April 27, 2020
Last week, the U.S. House passed a $484 bn fiscal package, taking the total U.S. fiscal response to $2 trillion or 15% of GDP. The stimulus package provides additional funding for the Paycheck Protection Program (PPP) small business loans, offers additional assistance to hospitals, and funds an expansion of testing capacity nationwide. On the data front, the latest initial jobless claims of 4.4 mm takes the last five-week total to 26.5mm, more than erasing the number of jobs created by the U.S. since the 2008 global financial crisis. The yield on the benchmark 10-year note was down 4 bps to 0.60% as interest rate volatility has subsided in recent weeks, but financial markets continue to experience periods of significant volatility based on economic developments and virus-related headlines. Yield spreads between new-issue hybrid ARMs and Treasurys were unchanged last week. ARMs underperformed their fixed-rate MBS counterparts, with yield spreads tightening on this product approximately 6 to 15 basis points for the week.
Since the rally at the end of 2018, ARM pricing spreads have widened significantly, reacting strongly to each move lower in rates. For example, 5/1 ARMs have a 115 bp spread, almost 95 bps wider than they were in early-December 2018. Longer-reset 7/1s and 10/1s have a 120 and 124 bp spread, respectively, approximately 87 and 77 bps wider than levels in early-December 2018. Certainly, the environment for ARMs has changed dramatically over the years with the flattening yield curve, but today’s spreads are well wider than those seen just one month ago.
Factors such as diminished liquidity, lack of index sponsorship, and the small market size have increased their spread concessions to fixed rates. Spreads are substantially wider by approximately 47 bps on 7/1s versus their 15-year fixed-rate counterparts. 7/1s may offer better value than 15-years, but they are less liquid. Overall, we continue to see relative value in 7/1s 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 was active last week, with 218.5mm in new issue ARM selling split amongst Fannie Mae (78.6mm), Freddie Mac (136.7mm), and Ginnie Mae (3.2mm). Supply was focused in longer reset 10/1s with Fannie Mae and Freddie Mac issuing 59mm and 78.2mm, respectively. Freddie Mac also issued 28mm in 5/1s and 30.5mm in 7/1s. No 3/1s were issued as this shorter product continues to be largely abandoned by lenders and the GSEs. With 728.9mm originated month-to-date, April’s ARM issuance levels are on pace to exceed the year-to-date high of 733.7mm set in January. Last year, the monthly net supply of ARMs ran at a negative $2-3 billion pace, while fixed rates grew at $20-30 billion each month. As of April, hybrid ARM issuance represents ~ 0.67% of overall MBS issuance.
Last week, ARM activity was spread across a variety of lists and primarily focused on the following:
- New-issue Fannie 7/1s with ~ 0.85% yield and 84 months-to-reset traded around the $103.75 handle.
- New-issue Ginnie 5/1 2.5s with ~ 0.60% yields traded around a $103.5-dollar price. With the bulk of the market still at a premium, prepayment risk is still a concern for many investors, and 5/1 borrower prepayment speeds tend to be more muted than 3/1s in most rate environments.
On November 15, 2019, the Alternative Reference Rates Committee (ARRC) released recommendations on contract fallback language to be used for new closed-end residential adjustable-rate mortgages (ARMs). The recommended fallback language for each of these products is based on the following framework:
- Defining trigger events – The fallback language for ARMs identifies clear and observable triggers for the transition to the replaced index.
- Selection of a replacement index – Upon the occurrence of a triggering event, the ARM fallback language provides that the note holder will select a replacement index pursuant to a defined “waterfall.”
- Defining the spread adjustment between LIBOR and the replacement index – When an ARM transitions to using SOFR as the benchmark, the borrower should continue to pay an interest rate comparable to the LIBOR-indexed rate.
A recent Vining Sparks’s publication provides the latest developments and planning steps for the transition from LIBOR.
On July 11, 2019, the Alternative Reference Rates Committee (ARRC) released a white paper detailing how an average of the Secured Overnight Financing Rate (SOFR) can be used in newly issued ARMs in a structure that is comparable to today’s existing ARM loans. The white paper shows how SOFR can be used to develop products that are built on a robust reference rate that is grounded in market transaction. Here’s an overview of the ARRC’s proposed models of SOFR ARMs:
- Most aspects of a SOFR-based ARM would use the same conventions that currently exist in US Dollar LIBOR-based ARMs, including the range of fixed-rate periods available, the timing of payment determinations, and the structure of caps on the amount that mortgage payments can rise at the end of the fixed-rate period and over the life of the mortgage.
- However, a few key components would differ:
- These ARMs would be based on a 30- or 90-day average of SOFR, rather than 1-year LIBOR. Because SOFR tends to be lower than 1-year LIBOR, the margin for newly originated SOFR-indexed ARMs would likely be adjusted upward so borrowers’ overall floating-rate payments are comparable to existing LIBOR-based ARMs.
- In order to ensure that these SOFR-indexed ARMs can be offered at rates consistent with other competitive rates in the market, under the proposed models SOFR-indexed ARM, the borrower’s monthly floating-rate payment would adjust following the fixed-rate period once every six months rather than once every year, as is currently the market standard for LIBOR-based ARMs in the United States.
- To safeguard against unexpected payment increases to the borrower, the proposed models would cut the periodic adjustment cap to 1%. As a result, the borrower’s payment, even in a period of rapidly rising interest rates, would not change by more than 2% over a 12-month period, in accord with the current market convention for LIBOR-based ARMs.
The desk continues to look to bid odd-lot positions for both conventionals and Ginnies for clean-up. The disposition of odd-lot positions can result in enhanced transactional liquidity and higher earnings. Also, this is an opportunistic time to consider eliminating smaller line items that are subject to standard safekeeping and accounting fees that are more palatable for larger block sizes.
Ricky Brillard, CPA
Senior Vice President, Investment Strategies
Vining Sparks IBG, LP