The Month in Review September 2013

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1 Compass Analytics 580 California Street, Suite 1725 San Francisco, CA The Month in Review September 2013 What's New? Compass Analytics User Conference When: October 8th, 2013 Where: The Omni Hotel, San Francisco, CA Days on the Desk: October 7th & 9th, 2013 Compass Analytics' annual User Conference is just around the corner. This year's conference will include industry guest speakers, relevant industry topics, strategic discussions, hands-on training, and opportunities to get to know us here at Compass. We are looking forward to new and returning guest presenters from MountainView, Phoenix, JPMorgan, Richey May, and more. There will also be Client panels covering relevant MSR and Pipeline topics. This year we will be integrating technical breakout sessions during our Monday, October 7th Day on the Desk with computer lab sessions on Pooling, Ratesheet, and MSR tools. Registration is currently available for Compass Clients! Upcoming Webinars CompassPoint Updates & New Functionality Summary of our August 2013 CompassPoint Release Hosted by Senior Hedge Manager Bob Gundel Tuesday, September 24th at 10:00am PDT This upcoming Webinar focuses on new functionality from the August 2013 CompassPoint release. Bob Gundel will introduce and explain many of the exciting release enhancements to CompassPoint. In addition to new analytics, Bob will also cover new workflow capabilities including improved overall Process ID management and a Multi-User experience. We have updated the look of our reports with a newer version of Crystal Reports that enables Users to filter designated report columns and drill-down to desired data making Crystal reports within CompassPoint more customizable and interactive. Please join Bob Gundel to learn about the new reporting features and about the changes and new functionality in CompassPoint. Webcasts Trainings Available Also, ask us about our growing library of Webcasts (recorded trainings) that cover many CompassPoint tools and functionality as well as current business topics such as retaining servicing. There is no fee for Webinars or Webcasts and the material is suitable for various

2 levels. Typically Webinars are reserved for current Compass clients, but for more information about registering and Webinar training opportunities please Don t Miss Compass will be in Washington, D.C. for the MBA's 100th Annual Convention & Expo. We'd love to see you there! Send us an if you'd like to set up a meeting or swing by our new Washington, D.C. area office. Market Update Volatility in the bond markets, unsurprisingly, picked up over the last month as the specter of Fed tapering kept participants speculating. On Fannie Mae 30-year 4.0 coupons for October, a recent high price, set on August 27, of around deteriorated to by September 5, only to bounce back over one point in the next two sessions. The Fed, in general, has tried to calm the markets recently in the face of eventual tapering by way of the language used in their official statements and speaking engagements. Of course, the Fed has a tough task ahead of it. While the Fed wants to deleverage the fixed-income bubble created by the huge balance sheet expansion, they are very wary of creating a 1994-like route of fixed-income assets. The hope appears to be that they can talk their way, through forward guidance, into a gentle unwinding of the excess leverage. While the Fed may see the time approaching to begin an unwinding, the economic data still does not point to much of a robust, sustainable recovery. Although the headline unemployment rate has ticked lower of late, the significant drop in the labor participation rate is a driving factor. The three-month moving average of non-farm payroll growth currently sits below 150k, certainly not what most economists would consider robust. Also not showing much increase in temperature are the inflation readings themselves. While inflation may be more of a trailing indicator, it's tough yet to make a compelling case that the economy is on the verge of a spike higher. For now, it seems like the Fed and the markets will be left playing a little cat and mouse around when is too soon and when is too late. As has been the experience over the last month, the uncertainty makes volatility in the bond markets appear likely to continue for now. - Lindsay Hill Primary-Secondary Spread Analysis In light of the heightened primary-secondary spread environment of the past couple years, Compass and the broader industry has found it valuable to measure and model the component of primary-secondary spread that is attributable to originators being capacity constrained, allowing them to expand margins without reducing origination volume or profitability. Since this "excess" primary-secondary spread rises and falls with production levels (e.g. refinance waves) which are rate dependent, isolating this excess allows us to more accurately model primary mortgage rates over time across various rate scenarios. As an example, the excess primary-secondary spread can decline without any move in the yield curve (LIBOR/swap) as the industry's capacity meets and/or exceeds volume. Accurately forecasting primary rates is critical for generating any mortgage asset's prepayment profile, valuation and duration and can materially (often favorably) impact balance sheet volatility and required hedge notional. Copyright Compass Analytics, LLC Page 2

