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:
- New-issue Ginnie 5/1 3s with ~ 1.8%+ yields traded around the $102.5 handle. 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 in most rate environments.
- New-issue Freddie 10/1s with yields slightly less than 2% traded at a moderate premium ($103).
- New-issue Fannie Mega 10/1s with ~ 2% yield and less than 10 years-to-reset traded at a lower dollar price (~ $102).
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:
- Defining trigger events – The fallback language for ARMs identifies clear and observable triggers for the transition to the replaced index.
- Selection of a replacement index – Upon the occurrence of a triggering event, the ARM fallback language provides that the note holder will select a replacement index pursuant to a defined “waterfall”.
- Defining the spread adjustment between LIBOR and the replacement index – When an ARM transitions to using SOFR as the benchmark, the borrower should continue to pay an interest rate comparable to the LIBOR-indexed rate.
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:
- 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- r 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