Weekly Relative Value
December 9, 2013
Back to the Basics
Overview of Hybrid ARMS
Many credit unions are now faced with declining income and net interest margin compression caused by low interest rates and weak loan demand. This has lead to higher than normal liquidity in a low interest rate environment, conditions which may continue as interest rates and loan demand remain low for some time.
One solution to the problem is to extend maturities to pick up more yield. For example: Today, a two-year Agency bullet yields 0.31% % and a five-year Agency yields close to 1.8%. Therefore by extending, yield could be enhanced by 150 basis points! However, with the market poised for Fed tapering, many credit union investors are worried about higher rates. As such, they have been reluctant to buy longer maturity securities to increase their investment yields/income because of the interest rate risk (price risk) in this strategy.
Given this dilemma, this week’s "Back to the Basics" edition of the Weekly Relative Value will focus on the risk/return characteristics of investing in agency hybrid adjustable rate mortgage securities (ARMs). Hybrid ARMs can provide significant income with less price risk associated with longer duration fixed rate mortgage securities. As such, they may be more suitable to those credit unions that need more income today but want some protection from higher interest rates in the future.
Hybrid ARMS
Although fixed-rate mortgage loans remain the most common, a borrower can choose a loan that has an adjustable interest rate. Such a loan is called an adjustable-rate mortgage loan or "ARM." The simplest form of ARM provides for adjustments to its interest rate annually or semiannually. The adjustment is determined by changes in a published market index, such as LIBOR or the yield on U.S. Treasury securities with a remaining maturity of one year. Some ARMs start with low initial interest rates that last until the first adjustment.
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December 9, 2013 Market Size and Issuance
While hybrid ARM issuance by the GSEs has been modest in recent years, mainly due to 30-year fixed rates reaching historical lows, this small sector of the mortgage market has gained renewed interest as primary mortgage rates have been on the rise. Currently, 30-year mortgage rates are approximately 4.55% vs. 3.33% for a 5/1 hybrid ARM.
Over the first ten months of 2013, the gross and net issuance of Hybrid ARM pools has totaled around $37.5 billion. The issuance of Fannie and Freddie pools was about $15 billion per GSE, while the issuance of Government National Mortgage Association (“GNMA”) pools totaled $7 billion year-to-date, 2013. In aggregate, there is approximately $250 billion of outstanding hybrid ARM securities.
From an issuance perspective, FNMA and Freddie Mac account for 48% and 34% of the market. The GNMA share of aggregate issuance (approximately 20%) continues to remain elevated from a historical perspective. GNMA holds a dominant market share position of the 3/1 market. In terms of structure, the 5/1 hybrid is the largest sector representing 56% of all hybrid securities, followed by 7/1s (24%) 3/1s, (13%) and 10/1s (7%), respectively.
It’s interesting to note that the hybrid ARM sector has also witnessed negative net issuance for the second consecutive year, likely because borrowers refinanced into fixed rate loans to take advantage of the historically low rates. Additionally, a major portion of the recent ARM issuance has come from refinance loans. Analysts estimate that around 70% of aggregate ARM issuance over the past few years has come from refinance loans. With that said, due to the changing mortgage landscape, ARM issuance has started to trend higher.
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December 9, 2013 The Importance of the Yield Curve
The primary determinant in deciding on whether to finance via ARMs is the absolute level of fixed interest rates, and most importantly, the interest rate differential between 30-year fixed rate mortgages vs. hybrid ARMs.
The steeper the curve, as measured by the spread between the two-year and 10-year on-the-run Treasury yields, the larger the difference between long-term and short-term rates. Given that most hybrid ARMs are indexed to the one-year LIBOR or one-year Treasury rates (CMT) and they adjust for the first time in three to 10 years, they are usually more correlated with the shorter end of the curve. This usually translates into a larger difference between 30-year mortgage rates and hybrid ARM rates. The larger the difference between the two rates, the more likely a
borrower will opt for a hybrid ARM as opposed to a 30-year fixed rate loan. Lower ARM rates increase the affordability and purchasing power of the borrowers.
The recent sell-off in the bond market, since late May, has caused 30-year fixed rates to increase significantly. Although hybrid ARM rates have also risen, they still sit 120 basis points below their 30-year counterparts. Historically, a 1% differential between fixed and Hybrid rates has resulted in a significant shift towards Hybrid ARM financing.
