March 23, 2020
Last week, the Fed delivered a series of easing measures, including a 100 basis point rate cut, enhancing its dollar swap capabilities to ease international liquidity stress, and numerous programs intended to support specific markets, including money market funds and commercial paper. ARM spreads continued to widen as the broader fixed income market remained volatile. Week over week, 5/1s and 7/1s experienced the most widening at 50 and 52 basis points, respectively, while longer-reset 10/1s widened 40 basis points. At these wides, ARMs reversed course and underperformed mortgage-related sectors with 15- and 30-year fixed-rate mortgages widening 31 and 0 basis points, respectively, on the week.
Since the rally at the end of 2018, ARM pricing spreads have widened significantly, reacting strongly to each move lower in rates. For example, 5/1 ARMs have a 145 bp spread, almost 125 bps wider than they were in early-December 2018. Longer-reset 7/1s and 10/1s have a 152 and 160bp spread, respectively, approximately 119 and 113 bps wider than levels in early-December 2018. Certainly, the environment for ARMs has changed dramatically over the years with the flattening yield curve, but today’s spreads are well wider than those seen just one month ago.
Factors such as diminished liquidity, lack of index sponsorship, and the small market size have increased their spread concessions to fixed rates. Spreads are wider by approximately 11bps on 7/1s versus their 15-year fixed rate counterparts. 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 more active last week, with 267.6mm in new-issue ARM selling split amongst Fannie Mae (154.5mm), Freddie Mac (111.7mm), and Ginnie Mae (1.4mm). Supply continues to be focused in longer-reset 7/1s and 10/1s with Fannie Mae and Freddie Mac combined issuing 146.7mm and 91.1mm, 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 as it came under 1 billion for the tenth consecutive month in February. 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 March, hybrid ARM issuance represents ~ 0.75% of overall MBS issuance.
Last week, ARM activity was primarily focused on the following:
- New-issue Freddie 10/1s with yields slightly less than 2% traded at a moderate premium ($103+).
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