The steadily increasing issuance of hybrid ARMs relative to fixed-rate mortgages is negatively affecting the ARM product.
"While technicals in the fixed-rate market remain excellent, with diminishing net supply and moribund swaption premiums, the ARMs market has been in near free-fall, suffering from high net supply and rising cap volatilities," JPMorgan Securities said in a recent report. These trends are expected to continue with net fixed-rate supply in May expected to decline while ARM supply will probably remain robust with rising securitization rates, analysts added.
JPMorgan also stated that with the Federal Reserve seen gearing toward a tightening bias, cap volatility in hybrids has remained firm and has actually been increasing since the end of the first quarter. Longer-dated swaption premiums have resumed their decline with servicer demand gone. They also noted that the cap costs for short reset hybrids are still a predicament that has hindered the performance of the sector.
Investors have shifted from ignoring ARM caps to "microanalyzing" their values. "Cap and tail' valuations on hybrids, which have generally been a relative non-issue in a refinancing charged environment over the last three years, can have a significant impact on valuations in a rising interest rate environment," wrote analysts from Credit Suisse First Boston (see ASR 05/24).
In a related report, UBS said that with the market's sharp sell-off, there has been significant focus on hybrid ARM caps. Due to binding caps, Agency 3/1 hybrids cheapened significantly and are currently cheaper on an OAS basis compared to 5/1 hybrids, said analysts. The market is also overvaluing the caps that are implicit in 5/1 Agency hybrids with 2/2/5 caps. UBS said that these bonds seem cheaper relative to 5/1s with better cap structure. The firm noted that in non-Agency Alt-As 2/2/6, 3/2/6 and 5/2/6 cap structures coexist, adding that buysiders are hesitant to pay up for the better cap structure.
Data tells all
The popularity of ARMs is made evident by recent data. The ARM refinancing share is now at 48.1% on a dollar volume basis. Analysts said that as interest rates increase, the popularity of lower-rate ARM products usually rises. Aside from this situation, Nomura Securities pointed out last week that hybrid ARMs now dominate the jumbo market, with negative net fixed-rate jumbo supply expected in the next two to three months. Fixed-rate agency net supply will probably be slightly negative for another month before turning positive in July, stated the firm.
CSFB, analysts said, believes that as the understanding of hybrids increases, the investor base for the product has broadened to include banks, mortgage REITs, the GSEs and benchmarked total-return investors. Analysts also looked at historical issuance in the product to show growth. CSFB said that total issuance of $755 billion in 2002 and 2003 combined has gone above cumulative issuance of $700 billion in ARMs from 1991 to 2001.
In contrast, fixed-rate issuance reached $3.84 trillion combined for 2002 and 2003, compared with $5.95 trillion in the previous 11 years. The non-Agency hybrid sector has grown even faster with total issuance reaching $259 billion in 2003 from only $42 billion in 2001, CSFB said. Issuance in Agency hybrids also increased to $206 billion in 2003 from $52 billion in 2001.
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