April 11, 2022
Last week, minutes from the Fed March meeting revealed growing support for policy to move from an ultra-easy to neutral or even restrictive setting. The Fed is expected to set a monthly cap of $95 billion for balance sheet reduction and indicated stronger than expected support for 50bp rate hikes versus the usual 25bps. On the week, yield spreads on Ginnie and conventional ARMs were unchanged while fixed-rate mortgage backs were wider. Shorter 15-year product widened 4 basis points while longer 30-year MBS widened 2 basis points.
ARM pricing spreads have tightened and are at levels seen during the first half of 2018. Shorter 5yr/6m conventional ARMs have a 19 bp spread, almost 12 bps wider than median levels from the first half of 2018. Longer-reset 7yr/6m and 10yr/6m conventionals have a 23 and 26 bp spread, respectively, approximately 9 bps wider. Adjustable-rate mortgage products remain an attractive place to put excess cash and liquidity without extending duration, regardless of portfolio strategy.
Factors such as diminished liquidity, lack of index sponsorship, and the small market size have slightly increased ARM spread concessions to fixed rates. 7yr/6m may offer better value than 15-years, but they are less liquid. Overall, we continue to see relative value in 7yr/6m due to appealing yields, shorter durations, and less negative convexity than comparable coupon 15-year fixed rate MBS. Investors concerned about potentially faster prepayments could focus on lower-WAC new-issue pools or moderately seasoned paper.
The ARM origination cycle continued last week with 415.5mm in new issue ARM selling split amongst Fannie Mae (202.7mm), Freddie Mac (174.9mm), and Ginnie Mae (37.9mm). Supply was concentrated in longer-reset 7yr/6m and 10yr/6m products indexed to the 30-day SOFR average. Fannie Mae issued 73.7mm and 84mm while while Freddie Mac issued 49.5mm and 119.1mm, respectively, in those products. Minimal (37.9mm) 3/1s and 5/1s were issued as these shorter products continue to be largely abandoned by lenders and the GSEs. This comes after ARM issuance skyrocketed in June, July, and August to the highest levels of issuance since the Fall of 2017. The surge in issuance was due to two primary factors – the completion of the SOFR transition for new production ARMs and the rise of mortgage origination rates. Pickup in issuance comes at the perfect time for investors to diversify away from other products while adding floating exposure to the portfolio. In recent years, the monthly net supply of ARMs has run at a negative pace, while fixed rate products have grown at a much faster pace. As of April, hybrid ARM issuance represented ~ 1.24% of overall MBS issuance.
ARM Prepay Commentary
Prepayment speeds of conventional hybrid ARMs continued to increase in March. April-released factors indicated the prepayments of FNMA and FHLMC ARMs rose by 15.7% and 15.2%, respectively. The prepayment speeds of FNMA 3/1s, 5/1s, 7/1s, and 10/1s increased by 14.3%, 22.6%, 14.1%, and 18.8%. Similarly, prepayment speeds for FHLMC 5/1s, 7/1s, and 10/1s rose by 13.2%, 14.5%, and 17.2%. Like conventionals, prepayments in the Ginnie space sped up with GN II hybrid ARMs rising 3.5%. For the Treasury indexed GN II hybrid ARMs, the prepayment speeds for GN II 5/1 and 7/1 cohorts increased 6.8% and 36.2%, respectively. In aggregate, FNMA and FHLMC speeds sped up to 24.3 and 25 CPR while GN II rose to 29.6. The Ginnie 36-month average CPR is slightly higher at 33.9 compared to Fannie Mae and Freddie Mac at 31.1 and 31.9, respectively.
LIBOR-based Fannie 3/1s, 5/1s, 7/1s and 10/1s paid 22.4, 27.1, 31.5, and 32.2 CPR while Treasury-based Ginnie 3/1s, 5/1s, and 7/1s paid 27.4, 31.3, and 44 CPR. Longer-reset SOFR-based Fannie 7yr/6m products rose to 12.2 CPR while Freddie 10yr/6m products rose to 9.5 CPR.
ARM LIBOR Transition Update
The LIBOR to SOFR transition has come to the agency ARM market with more specificity. Directed by FHFA, Fannie Mae and Freddie Mac announced that they will start to wrap SOFR based ARMs later this year although no specific date has been set. The following table from a Vining Sparks’s publication describes the key features of the new SOFR ARM product:
For SOFR ARMs, both agencies introduced a batch of four basic types with standard 3-year to 10-year fixed-rate terms. Each will float off of 1-month SOFR averages with a 6-month reset frequency instead of the 1-year reset that most LIBOR hybrids currently have. Moreover, 1-month SOFR is a backward-looking index rate versus the forward-looking 1-year LIBOR.
A typical 1-year LIBOR loan margin in 225bps. The margin on these SOFR ARMs needs to be higher to compensate for the shorter tenure of the 1-month index. However, a higher reset frequency should also help to offset the term difference. ARRC published a white paper in July 2019 on this topic and recommended that SOFR ARM loan margins be between 2.75% and 3% so that their fully indexed rate may be comparable to the annual reset 1-year LIBOR ARM consumer rate. The agencies did not dictate a margin in the announcement, but it did impose a maximum margin of 300 bps.
The GSEs have recently stated that LIBOR loan applications would not be accepted past September 30, 2020, and they won’t be securitized after December 1, 2020. Fannie Mae will start accepting SOFR ARMs on August 3, 2020, while Freddie Mac will permit them from November 16, 2020 and onward. In their LIBOR Transition Playbook, the GSE’s provided the following timeline, which identifies key transition milestones for SOFR-indexed ARMs:
The administrator of LIBOR has announced it will cease the publication of one week and two-month LIBOR after December 31, 2021, and the remaining tenors after June 30, 2023. Extending the publication of certain LIBOR tenors until mid-2023 would allow most legacy LIBOR contracts to mature before LIBOR experiences disruptions.
The vast majority of ARM loans are retained by banks. The issuance of agency ARMs has been falling since the 2008. Thus, the impact of this transition timeline may be relatively minor. Should the current timeline for agency ARM transition stand, investors might expect lower ARM issuance as we move closer to year-end.
Recent SOFR ARM Announcements
- 7/11/19 ARRC releases white paper on using an average of SOFR to build an adjustable-rate mortgage product for consumers
- 2/5/20 Fannie Mae announces SOFR ARM loans beginning Q4 2020; LIBOR ARM loans should cease by year end 2020
Ricky Brillard, CPA
Senior Vice President, Investment Strategies