ARM Update

February 18, 2020



Last week, yield spreads between hybrid ARMs and Treasurys were mixed with 5/1s tightening 2 basis points while longer-reset 10/1s widened 3 basis points.  Z-spreads were generally tighter for GNMA, FNMA, and FHLMC products (see table below).  Shorter-reset 5/1 ARMs outperformed 15-year fixed rate mortgages, which widened 3 basis points on the week.  Rates on domestic sovereign debt were slightly higher as continued uncertainty surrounding the spread of the coronavirus spurred demand for perceived safe haven assets.  On the short end of the curve, the 2-year note rose 2.7 bps to 1.43% while the 10-year bond remained stable at 1.59%.



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 50 bp spread, almost 22 bps wider than they were in mid-February.  Longer-reset 7/1s and 10/1s have a 61 and 66 bp spread, respectively, approximately 23 and 16 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.  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 73mm in new-issue ARM selling split amongst Fannie Mae (65.3mm), Freddie Mac (3.1mm), and Ginnie Mae (4.6mm).  Supply was focused in 7/1s and 10/1s with Fannie Mae issuing 20.2mm and 33.4mm, respectively.  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 ~ 0.68% of overall MBS issuance.



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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