June 8, 2020
Investor optimism about the re-opening of the economy has led to a significant rally in risk assets recently. On the data front, the U.S. economy added 2.5mm jobs in May and the unemployment rate fell from an 80-year high in April to 13.3% in May. The Treasury yield curve has steepened due to higher long-term yields amid high new supply, lack of clarity around the Fed’s buying schedule, and macro uncertainty. With the policy rate at its effective lower bound, there has been limited movement in the front-end of the curve. On the week, yield spreads on Ginnie ARMs were unchanged and conventional ARMs tightened 1 to 5 basis points. ARMs underperformed their fixed-rate counterparts as 15- and 30-year fixed-rate mortgages tightened 9 to 12 basis points.
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 54 bp spread, almost 24 bps wider than they were in March 2019. Longer-reset 7/1 and 10/1 conventionals have a 68 and 85 bp spread, respectively, approximately 28 and 38 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 2 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 68.2mm in new-issue ARM selling split amongst Fannie Mae (44mm), Freddie Mac (9.8mm), and Ginnie Mae (14.4mm). Supply was focused in longer-reset 7/1s and 10/1s with Fannie Mae issuing 15mm and 27.8mm, respectively. Minimal (1.2mm) 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. As of June, hybrid ARM issuance represented ~ 0.41% of overall MBS issuance.
Prepayments changed trend as May prepayments for hybrid ARMs were mixed. June-released factors indicated the overall prepayments of FNMA and FHLMC ARMs fell 0.96% and 5.04%, respectively. The overall prepayments for FNMA 3/1s and 7/1s declined 13.33% and 2.47%, respectively, while 5/1s and 10/1s remained stable at approximately 0.6%. Prepayments for FHLMC 5/1s, 7/1s, and 10/1s dropped between 1.58% and 6.16%. Contrary to conventional ARMs, overall prepayments of GN II hybrid ARMs surged 11.9% in May. For the Treasury indexed GN II hybrid ARMs, the overall prepayments for GN II 3/1s and 5/1s increased 6.51% and 15.69%, respectively, while 7/1s decreased 19.58%. In aggregate, FNMA and FHLMC ARM speeds decreased to 31.1 and 32 CPR while GN II increased to 34.8 CPR.
Shorter-reset LIBOR-based Fannie 3/1s decreased 2.6 CPR to 16.9 while 5/1s were relatively stable at 29.3 CPR. Longer-reset 7/1s fell 0.9 CPR to 35.6 while 10/1s remained stable at 32.3 CPR. In the Ginnie sector, Treasury-based 3/1s, 5/1s, and 7/1s paid 31.1 CPR, 37.6 CPR, and 19.3 CPR, respectively.
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