ARM Speeds and Durations January 21, 2015

(INSTITUTIONAL USE ONLY)

What in the heck is going on out there? In the last week, we have heard some

very, VERY odd comments on ARM durations.

No one is talking about speeds. No one seems to know where these risk numbers

are coming from. We’d like to offer some rational, hard-data-driven ideas back

into the melee.

Part of the problem, I suspect, is there are comments coming from traders with

mixed-vintage pools, portfolio managers with aged pools and pipeline hedgers

with phone numbers for both of the two. No matter which of the three you may be,

let’s talk about prepay speeds; not durations. Let’s talk about production age and

ARM class; not, “What are you using for 7/1’s…”

We’re going to cheat here and give the answers first. That said, a substantial

amount of data (on the attached spreadsheets) should illustrate where our speed-

guesses come from. No one is going to get speeds, dv’01s, durations and the like

correct. There should be, nonetheless, a reasonable set of boundaries for what

“may happen”—not just a prepay shout-out.

First up: Pipeline hedgers. The question (if my job is handling the pipeline) would

be along the lines of: “Where in the last few months has new production been

prepaying?” If I can get ballpark info on a HUGE range of new production, it

should be no problem to establish a starting point for hedge speeds.

Where to start? How about pulling every single agency pool produced from

September 2014 until now (well, 5-, 7- and 10-1s)? We did that and here’s what

came out:

The data to get all of the numbers in the pink boxes (above) is on the first three

pages of the (attached) spreadsheet. Once Coupon/WAM/AvgPPay/Avg Price are

established from very recent production, the risk numbers in the green boxes

may be calculated. DON’T LET SOMEONE GIVE YOU DV’01 AND DURATION! GET

THE INPUTS AND VERIFY THESE NUMBERS YOURSELF. USE OUR

MORTGAGEbuilder SOFTWARE OR BLOOMBERG™ “BC35” CALCULATOR. Our

program is easier and generates the proper hedge but, for the purpose of third-

party neutrality, here’s Bloomberg’s output:

So the risk numbers of dv’01 and duration may be calculated for all recent, like-

kind, pools. That’s great, but there are nuances YOU know about your pipe and

production that others may not. Perhaps your new issuance is coming from an

HPA surge area. Maybe your AEs just got a new expresso machine and they are

going to be pushing HARD for refi and recapture. Or maybe it’s the opposite of

both.

The first situation would likely push the pipeline hedge to re-run the risk at a 20%

faster speed. Or, maybe you’d like to see where your recent production has been

prepaying?-if you have pools trading from the last 4 months, we isolated each

servicer’s speed individually in the attached (look to the right of pool data for

each ARM class). You also know something about those pools—were they

“cherry picked” and the remainder sold or did your organization decide to go the

other way and fill those pools with slower retail origination?

The speed/performance data is out there. It will take a small effort to harness the

information. Calling around and asking for others’ opinions will not, in any

reasonable likelihood, get the correct answer.

Then, there is the portfolio hedger—be it trader on an available-for-sale desk or a

buy-hedge-hold manager. Portfolio speeds on seasoned ARMs do appear to be

picking up. There is also the seasonal kicker where prepays tend to make their

largest acceleration between January and July. In fact, speeds can jump by about

40% of their annual rate.

ARMs that were originated with wide gross-versus-net spreads look to be under

hard re-fi pressure.

Most of you that fall into the “portfolio/seasoned” hedger have “prepayment

specialists” on hand or who you pay as consultants. We absolutely have no

interest trying to interrupt that process.

For those hedgers that do not, we will offer a few projections on seasoned

Freddie ARMs.

If you are hedging any of these pools or like-kind pools/loans vastly faster or

slower, now would be a real good time to ask “am I sure?”

We, the Fixed Income Group at RJO, are not and never will be “the prepay guys.”

The last several business days have forced our hand. Successful hedging

requires a starting point of rational prepayment estimates.

Please look through the attached prepay data. Come to your own conclusions

based on that data and what you have specific to your product. The tendency will

be to guess faster; much faster. The data just isn’t there for new production.

The data appears to be there for faster speeds for older vintages.

More than anything, it is our hope that everybody challenges random prepayment

numbers. Accept the speed opinion of others with an understanding that you (or

ask us) will do the calculations. See the data—it’s all out there—and be

comfortable that your hedge numbers make sense to you.

Please see the attached workbook-

JC (for the Fixed Income Group)