ARM Update

May 18, 2020

Two key themes that emerged in rate markets over the past week were a steepening of the yield curve due to increased issuance on the long-end, and a pickup in rate volatility, especially at the front-end.  Despite pushback from Fed officials, Fed fund futures pricing declined to reflect a negative policy rate in 2021.  On the week, yield spreads on Ginnie ARMs tightened 10 basis points while conventional ARMs tightened 5 to 10 basis points.  Contrary to their adjustable-rate counterparts, 30-year fixed rate mortgages widened 10 basis points, while 15-years tightened 2 basis points.

Since the market dislocation in mid-March, ARM pricing spreads have tightened, but remain at attractive levels.  For example, 5/1 ARMs have a 85 bp spread, almost 55 bps wider than they were in March 2019.  Longer-reset 7/1s and 10/1s have a 90 and 120 bp spread, respectively, approximately 50 and 73 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 wider by approximately 17 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 active last week, with 130.9mm in new-issue ARM selling split amongst Fannie Mae (128mm), Freddie Mac (1.2mm), and Ginnie Mae (1.7mm).  Supply was focused in longer-reset 7/1s and 10/1s with Fannie Mae issuing 105.6mm and 15.7mm, 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 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 ~ 0.59% of overall MBS issuance.

Last week, ARM activity was primarily focused on the following:

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:

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:

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

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