ARM Update

January 13, 2020

Last week, hybrid ARM spreads continued their move tighter as 5/1s, 7/1, and 10/1s tightened 15, 10, and 4 bps, respectively.  The broader bond market moved down in price, sending yields higher across the curve as investors digested geopolitical updates and the December jobs report.  Non-farm payrolls rose by 145,000, which was lower than the projected 160,000 uptick, and the unemployment rate remained steady at 3.5%.  ARMs outperformed mortgage-related sectors with 15- and 30-year fixed-rate mortgages tightening 5 basis points on the week.

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 45 bp spread, almost 17 bps wider than they were in mid-February.  Longer-reset 7/1s and 10/1s have a 52 and 60 bp spread, respectively, approximately 14 and 10 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 made the ARM sector competitive 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 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 to start the year, with 116.7mm in new issue ARM selling split amongst Fannie Mae (77mm), Freddie Mac (28.3mm), and Ginnie Mae (11.4mm).  Supply continues to be focused in 7/1s with Fannie Mae issuing 46.1mm.  Fannie Mae also contributed to longer-reset 10/1 issuance with 30.9mm.  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 eighth consecutive month in December.

Hybrid ARM issuance remains quite low.  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 represents ~0.58% of overall MBS issuance.

Prepayments increased during the December refinance window despite the yield curve shifting to its steepest level since June 2018.  January-released factors indicated the overall prepayments of FNMA and FHLMC hybrid ARMs increased by 1.57% and 6.10%, respectively, in December as expected, reflecting the holiday effect and falling mortgage rates.  The overall prepayments for FNMA 5/1s and FNMA 7/1s increased by 2.17% and 2.64%, respectively, while prepayments for FNMA 10/1s decreased by 10.30%.  Similarly, prepayments for FHLMC 5/1s, FHLMC 7/1s, and FHLMC 10/1s increased by 6.52%, 4.21%, and 11.34%, respectively.  The overall prepayments of GN II hybrid ARMs increased as well by 7.05% in December.  For the Treasury indexed GN II hybrid ARMs, the overall prepayments for GN II 3/1 and 5/1 cohorts increased by 11.72% and 3.28%, respectively.  In aggregate, FNMA ARM speeds increased to 25.8 CPR, FHLMC rose to 26.1 CPR, and GN II surged to 31.9 CPR.

Shorter-reset LIBOR-based Fannie 3/1s increased 1.4 CPR to 21.9 and 5/1s rose 0.6 CPR to 28.2.  Longer-reset 7/1s rose 0.7 CPR to 27.2 and 10/1s dropped 2.4 to 20.9.  In the Ginnie sector, Treasury-based 3/1s, 5/1s, and 7/1s paid 32.4 CPR, 31.5 CPR, and 25.3 CPR, respectively.  Expect weaker, seasonal housing turnover to drive prepayments down in January.

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

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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