3 Compass' current conventional 30 year "base" primary-secondary spread, similar to other industry modelers, is 100 basis points using the following assumptions: Compass surveys a large, diverse sample of its originators on a daily basis in order to discover the weighted average note rate currently originated in the marketplace for various products. As an example, given an observed, weighted average conventional 30 year (excluding HARP, high balance and lower credit product) note rate across Compass clients (primary rate) of 4.70% and FNCL (secondary rate) of 3.5%, there would be 120 basis points of total primary-secondary spread and 20 basis points of excess primary-secondary spread (= ). Compass will continue to monitor the spread and its primary drivers, including the refinanceability of outstanding mortgages, mortgage employment and guarantee fees, and will tune our assumptions appropriately. - Dylan Faerstein Excess Primary-Secondary Spread Color We began August with FN30 MBS yielding 3.40% (FNCL) and borrowers paying 4.68%, for an excess primary-secondary spread of 28 basis points. We experienced heightened volatility during the period and there is likely more in store as we move into the unchartered territory of QE policy removal and a new Fed regime. Toss in military action in Syria and a weak August employment report, it is unsurprising that bp daily moves in current coupon FN30s have been the norm. The MBS market continued its downward trend, with FN30 4s falling nearly a point in price since July's close. Economic data had a generally positive tone and forecasts for the timing of QE3 tapering moved sooner and sooner. The resilient excess primary-secondary spread finally showed some compression, breaching the 15 bp level for the first time this year on August 21th. Four months after the rate lows of early May, originators have worked through those locks and Copyright Compass Analytics, LLC Page 3

4 margin compression appears to reflect pipeline capacity opening up. While volatility and thereby hedge cost is still elevated, volume has shrunk enough (MBA refinance index is down 64% since May 3rd) that lenders must trim margins. Production levels continued their decline; on September 9th, Compass's 3-day average Production Index was 83.5% of the early August 10-day average and the refinance percentage of originations has fallen 15% since May 3rd per the MBA. When the market closed on September 9th, FNCL closed at 3.66%, 26 basis points above its July 31st level, while borrower rate increased 18 basis points to 4.86%, implying a excess primarysecondary spread tightening of 8 basis points. Last month we predicted that if rates stayed static or rose a bit, the excess primary-secondary spread would print at 20 basis points. For once, our forecast was accurate; rates rose a bit more than anticipated but the PS spread contracted in line with the rate change. If conforming 30 year mortgages continue to be originated at or above the 4.75% level, we would expect early October's excess primary-secondary spread to print closer to 15 basis points. If flight-to-quality kicks in and mortgage rates fall, we predict that the excess PS spread will print in the basis point range. - Dylan Faerstein Specified Pool Commentary Political uncertainty continues to plague the specified market as call protection demand has remained tepid at best. Large scale events, such as Fed tapering, selection of the next Fed chairman, Syria, budget battles, possible government shutdown, etc. have left investors skittish with the exact timing and impact of these events still very much unknown. Prices on September/October rolls were elevated but the uncertainty is even more evident in the back month rolls which are priced roughly 2/32 higher. This "specialness" in roll prices erodes the available pay-ups on spec pools. Meanwhile, August prepays were in line with expectations but the overall 20% reduction in speeds demonstrates the second consecutive month of significant declines. With 30yr note rates at or above 4.5%, lenders have transitioned into this new range and are finally able to take advantage of the new production and low loan balance pay-ups available on these higher coupons. Of note, low loan balance "LLB" FN30 4.5s are still collecting pay-ups over a point (+35/32) but the levels are materially lower than the August level of +51/32. FN30 4.0s are still receiving payups of +14/32 but this well below last month's level of +23/32. Shorter duration 10yr and 20yr paper continues to thrive with 20yr 3.5s and 4.0s receiving pay-ups of +68/32 and 40/32, respectively. New Production (0-1WALA) Copyright Compass Analytics, LLC Page 4

5 50bps spread between gross and net rate Levels are for indicative purposes only -Jeff Casella Margin Tracker The FN30CC Spread is the difference between the FN30 Note Rate and the FN30 Current Coupon, in basis points. Following the summer trend, rates exhibited a good amount of volatility while continuing to push higher throughout the month of August and into early September, as FN30 Current Coupon (FN30Interp) increased from 3.53 to Typically, mortgage rates and note rate level spreads over current coupon are negatively correlated, which again was illustrated by our observations in August and early September with the spreads tightening as rates increased and widening as rates declined. FN30Interp ranged from a low of 3.37 early in the month to a peak of 3.81%, as the market sold off leading up to the August NFP release. The average spread between FN30NR and FN30CC tightened slightly in August by 2bps versus last month's observations. The tightest the spread observed was 111bps; the widest was 137bps; the average was 122bps. The FN30 NR is the average conventional note rate across a subset of Compass' Client base normalized for volume. The FN30 CC is the Fannie 30-year Mortgage Backed Security yield at par 30 days out. The difference between these numbers gives an indication as to how much margin is priced into the secondary market. The primary factors are interest rates, operational capacity and warehouse line constraints. Lenders may also be slower to improve rates during a rally, and quick to drop their pricing during a sell-off. -Bob Gundel Copyright Compass Analytics, LLC Page 5

