ARM Update

January 27, 2020



Last week, yield spreads between hybrid ARMs and Treasurys ended their month-long tightening trend as conventional 5/1s and 10/1s widened 1 to 2 basis points.  Week over week, Z-spreads were mixed for GNMA, FNMA, and FHLMC products (see table below).  ARMs underperformed mortgage-related sectors with 15- and 30-year fixed-rate mortgages tightening 2 to 4 basis point on the week.  Rates on domestic sovereign debt were pushed to 2020 lows as an increase in the number of confirmed cases of the Wuhan coronavirus outside of China inspired a perceived risk-off mood.



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 52 bp spread, almost 24 bps wider than they were in mid-February.  Longer-reset 7/1s and 10/1s have a 61 and 63 bp spread, respectively, approximately 23 and 13 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 6 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.



The ARM origination cycle was light last week, with 89.4mm in new-issue ARM selling split amongst Fannie Mae (60.1mm), Freddie Mac (24.3mm), and Ginnie Mae (5mm).  Supply was focused in 5/1s with Fannie Mae and Freddie Mac issuing 27.1mm and 10.4mm, respectively.  Fannie Mae also contributed to 7/1 issuance with 21.1mm.  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.  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 ~ 0.88% 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:


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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