30-Year Mortgage Rates have Risen by 100 Basis Points
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December 9, 2013 How Hybrid ARMS Work
As the name implies, this product contains elements of both a fixed rate mortgage and an adjustable rate mortgage. The mortgage rate is fixed for an initial period of time (generally 3, 5, 7 or 10 years), and then the rate is adjusted. With a hybrid ARM, borrowers are protected from interest rate fluctuations during the fixed rate period and typically pay a lower initial rate than they would with a traditional 15-year or 30-year fixed rate mortgage.
Once the fixed period has expired, the interest rate paid by the borrower adjusts on an annual basis. The rate adjustment depends on the index, margin and cap structure, each of which we discuss in detail below.
Index
The index is a referenced interest rate (benchmark) to which a loan’s margin (see below) is added when determining the new rate paid by a borrower when the hybrid ARM loan adjusts. While there are many different benchmarks, the most common is LIBOR, or London Interbank Offered Rate used for conventional hybrid ARMs. However, GNMA hybrids are typically indexed to one-year Constant Maturity Treasury (CMT).
Gross Margin and Net Margin
Currently, the standard margin on LIBOR indexed ARMs is 2.25%. This may also be referred to as the gross margin. The gross margin is added to the index to determine a hybrid ARM’s new interest rate at each rate adjustment.
Therefore, when a hybrid ARM’s rate adjusts, the new rate is calculated by adding the gross margin (2.25%) to the index rate and rounding to the nearest 1/8%. This new rate subject to caps (see below) remains on the loan until the next reset.
When hybrid ARM pools (MBS securities) are created, the lender must subtract the MBS
guarantee-fee and servicing amount from the weighted average of the borrower note rates, which is also referred to as the GWAC (gross weighted average coupon). This difference is referred to as “net” margin. The net margin is added to the referenced index rate (one-year LIBOR/CMT), which determines the coupon rate that is passed through to the investor of the MBS pool.
An ARM MBS pool is a WAC (weighted average coupon) pool. Therefore it is not uncommon to see an ARM MBS pool with a coupon of 2.47 % or a 3.56% etc. In the traditional fixed rate MBS space, coupons are quoted on the half or whole coupon, for example, 2.5%, 3.0% or 3.5%. Cap Structure
Of course, the reset coupon is subject to possible cap and floor limits. There are three parts to a typical cap structure: the initial adjustment cap, the periodic adjustment cap and the lifetime
adjustment cap. For the standard ARM products issued by the GSEs, the 5/2/5 and 2/2/5 cap
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December 9, 2013 For example, a hybrid ARM with an initial coupon of 3.0% and a 5/2/5 cap structure could have a maximum coupon of 8.0% following the first reset. The second number indicates the maximum coupon increase (or decrease) that can occur at all reset dates following the first reset (periodic cap). Generally, this will enable the lifetime cap to be applied over the term of the mortgage loan but not necessarily all at once from one year to the next. And the third number in the cap
designation represents the maximum increase relative to the initial rate that can occur over the life of the loan (the lifetime cap).
Floor
The interest rate floor on an ARM is simply defined as the lowest rate to which the interest rate can adjust at any point during the life of the loan. Because most ARM do not have an explicit or stated floor, its stated margin effectively becomes the floor. Thus, if the margin value is 2.25%, the borrower’s rate could not adjust any lower than 2.25%, even if the benchmark rate fell to zero.
Understanding Prepayment Risk in Hybrids
As with any mortgage product, one of the largest sources of risk inherent in Hybrids ARMS lies with prepayments. Hybrid borrowers tend to behave like balloon borrowers, since at the end of the fixed-rate period they tend to reassess their borrowing costs and options. Thus, a critical step in assessing the risk/reward proposition in the hybrid ARM market is to understand the general prepayment characteristics of the sector.
Prepayments can be broken into three main categories: demographic, lower financing costs and program specific reset dates.
Demographic Prepayments
Demographic prepayments (non-interest rate related) are driven by unplanned events of the borrowers. Events such as divorce, job relocation, death, natural disaster or default may trigger a demographic prepayment. The most dominant demographic prepayment component is caused by relocation.
By their very nature, demographic prepayments occur more frequently as time passes, with the exception of default. For example: A homeowner unlikely to get a divorce or relocate after having their home for just one or two months, but as time passes, the probability of such events increases.
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December 9, 2013 Reset Date
The time to reset for a loan, for a pool of loans has a significant impact on the refinancing behavior of ARM borrowers. As the reset date approaches, prepayment activity picks up. After the reset date, prepayment activity dampens quickly. We refer to this behavior as the reset or balloon effect. Essentially, the reset date creates a voluntary balloon mortgage of which many borrowers avail themselves. On subsequent reset dates, the remaining borrowers will tend to show less responsiveness, exhibiting a burnout of sorts.
