Lehman Brothers will be launching a stand-alone agency hybrid ARM Index - separate from the US Aggregate - next Monday, citing the remarkable hybrid ARM growth in recent years.
"The hybrid ARM market has come a long way from being a small, non-traditional mortgage sector a few years ago to becoming a mainstream mortgage product today," Lehman analysts wrote in announcing the index. "Not only has issuance in the sector increased several-fold in recent years, but also the demand landscape has expanded to include banks, the GSEs, index-benchmarked investors and REITs."
Lehman analysts added that it is typical for new asset classes to be set apart from the Aggregate Index, allowing the market time to familiarize itself with the particular index's performance. In this case, depending on hybrid ARM growth and acceptance, the sector could be considered for inclusion in the Aggregate Index at some point although at this time, Lehman analysts could not predict whether inclusion might actually take place.
Lehman analysts feel there is a strong need to start tracking performance of the ballooning hybrid ARM sector, noting that the impressive part of its growth is that most of the recent supply has come despite the flattening yield curve environment. Agency and non-agency hybrids currently total over $1.7 trillion, up from $700 billion just three years ago. Additionally, Lehman analysts noted that hybrids now account for 25% of all mortgage loans outstanding and 15% of all residential mortgage securitizations. By one week prior to its release, the agency hybrid Index had reached $275 billion, larger than both Lehman's CMBS and ABS indices.
The hybrid ARM Index's structure is similar to the fixed rate Index in some respects. Both encompass agency hybrids only and share almost identical pricing and return computations. Both indices also map pools according to aggregates based on coupon and the origination year. The key difference being that the hybrid Index will have sub-aggregates capturing the unique characteristics of ARMs - including the rate-index, cap structure, and IO features - allowing for more accurate pricing.
Aside from allowing only agency pools, inclusion in the Index is based on an aggregate's liquidity and reset date. While a sub-aggregate totaling less than $250 million may be included in the index, it must be part of an aggregate that tops $250 million. All eligible pools should have at least 12 months to reset.
The creation of an agency hybrid ARM index should be positive for the sector, Lehman stated, especially in promoting improved transparency in pricing and risk assessment. Lehman believes the index should be suitable for bank portfolios and investor types with short duration liabilities, including short insurance company money. Finally, should the ARM Index eventually be included in the Aggregate Index, the share of mortgages within the Aggregate would increase to 38% from 36%.
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