July 12, 2021
Last week’s release of the June meeting minutes provided us with more insight into the Fed’s thinking. The minutes revealed that various FOMC participants pulled forward their expectations for the appropriate timing of tapering, suggesting the potential for an earlier-than-anticipated removal of monetary stimulus and in turn peak liquidity. The yield on the 10-year U.S. Treasury has fallen for two consecutive weeks, reaching 1.25% last Thursday, the first time it has fallen below 1.3% since the beginning of the year. On the week, yield spreads on Ginnie and conventional ARMs were unchanged while fixed-rate mortgage backs widened 3 basis points in both 15- and 30-year product.
ARM pricing spreads have tightened and are at levels seen during the first half of 2018. Shorter 5/1 conventional ARMs have a 19 bp spread, almost 12 bps wider than median levels from the first half of 2018. Longer-reset 7/1 and 10/1 conventionals have a 23 and 26 bp spread, respectively, approximately 9 bps wider. Adjustable-rate mortgage products remain an attractive place to put excess cash and liquidity without extending duration, regardless of portfolio strategy.
Factors such as diminished liquidity, lack of index sponsorship, and the small market size have slightly increased ARM spread concessions to fixed rates. 7/1s may offer better value than 15-years, but they are less liquid. 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.
ARM issuance skyrocketed in June to just under $2 billion, the highest level of issuance since the summer of 2017. The surge in issuance was due to two primary factors – the completion of the SOFR transition for new production ARMs and the rise of mortgage origination rates. Supply was split amongst Fannie Mae (1,280.2mm), Freddie Mac (667.6mm), and Ginnie Mae (16mm). Supply was focused in longer-reset 7yr/6m (848mm) and 10yr/6m (649.7mm) indexed to the 30-day SOFR Average while 5yr/6m were issued in an amount of 450.1mm. Minimal (10mm) 3/1s were issued as this shorter product continues to be largely abandoned by lenders and the GSEs. In recent years, the monthly net supply of ARMs has run at a negative pace, while fixed rate products have grown at a much faster pace. As of July, hybrid ARM issuance represented ~ 0.68% of overall MBS issuance.
ARM Prepay Commentary
The overall prepayment of conventional hybrid ARMs reversed course again and increased in June. July-released factors indicated the prepayments of FNMA and FHLMC ARMs rose 7.78% and 8.28%, respectively. The prepayments for FNMA 3/1s, 5/1s, 7/1s, and 10/1s increased by 7.27%, 10.86%, 10.13%, and 10.82%, respectively. Similarly, prepayments for FHLMC 5/1s, 7/1s, and 10/1s rose by 14.98%, 6.93%, and 11.20%, respectively. The overall prepayments of GN II hybrid ARMs increased 9.28% in June. For the Treasury indexed GN II hybrid ARMs, the prepayments for GN II 3/1s and 5/1s surged 11.96% and 8.63%, respectively. In aggregate, FNMA and FHLMC ARM speeds increased to 36 and 36.6 CPR and GN II rose to 37.7 CPR.
Shorter-reset LIBOR-based Fannie 3/1s increased 1.6 CPR to 23.6 and 5/1s rose 3.3 CPR to 33.7. Longer-reset 7/1s increased 3.9 CPR to 42.4 while while 10/1s sped up 4.2 CPR to 43. In the Ginnie sector, Treasury-based 3/1s, 5/1s, and 7/1s paid 30.9 CPR, 42.8 CPR, and 27.1 CPR, respectively.
ARM LIBOR Transition Update
The LIBOR to SOFR transition has come to the agency ARM market with more specificity. Directed by FHFA, Fannie Mae and Freddie Mac announced that they will start to wrap SOFR based ARMs later this year although no specific date has been set. The following table from a Vining Sparks’s publication describes the key features of the new SOFR ARM product:
For SOFR ARMs, both agencies introduced a batch of four basic types with standard 3-year to 10-year fixed-rate terms. Each will float off of 1-month SOFR averages with a 6-month reset frequency instead of the 1-year reset that most LIBOR hybrids currently have. Moreover, 1-month SOFR is a backward-looking index rate versus the forward-looking 1-year LIBOR.
A typical 1-year LIBOR loan margin in 225bps. The margin on these SOFR ARMs needs to be higher to compensate for the shorter tenure of the 1-month index. However, a higher reset frequency should also help to offset the term difference. ARRC published a white paper in July 2019 on this topic and recommended that SOFR ARM loan margins be between 2.75% and 3% so that their fully indexed rate may be comparable to the annual reset 1-year LIBOR ARM consumer rate. The agencies did not dictate a margin in the announcement, but it did impose a maximum margin of 300 bps.
The GSEs have recently stated that LIBOR loan applications would not be accepted past September 30, 2020, and they won’t be securitized after December 1, 2020. Fannie Mae will start accepting SOFR ARMs on August 3, 2020, while Freddie Mac will permit them from November 16, 2020 and onward. In their LIBOR Transition Playbook, the GSE’s provided the following timeline, which identifies key transition milestones for SOFR-indexed ARMs:
The administrator of LIBOR has announced it will cease the publication of one week and two-month LIBOR after December 31, 2021, and the remaining tenors after June 30, 2023. Extending the publication of certain LIBOR tenors until mid-2023 would allow most legacy LIBOR contracts to mature before LIBOR experiences disruptions.
The vast majority of ARM loans are retained by banks. The issuance of agency ARMs has been falling since the 2008. Thus, the impact of this transition timeline may be relatively minor. Should the current timeline for agency ARM transition stand, investors might expect lower ARM issuance as we move closer to year-end.
Recent SOFR ARM Announcements
- 7/11/19 ARRC releases white paper on using an average of SOFR to build an adjustable-rate mortgage product for consumers
- 2/5/20 Fannie Mae announces SOFR ARM loans beginning Q4 2020; LIBOR ARM loans should cease by year end 2020
Ricky Brillard, CPA
Senior Vice President, Investment Strategies
Vining Sparks IBG, LP