This pattern is reflected in the graph below. Over the past 24 months, conventional (FNMA /FHLMC) ARM prepayment speeds have ramped up quickly and then leveled off at
approximately 30 CPR, until the initial reset date. The speed of the initial ramp-up varies by reset type with 3x1s accelerating the fastest and both 7x1s and 10x1s ramping more gradually. Post reset prepayment decline significantly to 12-15CPR.
Unlike the conventional ARMS, GNMA ARMs tend to ramp up slower. Ginnie 3x1 speeds gradually ramp to about 30 CPR around the first reset date before settling in at a much slower speed after the initial reset. Likewise, Ginnie 5x1s tend to track GNMA 3/1 speeds up to month 36. However, GNMA 5x1s prepays continue to ramp up to month 60 (the first reset date). In the post-reset (past first reset date) prepayment profiles are quite subdued and generally in the 10-20 CPR range.
Lower Financing Rates
As with fixed-rate borrowers, ARM borrowers will respond to opportunities to save when interest rates fall. Some borrowers will prefer the peace of mind from the known payments on a fixed-rate loan. In fact, such borrowers may even be willing to pay some premium for this security (in the form of a higher rate than they currently have on their ARM). Alternatively, a certain percentage will prefer to go after the lowest rate available and thereby stick with an ARM.
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December 9, 2013 Other Risk Factors
In addition to the prepayment risk investors must be aware of the following risk factors:
Pool size: Size impacts liquidity. Pools over $10 million tend to receive a greater amount of liquidity.
Loan balance: Higher loan balances tend to prepay faster and investors look carefully at the percentage of higher conforming-balance loans (over $417 thousand).
Number of Loans: The greater the number of loans in a pool, the smaller the affect that a single loan paying off has on the whole pool.
Age: Age is also referred to as “seasoning.” Seasoned pools may trade differently than new pools since borrowers tend to refinance their loans as they approach their reset dates. Hence, prepay speeds on seasoned pools can be much faster than newer issues.
Geography or GEO: Certain states tend to prepay faster/slower so pricing can vary depending upon state concentration.
TPO Percentage: Third-Party Origination indicates that it was not originated directly by a lender. TPO pools may have a tendency to prepay faster than traditional retail pools, so pricing can vary significantly.
GWAC: By comparing the GWAC to current, comparable interest rates, investors seek to evaluate the refinance incentive of the loans in the pool. The higher the GWAC, the more likely the borrower may refinance at a lower rate, which can lead to faster prepay speeds. Note Rate Distribution: This term describes the difference between loans with the highest
and lowest note (interest) rates in a pool. A wide note rate distribution could make a pool less attractive to an investor as higher note rates would likely pay off sooner than lower note rates, causing the weighted average coupon to decrease more quickly as the pool seasons, a phenomenon known as “coupon drift.” Pools with this wide coupon dispersion are referred to as a “barbell.” Typically, investors prefer to purchase a pool with no more than a 50 basis points difference between the highest note rate and the lowest note rate.
Representative Hybrid ARMS Yields
Security 3/1 5/1 7/1 10/1
Yield to Maturity 1.367 1.87 2.232 2.517 Effective Duration 3.894 3.597 4.201 5.943 Below, we discuss an example of a newly issued FNMA 5/1 Hybrid security.
FNMA 5/1 Hybrid ARM
Issuer Coupon Months to Reset
“Net” Margin
Index Yield Caps
FNMA 2.59% 59 1.51% 1Y
Lib
1.75 5/2/5
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December 9, 2013 This 5/1 Hybrid security has a 30-year amortization schedule and has a fixed coupon (2.59%) for five years. After the five-year fixed period the coupon adjusts annually based on the “net”
margin (+1.51%) plus the index (1-year Libor). The cap structure (5/2/5) limits how high a borrower’s rate can increase at the initial reset, periodically after reset and over the life of the loan.
In this example, the ARMS’s rate passed through to the investor is 2.59% % for the first five years until the first adjustment on August 1, 2017. The initial adjustment cap of 5% means that at the first adjustment at the end of the five-year initial fixed rate period, the rate could adjust as high as 7.59% or as low as 1.51%, which is the floor.
The periodic adjustment cap is 2%, so if the rate adjusted to 4.59% at the first adjustment, it could adjust to a maximum of 6.59 % and a minimum of 2.59% % at the next adjustment, a year later. The lifetime adjustment cap is 5.0%, so the maximum the rate could reach in our example is 7.59% (initial rate + lifetime cap).
How are Hybrid ARMS PRICED?
