What is Mortgage Banking?

What is Mortgage Banking? • June 18, 2003

Executive Summary • The mortgage market in the United States is vast • Marketplace characteristics are driven by borrower and investor demands • The mortgage banking business links the borrower to the investor creating high market liquidity • Servicers move the cash • Accounting adds complexity

Table of contents • 1 Overview of the mortgage market Page 04 • 2 Mortgage marketplace Page 09 • 3 Originators: the distribution channel Page 19 • 4 The role of the Servicer Page 31 • 5 Accounting considerations Page 43 • 6 Hedge accounting Page 52 • 7 Questions Page 57

1Overview of the mortgage market

U.S. Mortgage Market The mortgage market has two primary sectors: retail and commercial. Single-family constitutes the retail sector. Multi-family comprises part of the commercial sector. • Vast: in excess of $6 trillion of mortgage loans outstanding • Demand for mortgage product high: over 6.4 million single-family homes purchased in both 2002 and 2001 • Government sponsored entities (Agencies) facilitate highly liquid securitization market • Securities market deep: over $ 1 trillion in securities issued in both 2002 and 2001 • Mortgage products highly standardized with virtually no penalty for prepayment

Borrowers / Home Buyers Lowest all-in rate Broadest selection of product type Lowest out-of-pocket costs Efficient, reliable delivery of product Ease of access Transparency Investors Invest in mortgage product without business infrastructure Large pools of standardized, small dollar product Low, well-diversified credit risk Well-collateralized investment Additional credit enhancement Highly liquid investment Efficient delivery Managed prepayment volatility Market Demands Drive Product Market liquidity also drives innovation in product development .

U.S. Mortgage Banking Industry Mortgage Banking connects the needs of borrowers with the demands of investors to provide a deep and liquid mortgage marketplace in the U.S. Mortgage Banking Originations Borrowers / Home Buyers Investors Servicing

Servicing Collect payments from borrowers Remit principal and interest to investors Remit taxes and insurance to appropriate parties Pursue delinquent loans Initiate foreclosure proceedings No credit exposure Mortgage Banking Roles • Originations • Source qualified borrowers • Underwrite mortgages • Fund mortgages • Pool mortgages by type • Sell mortgages to investors • through Agencies • through private securitization vehicles

2Mortgage marketplace

Government-sponsored entities create a liquid securitization market: Credit risk sold Need not be self-funded Standardized product Virtually no prepayment penalties Results in high refinance market Capital requirements low Limited secondary market, assets retained Credit risk retained Funded through bond issuances Prepayment penalties Limits refinance market and origination volume Capital requirements high Key Differences: U.S. vs. Europe Although the underlying characteristics are similar across the two regions, fundamental differences exist in the two markets. U.S. Market European Market

U.S. Borrowers’ View of Mortgage Product ABN AMRO offers a variety of product but does not participate in interest-only mortgages, reverse mortgages or balloon mortgages. • 1st liens on real property (e.g., collateral specific) • Typically no penalty for prepayment • Variety of basic terms: • Fixed rate mortgages: predominantly 15 year or 30 year • Adjustable rate mortgages: ARM and ARM hybrids • Other hybrid products: • Interest only payments • Reverse mortgages • Balloon principal

Borrowers’ Decisions The most prevalent are fixed rate mortgages where the payments are both principal and interest. 30 year mortgages are common although the current low interest rate environment has resulted in an increase in shorter tenors. • Interest type: • Fixed, floating or hybrid • Payment type: • Principal and interest or interest only • Current interest rates (purchase or refinancing) • Tenor (various including 15 year and 30 year) • Cash contributed to property purchase (equity) • Loan to property value (LTV) < 80% – standard • LTV > 80% requires borrower to buy insurance • Cash paid at closing (fees, points, etc.)

