March 9, 2020
Hybrid ARM spreads widened dramatically last week as the risk-off sentiment swept the markets. 5/1 cohorts widened 24 basis points while longer-reset 7/1s and 10/1s widened 21 and 22 bps, respectively. At wider spreads, ARMs underperformed mortgage-related sectors with 15- and 30-year fixed-rate mortgages widening 2 and 3 basis points, respectively, on the week. An uptick in new coronavirus cases outside of China continued to unnerve markets. In response, Treasury yields plunged across the board to record lows, with the entire curve briefly trading below 1% for the first time in history.
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 an 85 bp spread, almost 57 bps wider than they were in mid-February 2019. Longer-reset 7/1s and 10/1s have a 90 and 100 bp spread, respectively, approximately 52 and 50 bps wider than levels in mid-February 2019. 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 during 2017 at lower dollar prices.
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 22 bps 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 light last week, with 117.2mm in new-issue ARM selling split amongst Fannie Mae (106.7mm), Freddie Mac (10mm), and Ginnie Mae (0.5mm). Supply was focused in longer-reset 7/1s and 10/1s with Fannie Mae issuing 46.5mm and 40.3mm, 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 ninth consecutive month in January. 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 ~ 0.57% of overall MBS issuance.
The overall prepayments of conventional hybrid ARMs increased in February as anticipated, reflecting a flat yield curve and increased seasonal housing turnover. Prepayments surged despite the shorter day count (-2) during the February refinance window period. March-released factors indicated the overall prepayments of FNMA and FHLMC ARMs rose by 4.18% and 1.23%, respectively. The overall prepayments for FNMA 7/1s and 10/1s increased by 9.16% and 10.89%, respectively, while 5/1s experienced a decline of 3.42%. Similarly, prepayments for FHLMC 7/1s and 10/1s rose by 4.35% and 7.69%, respectively, while FHLMC 5/1s fell 4.75%. The overall prepayments of GN II hybrid ARMs rose a mere 0.69% in February. For the Treasury indexed GN II hybrid ARMs, the overall prepayments for GN II 3/1s fell 4.52% while 5/1 cohorts increased 4.71%. In aggregate, FNMA ARM speeds increased to 24.9 CPR while FHLMC and GN II rose slightly to 24.7 and 29.1 CPR, respectively.
Shorter-reset LIBOR-based Fannie 3/1s increased 1.1 CPR to 20.3 and 5/1s fell .9 CPR to 25.4. Longer-reset 7/1s rose 2.3 CPR to 27.4 along with 10/1s, which surged 2.2 CPR to 22.4. In the Ginnie sector, Treasury-based 3/1s, 5/1s, and 7/1s paid 29.6 CPR, 28.9 CPR, and 24.1 CPR, respectively. Expect a longer day count (+3) and an increase in seasonal housing turnover to increase prepayments in March.
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