end of September. With rates remaining historically low, the portfolio yield trended lower another 13 basis points to 4.62%, while the effective duration fell to 2.17, near the low-end of the Bank target range. The Bank will continue to emphasize core Government Agency securities that are continuing to be purchased by the government and avoid the temptation of high yielding, illiquid assets like certain corporate bonds or private-issue MBS. With the yield curve remaining quite steep over the 3rd quarter and prospects of continued steepness, the Bank will maintain its focus on the intermediate sector of the curve and strive to sustain a slightly above average portfolio duration. The mix of the portfolio has continued to shift out of Agency securities and into fixed-rate Agency MBS/CMO and Municipal bonds to take advantage of relatively wide spreads. As the market normalizes and volatility drops, the Bank will look for opportunities to replenish the Agency sector. With the fiscal stimulus increasing the supply of “bank qualified” issues and Build America Bonds, the Bank will attempt to add quality bonds with good underlying ratings/financials with maturities in the 5-15 year range. With cash earning virtually zero, the Bank will make efficient deployment of all idle funds and evaluate all options for enhancing income through the portfolio. Austin, TX | Indianapolis, IN | Oklahoma City, OK | Salt Lake City, UT | Springfield, IL Member: FINRA & SIPC Page 1 of 3 The Baker Group % Portfolio Agency Muni MBS June, 2017 Eff. Dur/ Conv 09/30 Target 09/30 Target The Agency sector continued to outperform the Treasury market during the 3rd Quarter with 5-year bullet Agencies another 5 basis points to just under 40 basis points currently. Due to relatively low yields offered by this sector, Agency holdings continued to contract slightly over the quarter and are at the low end of target. Given the uncertainty of the economic and interest rate environment, the Bank does not believe it is the right time to chase yield and take on substantial negative convexity in longer callable agency products. Sector duration will be maintained by buying securities with at least one year of call protection, while favoring premium one-time callable securities with at least 1 year to call and 3 to 10-year maturities. The Bank will continue to look for opportunities to sell short instruments and deploy the proceeds on the intermediate portion of the curve. 21% 20%30% 2.16 / 2-2.5/ (.25)(1.0) The municipal sector enjoyed a very robust quarter, with bank qualified issues in the 10- year range tightening another 75 basis points to currently offer a 120 basis point advantage over Treasuries. A lack of tax-free supply has been a major factor in the municipal market, large amounts of longer (i.e. >10yrs) taxable Build America Bonds (BABs) continue to be issued as a result of the Obama administrations American Recovery and Reform Act. This reduced shorter maturity supply has kept the Municipal curve quite steep. The Bank will look to take advantage by ongoing purchases of taxfree municipal bonds in the 10 to 15 year range as well as adding BABs with 7 – 12 year maturities. The Bank will purchase BABs with slightly shorter maturities because they do not have the reduced duration benefit as the tax-free issues. Preferred insurers of municipal holdings will be the Texas Permanent School Fund, Berkshire Hathaway, FSA and Assured Guarantee, although the Bank will carefully review the creditworthiness of all underlying municipal issuers in addition to assessing the strength of the bond insurer. Given prudent credit analysis, the turmoil continues to offer excellent opportunities to add to the Municipal sector. Under the current steep Municipal yield curve environment, the Bank will continue to maximize municipal holdings. Additionally, as opportunities become available, the Bank will look for opportunities to swap out of short maturities and deploy the proceeds out on the preferred range of the curve. 24% 25%30% 3.31/ The FOMC recently announce the Federal Reserve will extend its MBS buy program through the end of 1Q 2010. They reiterated their intention to purchase a total of $1.25tn of Agency MBS, with purchases gradually tapering off. With the Fed having purchased just under $900bn year-todate, just over $350bn remain to be purchased. The Fed/Treasury buy program has kept MBS market spreads to their tightest levels of the year. Response to government implementation of various housing stimulus programs has been muted and has lead to only a slight increase in prepayments. After peaking in June, prepayments have declined the past two months. Since the end of June, the MBA Refinance index has gradually climbed from about 2,000 to 2,870, but is still over 60% below the 7,400 recent peak in Jan 2009. Unless mortgage rates drop to new lows, it appears too many obstacles will prevent prepayments from getting too fast. As the Government looks to reduce its role in the MBS market over the next several months, specific security selection will be more crucial now than ever. To combat the ultimate temporary nature of the governments 46% 35%50% 1.74/ (.81) (.26) (.79) 3–3.5/ 0 -(.5) 2.0–3/ (.5)(1.25) Austin, TX | Indianapolis, IN | Oklahoma City, OK | Salt Lake City, UT | Springfield, IL Member: FINRA & SIPC Page 2 of 3 The Baker Group % Portfolio June 2017 Eff. Dur/ Conv 09/30 Target 09/30 Target 8% 5%10% 1.65/ 2 – 3/ (.5)(1.25) support through direct MBS purchases and housing stimulus packages, the Bank will continue to focus on Agency MBS pools with one or more of the following characteristics; 1) seasoned underlying mortgages (e.g. 2005 and earlier origination), 2) higher coupon pools (5.5%+) with particular loan attributes that should provide prepay protection (e.g. low loan balance, investor properties, low FICO, geographic, etc.), and 3) lower loan balance GNMA pools. MBS Float: The Bank’s MBS Floating sector continues to be quite small. With an increase in origination, the Bank will evaluate new 3x1 and 5x1 Hybrid ARMs as possibilities to build intermediate cash flows and pick up significant spreads without taking on excessive duration. CMO The CMO sector will continue to be comprised of only FNMA, FHLMC, and GNMA backed securities. The Bank will look for opportunities to buy Agency CMO structures with quality collateral characteristics that should provide intermediate cash flows in the 2-7 year range. All CMO’s will be prudently analyzed for both extension and call risks. (.76) Historical U.S. Treasury Yield Curves 5.5% 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 9/30/2008 3/31/2009 6/30/2009 9/30/2009 Fed Funds Futures – Current Market Expectations for FUTURE levels (as of 09/30/09): Austin, TX | Indianapolis, IN | Oklahoma City, OK | Salt Lake City, UT | Springfield, IL Member: FINRA & SIPC Page 3 of 3