Growth in Mortgage Debt Outstanding In the U.S., the retail mortgage sector is single-family mortgages. Single-family is often defined as 1-4 units per property. CAGR = 8.53%↑ Source: The Bond Market Association

Who are the Agencies? • Primary roles: • Attract investors to the mortgage marketplace to ensure adequate funding and liquidity for mortgage market needs • Increase home ownership by making home mortgages more affordable • Minimize regional disparities through high standardization • The Agencies • Ginnie Mae (GNMA) • US Government agency – fully guaranteed by the US Government • Fannie Mae (FNMA) & Freddie Mac (FHLMC) • US Government-sponsored agency • Indirect guarantee by the US Government

Investors’ View of Mortgage Product ABN AMRO targets conforming mortgages (GSE securitization). Additionally, ABN AMRO focuses on prime jumbo mortgages for which it maintains its own securitization vehicle. ABN AMRO does not participate in sub-prime lending. • Conforming (Agency) • Highly standardized to facilitate securitization • Agencies specify guidelines • Loan to property value < 80% unless insured • Prime loans to customers of high credit quality • Size limitations on individual loans (< $322,000) • Non-conforming (includes many types) • Private securitization vehicles (“private-label”) • Jumbo mortgages (principal exceeds conforming limit) • Sub-prime: borrowers ineligible for conforming loans • Hybrid products

Investor Decisions • Invest in mortgages without business infrastructure • Low, well-diversified credit risk • Highly liquid investment • Investment well-collateralized • Risk vs. return profile (Agency vs. non-conforming securities) • Initial market development facilitated by Agencies • Private-label market now well-developed

Outstanding Agency Securities ABN AMRO securitizes through all three Agencies. The primary Agency utilized by ABN AMRO is FHLMC. CAGR = 9.39 ↑ Source: The Bond Market Association

Balance of Mortgage Banking Industry Servicers – 2002 Originators – 2002 Source: Inside Mortgage Finance

3Originators: the distribution channel

Market Drivers to Volume • Home Purchases • Real estate transaction-based • Nearly all home purchases • Mortgage Refinancings • Lower interest rates • Change other terms • Leverage equity in property • Underlying collateral remains unchanged

Cultural Influences on Market Drivers America’s consumer culture significantly influences the mortgage marketplace. • Purchase business • Labor market is less regulated • High geographic mobility • Relocation from region to region is not uncommon • Homes are viewed as an investment or a commodity • Refinancing business • Highly liquid retail financial services marketplace • Consumers are financially savvy • Consumers expect variety of products for different circumstances and needs • Mortgage brokers serve as financial advisor to mortgage consumers – monitoring market developments

Refinancing: An Interest Rate Relationship Source: Mortgage Bankers Association of America

Purchase Mortgages: Steady Growth ABN AMRO is a low cost producer in the marketplace and well-positioned to capture future growth in purchase mortgages. CAGR = 8.77% ↑ Source: Mortgage Bankers Association of America

Origination Channels ABN AMRO’s efficient origination network delivers product nationally through its extensive broker network and regionally through its retail branches. • Optimal price and efficiency achieved through standardized mortgage products and processes • Origination channels: • Neighborhood stores (branches) • Mortgage brokers (wholesale) • Correspondent banks • Internet access

Origination Channels ABN AMRO is the leader in its targeted channels of distribution: broker (nationwide) and retail branches (within Michigan and Illinois). • ABN AMRO Originations Source: Inside Mortgage Finance

Margins Counterintuitive • Supply constrained • Supply slowly adjusts to demand

Origination Profitability: Gross Margin • Gains comprised of: • Cash proceeds from the sale of net coupon loans • Net present value (NPV) of rights to service loans • US GAAP requires recognition of NPV of net cash flows expected from servicing • Recognition of fees charged to borrower at origination, if any, net of direct origination costs deferred

Origination Profitability: Channel Costs ABN AMRO focuses on its retail footprint and the low-cost broker channel. • Channels have different relative costs: • Additional/Ongoing benefits: • Retail footprint provide cross selling opportunities • Retail structure and employee base have other roles Source: MBA/Stratmor Peer Group Survey

