October 19, 2020
Last week, U.S. Treasury yields rallied over the week on dimming prospects of pre-election fiscal stimulus, a rise in COVID-19 cases, and signs that the labor market recovery might be running out of steam given the uptick in jobless claims. On the data front, retail sales were firmer than expected in September with an increase of 1.9% month-over-month. On the week, yield spreads on Ginnie and conventional ARMs tightened 1 to 5 basis points while fixed-rate products widened 5 bps in 15-years and 2 bps in 30-years.
ARM pricing spreads have tightened and remain at levels seen during the latter half of 2019 and early 2020 before the market dislocation in mid-March. Shorter 5/1 conventional ARMs have a 46 bp spread, almost 16 bps wider than they were in March 2019. Longer-reset 7/1 and 10/1 conventionals have a 59 and 68 bp spread, respectively, approximately 19 – 21 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 6 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 continued last week with 268.7mm in new issue ARM selling split amongst Fannie Mae (192.5mm), Freddie Mac (73.2mm), and Ginnie Mae (3mm). Supply was concentrated in longer-reset 7/1s with Fannie Mae and Freddie Mac issuing 126.4mm and 32.5mm, respectively. Minimal (1.9mm) 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, but recently broke the 1-year run of monthly issuance under $1 billion, and increased supply to levels not seen in over two and a half years. 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. The decline closely tracks 5/1 hybrid ARM rate spread to the 30-year fixed mortgage rate, which has dropped to approximately 1 basis point. As of October, hybrid ARM issuance represented ~ 0.34% of overall MBS issuance.
ARM Prepay Commentary
The overall prepayment of conventional hybrid ARMs was mixed in September. October-released factors indicated the overall prepayments of FNMA and FHLMC ARMs rose a slight 0.77% and 4.94%, respectively. The overall prepayments for FNMA 7/1s and 10/1s increased by 1.15% and 3.97%, respectively, while 5/1s declined by 1.34%. Similarly, prepayments for FHLMC 7/1s and 10/1s rose by 5.39% and 13.74%, respectively, while shorter reset 5/1s declined by 1.1%. The overall prepayments of GN II hybrid ARMs fell 4.08% in September. For the Treasury indexed GN II hybrid ARMs, the overall prepayments for GN II 3/1s remained unchanged, 5/1s dropped 6.05%, and 7/1s surged 83.26%. In aggregate, FNMA and FHLMC ARM speeds increased to 39.1 and 40.4 CPR and GN II declined to 37.6 CPR.
Shorter-reset LIBOR-based Fannie 3/1s decreased 4.5 CPR to 18 and 5/1s decreased 0.5 CPR to 36.8. Longer-reset 7/1s increased .5 CPR to 44.1 while 10/1s increased 1.6 CPR to 41.9. In the Ginnie sector, Treasury-based 3/1s, 5/1s, and 7/1s paid 35.7 CPR, 38.8 CPR, and 43.8 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 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
Vining Sparks IBG, LP