6 MSR Rich/Cheap & Mandatory/Best Effort Spread As rates continued to grind higher throughout August and into September, the average Best Efforts to Mandatory spread and average Profit Margins tightened while the MSR Rich/Cheap IRR displayed lower returns relative to our observations in July. With the bulk MSR market continuing to firm up and demand for servicing assets continuing to increase, MSR Rich/Cheap averaged 10.09%, a 2.00% decrease from the reading in July. The peak IRR value was 12.2% and the low value was 7.5%. Conversely, the Conventional BE/Mandatory Spread eroded somewhat with an average value of 52 bps, a 6 bp decrease over the observation in July. The peak value was 65 bps and the trough was 44bps. The average 30-year gross profit margin tightened for the third consecutive month in a row, as expected given the higher rate environment and resulting decrease in pipeline volume. Profit Margins displayed an average reading of 152bps, (a 4bp reduction versus the average in August) with a peak of 172bps and a trough of 118bps. The MSR Rich/Cheap gives the internal rate of return for retaining servicing and provides a general measure of how aggressive aggregators are in their servicing bid. If a client is considering retaining servicing, or is deciding between retaining or selling servicing-released on any given day, this number can serve as a guide. Compass uses best execution across aggregators each day for note rates bracketing the FN30NR. The Mandatory/BE spread tracks the difference of a representative seller's basis point pick-up using mandatory delivery instead of best efforts. Compass uses several investors, for best efforts and mandatory, and compares the best execution of each of the two delivery methods for note rates flanking the FN30NR. The Conventional 30-year average gross profit margin tracks the originator's gross profit margin, i.e. the difference between what the originator pays for the loan (what is posted on a rate sheet) and what the originator could sell the loan for into the secondary market. - Bob Gundel Copyright Compass Analytics, LLC Page 6

7 Monthly Spreads Yields continued to rise and the yield curve continued to steepen in August, as positive economic data caused economists to revise their taper timeline forecasts sooner. Spreads between mortgages and other fixed income assets tightened following a three month widening trend. QE3 tapering details continued to be on the forefront of investors' minds, as the private market will eventually have to absorb substantial duration supply, especially in the 5yr-10yr part of the curve. Investors will be keenly awaiting signs as to how much of the reduction in Fed purchases will occur in Treasuries vs. MBS. Mortgage yield, measured as a spread over a blend of the 2 and 10 year points on the swap curve, spiked mid-month but fell dramatically following August 23rd's shockingly weak new home sales report, which raised questions about the true strength of the housing market rally. September 6th's employment report included a 74,000 net downward revision to the prior two months and the mortgage-swap spread fell 10 basis points during the bond rally that ensued. On September 9th, this spread had contracted to 83 basis points, 5.4 basis below the August 1st level. On a LIBOR-OAS basis, mortgage yield tightened 6 basis points to close the period at 16.4 basis points for the FNMA 3.5% coupon. On September 9th, the 2-10yr Treasury spread closed at 247 bps, steepening 9 basis points since August 1st. -Dylan Faerstein Copyright Compass Analytics, LLC Page 7

8 Swap Curve Analysis August saw Nonfarm Payrolls grow less than expected with actual payrolls expanding 162,000 vs. consensus of 175,000. Prior month payrolls were also revised downward, yet Unemployment Rate declined due to a drop in the Labor Force. This disappointment sent the rate markets on a short lived rally for the next two days causing the swap curve to flatten. Jobless Claims were slightly better than consensus for 3/5 off the reports with claims averaging about 329,000 for the month. The housing market saw a continued drop in Refinances, but Purchases have been on the rise. Existing Home Sales grew at a much higher rate than consensus with Month over Month change increasing 6.5% and Housing Starts showed similar pace with a 5.9% increase. The swap curve saw better than expected economic data during August, however increasing scale of conflict in Syria pushed the curve wider while Oil and Gold rallied hard. At the beginning of September the curve was higher in yield, without much shift in the slope of the curve. The September Nonfarm Payrolls however were dismal with the previous numbers being revised down 58,000 (close to 36%) sending the curve immediately higher. While the situation is Syria has slightly calmed, rates remain elevated while commodities have started to dip again. The 2s- 5s swap curve closes at 130bps, 14bps wider from August 1st. 2s-10s swap curve closes at 251bps, 12bps wider and mortgages close the month 2bps tighter to swaps. -Saket Nigam Copyright Compass Analytics, LLC Page 8

9 Production Index *Production in the 30-day period ending September 10, 2013 increased slightly while rates traded in a wider range (43 bps range in this period versus 27 bps in the prior period), with the average yield increasing month over month by 20 bps. Average volume for the last 30 days was 177% of our base volume (vs. 176% in the prior period) ranging from a low of 110% to a high of 285%. The average yield on the FN30 RNY in this period was 4.170% (vs % in the prior period) ranging from a low of 3.917% to a high of 4.350%. *Please note a change in the graph from the prior newsletter since we have modified our sampling data for the production volume Compass Analytics Copyright Compass Analytics, LLC Page 9