Net Margin: Infrastructure Costs • Primary infrastructure costs • People resources • Facilities • Technology • Processing costs • Primary scalable cost: people resources • Mortgage brokers – commission-based payments • Temporary staff • Overtime

Originations business During this time period ABN AMRO grew from 9th with a 1.8 market share to 5th with a 4.8 market share. • Economies of scale provide significant cost advantages • As with well-developed markets, mortgages have relatively thin margins, placing an emphasis on efficient processes • Industry consolidation

4The role of the Servicer

What is the role of the Servicer? • Ongoing connection between borrowers and investors • Collect principal, interest, tax and insurance payments from borrowers • Remit principal and interest to investors • Protect mortgage collateral, and investors, through: • Remitting tax payments to taxing authorities • Remitting insurance payments to insurers • Initiating foreclosure proceedings, if appropriate • No credit risk retained

Investors (Bond Holders) Agency or Pass Thru Vehicle Servicer Borrower Servicing Process Flow • Retains service fee to cover costs to service • Remits principal, security interest and guarantee fee to agent • Remits taxes and insurance to appropriate authorities • Pays Servicer principal, interest & escrow • Conforming: Agency retains a guarantee fee in exchange for accepting default risk • Non-conforming: primary structures – pari passu, senior subordinated or seller retains credit risk. • If securitized, investors receive principal and stated security coupon interest

Escrow Monthly Payment Principal Interest What is the borrower’s mortgage payment? Commonly borrowers pay monthly. Some servicers permit twice monthly payments that ultimately reduce interest costs to the borrower. Casualty insurance on the collateral property to protect the investors in the mortgage (some borrowers pay direct to insurer). States taxproperty owners and government liens are senior. To protect investors, servicers often collect and remit taxes due. Virtually all consumer mortgages require at least monthly remittance of principal. Interest remitted is based upon unpaid principal balance outstanding.

Where does the Servicer remit the monies? ABN AMRO services approximately 1.5 million loans aggregating more than $180 billion of unpaid mortgage principal balances making ABN the 7th largest servicer in the United States in 2002. The Servicer holds these funds as a non-interest bearing deposit (escrow) until payment to tax or insurance entities. Escrow Principal The Servicer holds these funds as non-interest bearing deposits (float) until remitted to the agent and investor (monthly). Interest

Illustration of Remittance of Interest Spread Borrower’s Interest Payment Interest paid by the borrower is the source of fee income to participants in the securitization process. Primary variables are mortgage coupon and security coupon. Guarantee fee and servicing fee have less variability. Guarantee Fee: Paid to the Agency as the compensation for credit enhancing the security issued. .15 % .35 % Servicing Fee: Retained by the Servicer as compensation for collecting and remitting payments. Mortgage Coupon Interest = 6.0% 5.50 % Security Coupon Interest: Remitted to the investor in the mortgage-backed security.

Investors (Bond Holders) Agency or Pass Thru Vehicle Servicer Borrower Servicing Process Flow – Example Proceeds are invested to earn Float (interest) income between the collection of the payment from the customer and remittance. Typically between 5 and 10 days. Remits principal and 5.50% in interest Pays Servicer principal & interest (6%) Remits principal and 5.65% in interest • Retains 35 bps of 6% coupon to cover costs to service • Holds Escrow deposits at no cost until remitted • Investors receive principal and 5.50% in coupon payments for initial investment • Agent retains a guarantee fee of 15 bps in exchange for default risk • Pass thru vehicle retains portion of cash flows to absorb default risk

Key Components in the Servicing Income • What are the cash components of servicing income? • Servicing fee income: fixed spread of unpaid principal balance (typically 30-35 bps) • Float: interest earned on mortgage payments received (prior to remittance) • Escrow: low cost source of funds (prior to remittance) • Ancillary income: account fees such as late charges • Cross-selling: maintaining the account relationship provides opportunities to cross-sell other products of the servicer

