ARM Update

February 3, 2020



Last week, demand for new-issue hybrid ARMs slowed, which resulted in yield spreads to Treasurys widening 3 to 6 basis points.  Z-spreads were wider for GNMA, FNMA, and FHLMC products as well (see table below).  ARMs slightly underperformed mortgage-related sectors with 15- and 30-year fixed-rate mortgages widening 5 basis points on the week.  The coronavirus was a source of volatility in financial markets on concerns around whether the emergent global growth recovery will be able to withstand slower Chinese growth.  Rates on domestic sovereign debt rallied across the yield curve, with the 10-year declining to 1.51%.



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 58 bp spread, almost 30 bps wider than they were in mid-February.  Longer-reset 7/1s and 10/1s have a 64 and 69 bp spread, respectively, approximately 26 and 19 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 4 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.



Issuance levels to start the year remain weak as new ARM issuance for January totaled 727.1mm.  Supply was split amongst Fannie Mae (426mm), Freddie Mac (272.6mm), and Ginnie Mae (28.5mm).  Supply continues to be focused in 7/1s (331.2mm) with 5/1s and 10/1s issued in amounts of 142.1mm and 253.8mm, respectively.  For the second straight month, 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.  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 January, hybrid ARM issuance represented ~ 0.88% 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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