May 11, 2020
Last week on the data front, the U.S. economy shed 20.5mm jobs in April as the coronavirus erased 10 years of U.S. job growth in a single month. The unemployment rate surged to a record 14.7%, though it is still below estimates of the unemployment rate during the Great Depression. The U.S. 10-year Treasury yield rose, and the curve steepened as the Treasury announced a larger-than-expected issuance pattern for the longer end of the curve and introduced a new 20-year coupon bond. On the week, yield spreads between hybrid ARMs and Treasurys were mixed with 5/1 and 7/1 conventionals tightening 15 to 20 basis points while longer-reset 10/1s widened 5 basis points. Like their longer-reset adjustable-rate counterparts, 15- and 30-year fixed-rate mortgages widened 2 and 11 basis points, respectively, on the week.
Since the market dislocation in mid-March, ARM pricing spreads have tightened, but remain at attractive levels. For example, 5/1 ARMs have a 95 bp spread, almost 65 bps wider than they were in March 2019. Longer-reset 7/1s and 10/1s have a 100 and 125 bp spread, respectively, approximately 60 and 78 bps wider. 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 even earlier this year.
Factors such as diminished liquidity, lack of index sponsorship, and the small market size have increased ARM spread concessions to fixed rates. Spreads are substantially wider by approximately 25 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.
Last week, the ARM origination cycle saw levels not seen since mid-January, with 422.5mm in new-issue ARM selling split amongst Fannie Mae (354.7mm), Freddie Mac (57.2mm), and Ginnie Mae (10.6mm). Supply was focused in longer-reset 7/1s and 10/1s with Fannie Mae issuing 215.2mm and 104.7mm, respectively. Ginnie Mae issued 1.3mm of a short-reset 3/1 indexed to the Treasury 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 twelfth consecutive month. 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 May, hybrid ARM issuance represented ~ 0.58% of overall MBS issuance.
The overall prepayment of conventional hybrid ARMs increased in April as the activity captured much of the time frame before social distancing and massive unemployment figures began to emerge. Prepayments surged despite the shorter day count (-1) during the April refinance window period. May-released factors indicated the overall prepayments of FNMA and FHLMC ARMs rose by 7.9% and 11.59%, respectively. The overall prepayments for FNMA 5/1s, 7/1s, and 10/1s increased by 0.34%, 11.28%, and 21.13%, respectively. Similarly, prepayments for FHLMC 7/1s, and 10/1s rose by 14.76% and 25.83%, respectively. The overall prepayments of GN II hybrid ARMs fell 4.6% in April. For the Treasury indexed GN II hybrid ARMs, the overall prepayments for GN II 3/1s decreased 12.05% while 5/1 and 7/1 cohorts rose 0.62% and 32.6%, respectively. In aggregate, FNMA and FHLMC ARM speeds increased to 31.4 and 33.7 CPR while GN II fell to 31.1 CPR.
Shorter-reset LIBOR-based Fannie 3/1s decreased 1.3 CPR to 19.5 while 5/1s were relatively stable at 29.1 CPR. Longer-reset 7/1s rose 3.7 CPR to 36.5 along with 10/1s, which surged 5.6 CPR to 32.1. In the Ginnie sector, Treasury-based 3/1s, 5/1s, and 7/1s paid 29.2 CPR, 32.5 CPR, and 24 CPR, respectively. Decreased housing turnover, social distancing, job losses, qualifying for a mortgage, and forbearance should pressure prepayments down in May.
Last week, ARM activity was spread across a variety of lists and primarily focused on the following:
- New-issue Fannie 7/1s with ~ 0.65 – 0.85% yield and 5 years-to-reset traded near the $104+ handle.
- New-issue Ginnie 5/1 2.5s with ~ 0.60 – 0.65% yield traded around the mid $103-dollar price. With the bulk of the market still at a premium, prepayment risk is still a concern for many investors, and 5/1 borrower prepayment speeds tend to be more muted than 3/1s in most rate environments.
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