What comprises servicing revenue? Mortgage servicing rights (MSRs) significantly impact servicing revenue. • MSRs represent the net present value of net cash flows expected from servicing • MSRs are created: • when loans are sold with the right to service the loans retained or • when servicing rights are separately purchased • MSRs are amortized over the life of and in proportion to the cash flows expected from the underlying loan • MSRs must be assessed for impairment (fair value deficient to book value)

MSR – Economic Valuation The value of a Mortgage Servicing Right is based on the present value of expected cash flows Cashflow Assumptions • Value of each payment - 25 to 50 basis point strip • Expected average life of the loan - this expectation is based on anticipated prepayment speeds • Add benefit of float, escrow and ancillary income • Less: costs to service Discount Rate • The discount rate implies a certain level of profitability/return • Expectations of return are based on compensation for the riskiness of the asset and the cost of servicing Value of MSR The value of this asset can change significantly (both positively and negatively) because of both interest rate and prepayment risk

Why is the earnings effect so volatile? • Servicing Income comparison

Objectives in Hedging MSRs Typically mortgage bankers actively manage the risk of the MSR asset utilizing a variety of cash and derivative instruments.

Servicing business During this time period ABN AMRO grew from 18th with a 1.0 market share to 7th with a 2.9 market share. • Economies of scale provide significant cost advantages • As with well-developed markets, servicing has relatively thin margins, placing an emphasis on efficient processes • Industry consolidation

5Accounting considerations (US GAAP)

The Mortgage Origination Timeline Approval Process Pipeline Warehouse 0 to 14 days 30 to 45 days 30 to 45 days Application Lock Date Funding Date Sale Date Lender pools mortgages Borrower applies for mortgage Lender extends irrevocable commitment to fund mortgage Borrower may decline with no penalty Mortgage banks typically “sell forward” expected production Lender funds mortgage Lender delivers mortgage to agent Sale process complete

Accounting for Mortgage Originations (US) Approval Process Pipeline Warehouse Application Lock Date Funding Date Sale Date No entries – no accounting event has occurred Lender recognizes commitment and related hedges (initial value typically zero) Lender funds mortgage and recognizes on balance sheet Gain or loss on sale recognized Any unhedged declines in loan value are recognized immediately in earnings Lender marks commitment and related hedges to fair value through earnings

Components of Gain on Sale • Cash proceeds • Book value of loans sold • Original par (funded amount) • Fees received from borrower at closing less direct costs to originate (deferred) • Any impairment charges recognized during the hold period • Retained interests • Mortgage servicing rights: • Present value of net cash flows expected over the expected life of the loan discounted at current market rates • Recourse obligations, if any

Gain on Sale – an Illustration • A 100,000 par mortgage is sold at 99,500 • Net deferred costs aggregate to 500 • Expected value of mortgage servicing rights aggregates 1,500 • No impairment charges were recognized while “held for sale” • Typically, “A” paper single-family mortgages are sold without recourse Par value 100,000 Net deferred costs 500 Net book value 100,500 Cash proceeds 99,500 MSR 1,500 Net gain on sale 500

Investors (Bond Holders) Agency or Pass Thru Vehicle Servicer Borrower The Accounting Process – Servicing • Retains service fee to cover costs to service • Remits principal, security interest and guarantee fee to agent • Remits taxes and insurance to appropriate authorities • Pays Servicer principal, interest & escrow • Conforming: Agency retains a guarantee fee in exchange for accepting default risk • Non-conforming: primary structures – pari passu, senior subordinated or seller retains credit risk. • If securitized, investors receive principal and stated security coupon interest

General Accounting Principles (U.S. GAAP) • Loan Servicing Income: the servicer collects a spread on outstanding mortgage loans every month • Accounting: service fee income is accrued as earned. Similarly, costs to service the loans are expensed as incurred • MSR: the servicer estimates the net present value of servicing income of the underlying mortgage, net of expected costs to service • Amortization: the MSR is amortized in proportion to the expected net cash flows of the asset. Prepayments significantly impact the expected life

What is Mortgage Banking?