Pricing for hybrid ARMs is often quoted as an N or Z Spread. The N spread is the static spread to a single point on the swap curve. A Z spread (shown below) is defined as the zero volatility spread to the US Treasury curve. The street traditionally prices newly originated ARMs at 15 CPB. This prepayment assumption assumes that the mortgage will prepay at 15 CPR for its fixed life followed by a balloon prepayment at reset date. It should be stressed that while this is the street pricing convention, it is not sufficient to use only 15 CPB to determine a Hybrid’s risk and cash flow profile or valuation.
Weekly Relative Value
December 9, 2013 As shown on the graph below hybrid ARM spreads (Z and/or N spread) widened significantly in the sell-off in May/June of this year. While Z spreads on hybrid ARMs have recently
stabilized and have begun to tighten. Spreads remain much wider than where they began this year.
Hybrid Spreads Widen during Sell-off
Total Rate of Return Analysis
Below we show the 12 and 24 month comparative total rate of return performance of the 5/1 FNMA Hybrid ARM versus a 15-year fixed rate MBS pass through security.
The total rate of return analysis below shows that in an increasing rate environment, the 5/1 ARM has a much better risk/return profile than the 15 year fixed rate pool (See blue highlighted area). Even if there was no change in rates the Hybrid would outperform the 15-year MBS. This outperformance in a no change rate environment is attributable to the added roll-down
performance from the ARM. Interesting only if rates were to decline, would the 15 year MBS out-perform on a total rate of return basis.
The FNMA 5/1 superior relative outperformance is primarily attributable to two factors. First, as the security nears its reset date, it takes on more characteristics of a floating rate security. Second, Hybrid ARMs tend to have faster prepayment speeds in a rising interest rate
Weekly Relative Value
December 9, 2013
Total ROR Comparison-(12-Month/Aged)
Security 5/1 Agency Arm 15 year FNMA MBS
Yield to Maturity 1.87 2.461 Effective Duration 3.59 4.82 Total Return* 300 -7.765 -10.677 200 -3.729 -6.249 100 -0.048 -1.608 50 1.650 0.730 0 3.021 2.808 -50 3.888 4.420 -100 4.456 5.751
Total ROR Comparison-(24 month/Aged)
Security 5/1 Agency Arm 15 year FNMA MBS Yield to Maturity 1.87 2.46 Effective Duration 3.59 4.82 Total Return* 300 -2.141 -5.576 200 0.968 -1.892 100 3.421 1.834 50 4.409 3.595 0 5.099 5.047 -50 5.386 6.025 -100 5.437 6.722
*All projected returns are based an aged parallel shift in the yield curve using IDC’s Bondedge’s
prepayment modeling and cash flow assumptions. The BondEdge Hybrid ARM Prepayment model (BE-HAPM) incorporates the following factors:
Demographic prepayments with both seasoning and seasonality.
A reset effect, which reflects a balloon-like refinancing wave near reset dates.
Interest rate sensitive prepayments driven by ARM-to-fixed, and ARM-to-ARM refinancing opportunities.
Burnout functionality.
Weekly Relative Value
December 9, 2013 Conclusion
There are many unique considerations and moving parts when investing in hybrid ARMs. Hybrid ARMs can be complex and misunderstood. Prepayments are more volatile and less predictable than traditional fixed rate mortgages. Pricing can also be a challenge due to the fact that a TBA market does not exist and the market is not homogeneous. Thus, in determining the suitability of ARMs it is critical that one analyzes each ARM security in detail and models prospective cash flows under various interest rate scenarios before purchasing.
However, given the current steep yield curve environment; hybrid ARMS compare favorably to 15-year fixed rate mortgages (or comparable duration agency debentures/CMOs). As such they are an attractive investment for credit unions looking to enhance income today while reducing the price risk of the portfolio should interest rates rise in the future. Also, while not discussed in this space, select post-reset hybrids (seasoned ARMS) may also be attractive versus CMO floaters.
More Information
Author Tom Slefinger, Senior Vice President, Director of Institutional Fixed Income Sales, and Registered Representative of ISI, has more than 30 years of fixed income portfolio management experience, and has developed and successfully managed various high profile domestic and global fixed income mutual funds. He has extensive expertise in trading and managing virtually all types of domestic and foreign fixed income securities, foreign exchange and derivatives in institutional environments.
At Balance Sheet Solutions, Tom is responsible for developing and managing operations associated with institutional fixed income sales. In addition to providing strategic direction, Tom is heavily involved in analyzing portfolios, developing investment portfolio strategies and identifying appropriate sectors and securities with the ultimate goal of optimizing investment portfolio
performance at the credit union level. He can be reached at [email protected] or 800-782-2431, ext. 2753.
