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:
- New-issue Fannie 10/1s with ~2.25 yield and slightly less than 10 years-to-reset traded at a lower dollar price (~$102). Compared to GNMA hybrids, agency hybrids have a more generous cap structure – typically 5/2/5 vs. 1/1/5 – which allows the coupon to move more if rates move up more dramatically.
- Moderately-seasoned Freddie 7/1s with ~1.9 yield and slightly more than 2 years-to-reset traded at a lower dollar price (~$102).
- New-issue Ginnie II 5/1s with ~1.8 yield and slightly more than 3 years-to-reset traded at a lower dollar price (~$102).
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- or 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