ARM Update

July 13, 2020



Last week, the yield on the 10-year note and 30-year bond notched weekly declines of 2 bps and 9 bps.  Longer-date yields fell over the week as market participants began to question the pace of the economic recovery in light of a record number of new coronavirus cases across the U.S.  On the week, yield spreads on Ginnie and conventional ARMs were unchanged while fixed-rate mortgages tightened 8 to 10 basis points.  On the month, ARMs remained stable while agency MBS tightened 11 bps in 15-years and 15 bps in 30-years.  Mortgages have struggled to keep up with other risk assets recently due to heavy TBA mortgage supply during the peak summer home buying season.

Since the market dislocation in mid-March, ARM pricing spreads have tightened, but remain at attractive levels.  For example, 5/1 conventional ARMs have a 52 bp spread, almost 22 bps wider than they were in March 2019.  Longer-reset 7/1 and 10/1 conventionals have a 65 and 80 bp spread, respectively, approximately 25 and 33 bps wider.  Relative value players may find Ginnie 5/1s to be attractive with their 130 bp spread, approximately 93 bps wider than early 2019 levels.

Factors such as diminished liquidity, lack of index sponsorship, and the small market size have slightly increased ARM spread concessions to fixed rates.  Spreads are wider by approximately 8 bps on 7/1s versus their 15-year fixed rate counterparts.  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.



The ARM origination cycle was light last week, with 169.1mm in new issue ARM selling split amongst Fannie Mae (153.5mm), Freddie Mac (7.5mm), and Ginnie Mae (8.1mm).  Supply was focused in longer-reset 7/1s and 10/1s with Fannie Mae issuing 71.5mm and 69.9mm, respectively.  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, but recently broke the 1-year run of monthly issuance under $1 billion, and increased supply to levels not seen in over two and a half years.  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.  The decline closely tracks 5/1 hybrid ARM rate spread to the 30-year fixed mortgage rate, which has dropped to approximately 10 basis points.  As of June, hybrid ARM issuance represented ~ 0.42% of overall MBS issuance.



ARM Prepay Commentary

As expected, the overall prepayment of conventional hybrid ARMs increased in June.  July-released factors indicated the overall prepayments of FNMA and FHLMC ARMs rose by 18.65% and 17.5%, respectively.  The overall prepayments for FNMA 5/1s, 7/1s, and 10/1s increased by 19.11%, 17.7%, and 14.55%, respectively.  Similarly, prepayments for FHLMC 5/1s, 7/1s, and 10/1s rose by 15.43%, 17.6%, and 20%, respectively.  The overall prepayments of GN II hybrid ARMs increased 41.95% in June.  For the Treasury indexed GN II hybrid ARMs, the overall prepayments for GN II 3/1s and 5/1s surged 15.11% and 52.66%, respectively.  In aggregate, FNMA and FHLMC ARM speeds increased to 36.9 and 37.6 CPR and GN II rose to 49.4 CPR.




Shorter-reset LIBOR-based Fannie 3/1s increased 7.3 CPR to 24.2 and 5/1s surged 5.6 CPR to 34.9.  Longer-reset 7/1s rose 6.3 CPR to 41.9 along with 10/1s, which surged 4.7 CPR to 37.  In the Ginnie sector, Treasury-based 3/1s, 5/1s, and 7/1s paid 35.8 CPR, 57.4 CPR, and 57.8 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 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 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



Ricky Brillard, CPA

Senior Vice President, Investment Strategies

Vining Sparks IBG, LP

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