ARM Update

February 10, 2020

Yield spreads on hybrid ARMs to Treasurys tightened 3 to 6 basis points last week, which was the result of a bond market sell-off that sent yields higher across the curve.  ARMs slightly underperformed mortgage-related sectors with 15- and 30-year fixed-rate mortgages tightening 5 basis points on the week.  The U.S. economy added 225,000 jobs in January and the unemployment rate rose slightly to 3.6%.  The U.S. ISM manufacturing PMI rose from 47.8 in December to 50.9 in January, entering expansionary territory for the first time since July 2019.

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 52 bp spread, almost 24 bps wider than they were in mid-February.  Longer-reset 7/1s and 10/1s have a 61 and 63 bp spread, respectively, approximately 23 and 13 bps wider than levels in mid-February.  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 during 2017 at lower dollar prices.

Factors such as diminished liquidity, lack of index sponsorship, and the small market size have increased their spread concessions to fixed rates.  Despite the convergence, spreads are wider by approximately 6 bps on 7/1s versus their 15-year fixed rate counterparts.  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 light last week, with 148.1mm in new-issue ARM selling split amongst Fannie Mae (137.1mm), Freddie Mac (10mm), and Ginnie Mae (1mm).  Supply continues to be focused in 7/1s with Fannie Mae and Freddie Mac issuing 81.9mm and 10mm, respectively.  Fannie Mae also contributed to longer-reset 10/1 issuance with 35.3mm.  No 3/1s were issued as this shorter product continues to be largely abandoned by lenders and the GSEs.  ARM gross issuance remains at multi-year lows as it came under 1 billion for the ninth consecutive month 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 February, hybrid ARM issuance represents ~0.50% of overall MBS issuance.

The overall prepayments of conventional hybrid ARMs decreased in January as expected, reflecting the drop in seasonal home sales despite yield curve flattening.  February-released factors indicated the overall prepayments of FNMA and FHLMC ARMs decreased by 7.36% and 6.51%, respectively.  The overall prepayments for FNMA 5/1s, 7/1s, and 10/1s decreased by 6.74%, 7.72%, and 3.35%, respectively.  Similarly, prepayments for FHLMC 7/1s and 10/1s decreased by 6.99% and 15.74%, respectively, while FHLMC 5/1s remained stable .34%.  The overall prepayments of GN II hybrid ARMs decreased as well by 9.09% in January.  For the Treasury indexed GN II hybrid ARMs, the overall prepayments for GN II 3/1 and 5/1 cohorts decreased by 4.32% and 12.38%, respectively.  In aggregate, FNMA ARM speeds decreased to 23.9 CPR, FHLMC fell to 24.4 CPR, and GN II dropped to 29.9 CPR.

Shorter-reset LIBOR-based Fannie 3/1s decreased 2.7 CPR to 19.2 and 5/1s fell 1.9 CPR to 26.3.  Longer-reset 7/1s dropped 2.1 CPR to 25.1 CPR and 10/1s declined slightly to 20.2 CPR.  In the Ginnie sector, Treasury-based 3/1s, 5/1s, and 7/1s paid 31 CPR, 27.6 CPR, and 21.5 CPR, respectively.  Expect a shorter day count (-2) to increase prepayments in February.

Last week, ARM activity was spread across a variety of lists and primarily focused on the following:

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:

A recent Vining Sparks’s publication provides the latest developments and planning steps for the transition from LIBOR.

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 ARRCs proposed models of SOFR 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

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