November 15, 2021
Last week, central bank views about the transitory nature of rising inflation were challenged by recent economic data. October CPI surprised sharply to the upside with the composition of price pressures continuing to broaden into cyclical and underlying measures such as rents and wage growth. Treasurys extended their recent decline, with the yield on the 10-year ending Friday at 1.56% to cap an 11 basis point weekly rise. On the week, yield spreads on Ginnie and conventional ARMs were unchanged, while fixed-rate mortgage backs were mixed. Shorter 15-year product tightened 3 basis points while longer 30-year MBS widened 2 basis points.
ARM pricing spreads have tightened and are at levels seen during the first half of 2018. Shorter 5yr/6m conventional ARMs have a 19 bp spread, almost 12 bps wider than median levels from the first half of 2018. Longer-reset 7yr/6m and 10yr/6m conventionals have a 23 and 26 bp spread, respectively, approximately 9 bps wider. Adjustable-rate mortgage products remain an attractive place to put excess cash and liquidity without extending duration, regardless of portfolio strategy.
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 7 bps on 7yr/6m versus their 15-year fixed rate counterparts. 7yr/6m may offer better value than 15-years, but they are less liquid. Overall, we continue to see relative value in 7yr/6m 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 continued last week with 147.8mm in new issue ARM selling split amongst Fannie Mae (88.9mm), Freddie Mac (41.3mm), and Ginnie Mae (17.6mm). Supply was concentrated in longer-reset 7yr/6m products indexed to the 30-day SOFR average with Fannie Mae and Freddie Mac issuing 32.3mm and 21.2mm, respectively. Minimal (17.6mm) GNMA 3/1s and 5/1s were issued as these shorter products continue to be largely abandoned by lenders and the GSEs. This comes after ARM issuance skyrocketed in June, July, and August to the highest levels of issuance since the Fall of 2017. The surge in issuance was due to two primary factors – the completion of the SOFR transition for new production ARMs and the rise of mortgage origination rates. Pickup in issuance comes at the perfect time for investors to diversify away from other products while adding floating exposure to the portfolio. In recent years, the monthly net supply of ARMs has run at a negative pace, while fixed rate products have grown at a much faster pace. As of November, hybrid ARM issuance represented ~ 0.79% of overall MBS issuance.
ARM Prepay Commentary
Prepayment speeds of conventional hybrid ARMs continued their decent from peak speeds experienced in early 2021. November-released factors indicated the prepayments of FNMA ARMs fell by 4.6% and FHLMC ARMs dropped by 7.8%. The prepayment speeds of FNMA 3/1s, 5/1s, and 7/1s fell by 2.9%, 9.6%, 4.1%, respectively. Similarly, prepayment speeds for FHLMC 5/1s, 7/1s, and 10/1s dropped by 11.4%, 7%, and 4.8%. Like conventionals, prepayments in the Ginnie space slowed with GN II hybrid ARMs falling by 10.7%. For the Treasury indexed GN II hybrid ARMs, the prepayment speeds for GN II 3/1 and 5/1 cohorts fell by 11.4% and 9.4%. In aggregate, FNMA and FHLMC speeds both fell to 27.2 CPR while GN II slowed to 31.8. The Ginnie 36-month average CPR is slightly higher at 32.4 compared to Fannie Mae and Freddie Mac at 30.2 and 29.9, respectively.
Shorter-reset LIBOR-based Fannie 3/1s decreased 0.6 CPR to 20.1 and 5/1s fell 27.3 CPR to 27.3. Longer-reset 7/1s also slowed 1.5 CPR to 34.7. In the Ginnie sector, Treasury-based 3/1s and 5/1s paid 27.1 and 35.6 CPR, respectively.
ARM LIBOR Transition Update
The LIBOR to SOFR transition has come to the agency ARM market with more specificity. Directed by FHFA, Fannie Mae and Freddie Mac announced that they will start to wrap SOFR based ARMs later this year although no specific date has been set. The following table from a Vining Sparks’s publication describes the key features of the new SOFR ARM product:
For SOFR ARMs, both agencies introduced a batch of four basic types with standard 3-year to 10-year fixed-rate terms. Each will float off of 1-month SOFR averages with a 6-month reset frequency instead of the 1-year reset that most LIBOR hybrids currently have. Moreover, 1-month SOFR is a backward-looking index rate versus the forward-looking 1-year LIBOR.
A typical 1-year LIBOR loan margin in 225bps. The margin on these SOFR ARMs needs to be higher to compensate for the shorter tenure of the 1-month index. However, a higher reset frequency should also help to offset the term difference. ARRC published a white paper in July 2019 on this topic and recommended that SOFR ARM loan margins be between 2.75% and 3% so that their fully indexed rate may be comparable to the annual reset 1-year LIBOR ARM consumer rate. The agencies did not dictate a margin in the announcement, but it did impose a maximum margin of 300 bps.
The GSEs have recently stated that LIBOR loan applications would not be accepted past September 30, 2020, and they won’t be securitized after December 1, 2020. Fannie Mae will start accepting SOFR ARMs on August 3, 2020, while Freddie Mac will permit them from November 16, 2020 and onward. In their LIBOR Transition Playbook, the GSE’s provided the following timeline, which identifies key transition milestones for SOFR-indexed ARMs:
The administrator of LIBOR has announced it will cease the publication of one week and two-month LIBOR after December 31, 2021, and the remaining tenors after June 30, 2023. Extending the publication of certain LIBOR tenors until mid-2023 would allow most legacy LIBOR contracts to mature before LIBOR experiences disruptions.
The vast majority of ARM loans are retained by banks. The issuance of agency ARMs has been falling since the 2008. Thus, the impact of this transition timeline may be relatively minor. Should the current timeline for agency ARM transition stand, investors might expect lower ARM issuance as we move closer to year-end.
Recent SOFR ARM Announcements
- 7/11/19 ARRC releases white paper on using an average of SOFR to build an adjustable-rate mortgage product for consumers
- 2/5/20 Fannie Mae announces SOFR ARM loans beginning Q4 2020; LIBOR ARM loans should cease by year end 2020
Ricky Brillard, CPA
Senior Vice President, Investment Strategies