August 5, 2019
Last week, yield spreads between hybrid ARMs and Treasurys were mixed with Ginnie 2s tightening approximately 3 to 5 basis points and conventionals widening approximately 1 or 2 basis points. The broader bond market moved up in price, sending yields lower across the curve as the Fed cut rates by 25 bps in an effort to sustain the economic expansion. Fed Chairman Powell noted last week’s policy action was a “mid-cycle adjustment” which was perceived as slightly hawkish by markets. Despite tightening ARM spreads, we continue to see relative value in ARMs as they remain 23 to 47 bps wider compared to levels in early December.
New issuance for July totaled 748.6mm versus lower levels of 631.4mm and 642.mm in May and June, respectively. Supply was split amongst Fannie Mae (321.8mm), Freddie Mac (250.9mm), and Ginnie Mae (175.9mm). Supply was focused in 5/1s and 7/1s with 297.5mm and 276.9mm issued, respectively. Fannie Mae and Freddie Mac also contributed to gross issuance with a combined 170.5mm in longer-reset 10/1s. ARM gross issuance remains at multi-year lows as it came under 1 billion for the third consecutive month.
Last week, ARM activity was spread across a variety of lists and primarily focused on the following:
- New issue Fannie Mega 7/1s with coupons between 3.2% and 3.4% and ~ 6-year resets traded near the 102 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.
- New issue Ginnie 5/1 3.5s with approximately 5 years to reset traded at a moderate premium (+ $102). 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.
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