June 15, 2020
After a significant rally in risk assets recently, risk-off sentiment resurfaced last week on fear of a second wave of the virus. The 7- and 10-year part of the curve rallied last week, retracing around 50% of the steepening the yield curve observed in recent weeks. On the data front, initial jobless claims in the U.S. fell to 1.5mm, another sign that the labor market is improving. On the week, yield spreads on Ginnie and conventional ARMs tightened 2 to 5 basis points, a continuing trend since mid-March. Fixed-rate mortgage spreads were mixed with shorter 15-year product widening a modest 2 bps while 30-years tightened 3bps. The Fed provided more clarity on the pace of its MBS purchases, indicated that it will increase their holdings “at least the current pace” over the coming months in order to sustain smooth market functioning.
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. 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.
The ARM origination cycle was light last week, with 293.4mm in new issue ARMs split amongst Fannie Mae (259.7mm), Freddie Mac (30.2mm), and Ginnie Mae (3.5mm). Supply was focused in longer-reset 7/1s and 10/1s with Fannie Mae issuing 120.6mm and 136.4mm, 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 finally 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 ~ 0.51% of overall MBS issuance.
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:
- Defining trigger events – The fallback language for ARMs identifies clear and observable triggers for the transition to the replaced index.
- Selection of a replacement index – Upon the occurrence of a triggering event, the ARM fallback language provides that the note holder will select a replacement index pursuant to a defined “waterfall.”
- Defining the spread adjustment between LIBOR and the replacement index – When an ARM transitions to using SOFR as the benchmark, the borrower should continue to pay an interest rate comparable to the LIBOR-indexed rate.
A recent Vining Sparks’s publication provides the latest developments and planning steps for the transition from LIBOR.
On July 11, 2019, 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 ARRC’s 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