August 12, 2019
Demand for new-issue hybrid ARMs slowed, which resulted in yield spreads to Treasurys widening last week. A combination of US China trade tensions, Treasury auctions, dovish comments at various central banks, and political unrest across the world promoted the flight-to-safety narrative. The broader bond market moved up in price, sending yields lower across the curve. We see relative value in longer-reset 10/1s as they remain approximately 40 bps wider compared to levels in early March.
The following chart reflects the week over week change in Z-spreads for ARMs. Z-spreads widened for shorter-reset Ginnies and conventionals but tightened for longer-reset products.
The ARM origination cycle was light last week, with 120.3mm in new issue ARM selling split amongst Fannie Mae (74.1mm), Freddie Mac (22mm), and Ginnie Mae (24.2mm). Supply was focused in Fannie Mae 7/1s (51.3mm) and Ginnie Mae 5/1s (22.6mm). Freddie Mac also contributed to gross issuance with 13.1mm in shorter-reset 5/1s. ARM gross issuance remains at multi-year lows as it came under 1 billion for the third consecutive month in July.
Hybrid ARM issuance remains quite low. As of August, hybrid ARM issuance represents ~ 0.42% of overall MBS issuance. Nevertheless, issuance volumes have been at their highest levels in Ginnie Maes, followed by Fannie Maes and despite the meager volumes, hybrid ARM issuance as a percentage of overall MBS issuance trended higher last month versus May and June.
Prepayments continued their general year-to-date trend as July prepayments for hybrid ARMs increased. August-released factors indicated that July ARM prepayments increased 4.23% to 15.38% for all three agencies. In aggregate, Fannie ARM speeds increased 3.8 CPR to 28.5, Freddie rose 3.5 CPR to 27.1, and Ginnie increased 1.3 CPR to 32.
Shorter-reset LIBOR-based Fannie 3/1s increased 3.2 CPR to 24.3 and 5/1s increased 3.7 CPR to 32.7. Longer-reset 7/1s increased 4.1 CPR to 29.5 and 10/1s increased 4.5 CPR to 21.1. In the Ginnie sector, Treasury-based 3/1s, 5/1s, and 7/1s paid 31.3 CPR (+6.46%), 32.4 CPR (+2.86%), and 33.8 CPR (+17.77%), respectively.
Last week, ARM activity was spread across a variety of lists and primarily focused on the following:
- Seasoned Ginnie 3/1 3s with approximately 8 months to reset traded at a modest premium (+$101).
- New issue Fannie Mega 7/1s with coupons in excess of 2% and 13 months-to-reset traded near the 101 handle. This conventional ARM has a generous cap structures relative to GNMAs at 5/2/5. This lends to lower price impacts from rising rates.
- Seasoned Freddie 10/1s with ~ 3.4% WACs traded near the 101 handle. With interest rates down, ARMs (especially 7/1s and 10/1s) offer attractive yields with minimal extension risk and stable cash flows.
On July 11th, 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