July 6, 2020
Despite negative virus-related news flow, market sentiment has been bolstered by expectations of further government stimulus and accommodative policy from the Fed. On the data front, core PCE inflation edged down slightly to 1.02% year-over-year in May. On the week, yield spreads on Ginnie and conventional ARMs were unchanged and fixed-rate mortgages tightened 8 to 11 basis points. On the month, ARMs tightened 2 to 5 basis points while agency MBS tightened 1 bps in 15-years and 8 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.
Last month, ARM issuance totaled 957.3mm, the second-strongest monthly issuance since April 2019. Supply was split amongst Freddie Mac (508.5mm) and Fannie Mae (417.9mm), and Ginnie Mae (30.9mm). Freddie Mac’s issuance levels exceeded Fannie Mae’s for the second consecutive month. Supply was focused in longer-reset 7/1s (393.2mm) and 10/1s (399.9mm) while 5/1s were issued in an amount of 153.7mm. Minimal 3/1s (10.5mm) 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 ~ 0.67% of overall MBS issuance.
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
- 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