Newsletters:
February 2005

What’s New At Compass?

We are pleased to announce that we will be moving into our new office space on March 14th. Our new address is:

900 Larkspur Landing Circle, Suite 285
Larkspur, CA 94939

We’ll have more information to follow as far as phone and fax numbers in the next couple of weeks. If you are traveling to the Bay Area, let us know, we would welcome a visit.

New in CompassPoint™!

Compass is pleased to report its recent development progress in CompassPoint™, including:

• Report Distribution Automation (auto compression and distribution)
• Improved Eurodollar Reports
• Improved FAS 133 Month End Reporting
• Enhanced Report (.pdf) Viewer and Simplified Reporting
• Error Log Report and Inclusion in Batch
• Treasury Curve/Cash Flow Capabilities on Hybrid Arms

CompassPoint™ features and capabilities reflect the business needs as defined and requested by its users. For additional information on new features or to submit suggestions and requests, please contact Rob Kessel at (415) 925-2812 or e-mail at rkessel@compass-analytics.com.

Market Update

In a rather dramatic and unexpected move, bonds and mortgages rallied significantly in the month of January and following the employment report release on February 4th. This rally eventually brought the 10-yr yield back below 4.00% and mortgage lenders were offering the best rates in months.

At the beginning of January, expectations of higher rates seemed to be picking up steam. Bonds shrugged off a slightly weaker-than-expected December employment report and the Fed-speak of the day had heightened concerns of a faster pace to Fed Funds increases. The quicker release of the Fed minutes from the previous meeting (now released in three weeks instead of six) showed significant debate on a possible pick-up in inflation pressures. With the 10-yr yield hovering around 4.25%, it appeared that the bottom of the range that had contained bond prices since September would likely be tested again.

Then, along came the next round of economic data. The NY Empire Index, the Philly Fed Survey and the ISM Index all dropped from the previous month. The U of Mich. Consumer Survey displayed a drop in confidence and the Employment Cost Index rose less than expected. Originally estimated at 4.0%, 4th-quarter GDP was revised to 3.1%, well below the 3.5% consensus.

Once again, bond prices at the long end began to crawl back towards the top of the range. Even though the yield curve flattened considerably in 2004, many participants still saw room for additional flattening. Fed-speak seemed to steer away from inflation concerns or steer towards renewed talk of a tame inflation outlook. Although the dollar remained weak, oil prices moved higher once again which helped support bonds.

As is the case, everything leading up to each employment report can be quickly wiped away by a stronger- or weaker-than-expected report. In the case of January’s report released on February 4th, the tepid job growth simply added strength to an improving market. The 10-yr yield dipped below 4.00% and approached significant support at 3.96%. The support held once again and a weak 10-yr auction, on the heels of decent 3- and 5-yr auctions, pushed the yield back to 4.07%. Mortgages, which had tightened to treasuries most of the month, gave back some ground as the 10-yr yield hit its lows. In what has become one of the most directionless markets in recent memory, bonds continue to hold the tight range established since September. Volatility may increase but it looks like another month of well-contained prices.

Topic of the Month - Hedge Cost

Many lenders are rightfully concerned with how much it costs them to hedge their production. Ideally they would like to see the cost on a loan level basis, but recognizing the aggregate nature of hedging practices, begrudgingly hope for at least product level hedge cost reporting. Only through receipt of such data are lenders confident they are successfully hedging the products they hedge, i.e. that they are making more money over time by hedging their production than if they simply sold the production best efforts. The following is a topical summary of how Compass views hedge cost computations and factors that influence it.

Definitions:

Change in Loan Price: The change in price of the presumed best execution sale of the loan during the period in which it is hedged, typically from day of lock-in to day of sale. For example, assume Loan A’s price is 100 on day 1 and 102 on date of sale, the Change in Loan Price for Loan A would be 2% or 200 bps.

Change in Loan Value: The Change in Loan Price * Loan Amount for those loans that close.

Change In Hedge Price: The change in price of the applicable hedge instrument used to hedge the loan during the period in which it is hedged. For example, assume both Loan A and Loan B are being hedged with FNMA 5.5’s in April and the 5.5 price goes from 100 on day 1 to 102 on date of sale. The Change in Hedge Price would be 2% or 200 bps.

Change In Hedge Value: The change in price of the applicable hedge instrument and weighted amount (duration ratio and coverage weighted) used to hedge the loan during the period in which it is hedged. For example, assume that Loan A was hedged at 70% on day 1, 60% by day 15 and 50% by date of sale. Addressing pairoffs later, the Change in Hedge Value associated with Loan A is that -200 bps * 50 % * 1 (duration ratio) is -100 bps.

Loan Fallout: Loans that were hedged and fall out of the position due to cancellation, declination or renegotiation. Assume that Loan B falls out on day 15 and was originally covered at 70%.

Volatility: The movement of interest rates (prices) during a rate lock term. Another more descriptive term for high volatility is “whip-saw”. Volatile markets do not necessarily move higher or lower, just more frequently and with greater magnitude during the lock period.

Basis Risk: The risk that hedge instruments do not move in price as predicted relative to the loans they hedge.

Accumulated Pairoffs: Represents the accumulated profit/loss of pairoffs associated with a particular loan or group of loans. Following our example, assume for Loan A that 10% of its hedge is paired off when the market has improved 1% and another 10% when the market has improved another 1% (total of 2%). Pairoff losses on Loan A are -100 bps * 10% + -200 bps * 10 bps = -30 bps. Pairoff losses on Loan B are -100 bps * 70% = -70 bps. Total Accumulated Pairoffs = -100 bps.

Calculating Hedge Gain/Cost:

In our oversimplified example above, our Hedge Cost is 200 bps -100 bps -100 bps = 0 bps

Hedge Costs typically range from 0-25 bps depending on the type and channel of product hedged and market volatility.

The test to make sure hedging a product makes sense is to make sure that:

Hedge Opportunity – Hedge Cost (or + Hedge Gain) > 0.

In our example, 50 bps – 0 bps > 0, the product makes sense to hedge.

Factors Influencing Hedge Cost:

Best Execution Price: The better price execution lenders receive, the better the Change in Loan Price or Hedge Opportunity.
Fallout: In rallying markets, the more loans that drop out or are renegotiated, the higher the hedge cost, especially if such performance is not correctly modeled in the pullthrough function. Extra fallout in rallying markets manifests its increase to hedge cost by worsening Accumulated Pairoffs (hedge is paired off at a loss as loans fall out).
Volatility: The greater the interest rate volatility the greater the hedge cost. Volatility has more impact on hedge cost the more sensitive a coverage (pullthrough) function is. For example, a wholesale refinance loan’s pullthrough function may go from 50% to 90% based on where the market is compared to the first day of loan lock. Hedging the loan requires keeping the hedge coverage consistent with the pullthrough function. Volatile markets can lead to buying and selling as the market moves – unfortunately after the market moves. Volatility can manifest its increase to hedge cost by worsening Accumulated Pairoffs and Change in Hedge Price (applicable hedge may go down in open price if subsequent trades are added at lower price).
Basis Risk: Hedge models model and assume that certain cross hedges move with a certain relationship to the loans they hedge. This is not always the case – when hedges do not move as planned – they can increase or decrease hedge cost. For example, some hedgers of arm products who employ FN15 hedges sometimes see arm prices move in the same direction as the FN15 hedges.

Summary:

Hedge cost always has to be viewed in aggregate and with all necessary components: Change in Loan Value, Change in Hedge Value, Accumulated Pairoffs. Often these numbers are hard to ascribe to specific months or even harder to ascribe to specific loans. Nonetheless – understanding the components and factors influencing hedge cost can enable lenders to improve their hedge costs and overall performance.

Feel free to call Rob Kessel or your Hedge Manager to discuss the above in greater detail.

Alt A and Jumbo Spreads

The first week of 2005 was characterized with quite a bit of volatility for Alt-A and Jumbo spreads. It started on the second business day of the year as the market fell off with the release of the minutes from the Fed’s December 14th meeting, causing FN30 5.5’s to drop more than a quarter point. Spreads tightened by an average of 20 bps, and in line with past performance, 15yr spreads widened to above pre-rally levels the following day, while interestingly enough, 30yr spreads continued to tighten. The middle of the month was relatively stable, spreads bouncing around within a 5 bp range. As market prices increased steadily through the end of the month, spreads followed in a similar fashion increasing at a gradual rate, as can be seen in the graph below.

Compass valued five Alt-A and Jumbo Fixed bulk bids in January, for which, like all others, we saw a broad range of bids. There were several occurrences in this last month where new entrants won bids by 1 point higher then the cover, once again delineating the complexity in valuing these products.

Hybrid Arm Hedge Analysis

The curve continued to flatten going into the new year, although unlike December where most of the flattening was seen at the front end, the flattening manifested itself in the belly of the curve for January (see 3-10 Spread on Swap Curve Spreads). As past performance has generally indicated in a flattening curve environment, the Eurodollar hedge proved to be significantly more effective than Dwarfs for all hybrids. Although both instruments were challenged in January, the Eurodollar hedge outperformed Dwarfs by as much as 27 basis points for 3/1 Hybrids.

Production Index

January lock volume got off to a slow start, though production picked up mid-month as the holiday hangover wore off to show a solid finish. January’s daily volume averaged 92% of our daily production base, with quite a bit of dispersion about the mean. The FN30 RNY displayed an average yield of 5.47%, off 5 bps from last month’s average of 5.52%. Yield showed a range of 5.37% to 5.59%.