REQUIRED READING: Notwithstanding recent market volatility and a drop in rates, many secondary marketing managers have contemplated the possibility of higher adjustable-rate mortgage (ARM) production. Eventually, the yield curve will evolve to a level where ARMs look sufficiently attractive to borrowers and, thus, will generate a larger share of total originations.
Like fixed-rate mortgages, ARMs can be securitized, delivered and sold as mortgage-backed securities (MBS). However, due to the lack of liquidity, ARM MBS prices are not readily available from market data providers. This absence of readily available market prices complicates the rate sheet, pricing and best-execution needs.Â
However, there are alternative sources to ARM pricing. Agency hybrid ARMs are quoted and traded in terms of zero-volatility spreads (Z-Spreads). A Z-Spread over the spot-rate Treasury curve causes the price of the security ARM to be equal to the net present value (NPV) of its cashflows. This differs from another common term in mortgage pricing, nominal spreads (N-Spreads), which represent the spread over the yield on a single point (e.g., expected life) on the Treasury curve (as opposed to the spot Treasury curve).Â
An oversimplified explanation of a Z-Spread would be that it is the excess yield an investor would demand or receive for investing in a risky asset, like an ARM, as opposed to a safer asset, like a Treasury security with a similar term. A standard quoted Z-Spread uses accepted industry assumptions to allow for uniformity. Z-Spreads assume a 15% constant prepayment rate for all coupons and products (3/1, 5/1, 7/1 etc.).Â
The calculation also assumes that the borrower will make a balloon payment of the remaining principal balance at the end of the fixed-rate term of the loan. By using common assumptions and cashflow pricing models, the industry can use quoted Z-Spreads as the ARM price discovery mechanism, and the price will move in conjunction with rates.Â
Pricing models use Z-Spread quotes in order to calculate coupon pricing for ARM pools. Let's use a simplified example: Assume a 5/1 ARM on a 6% MBS is quoted as having a Z-Spread of 60 basis points (bps). In our simplified example, we'll assume two annual cashflows of $6, with a final cashflow of $106 being paid in the third year. The Treasury spot rates (e.g., Treasury rates for a one-year, two-year and three-year term) at each cashflow are 3.5%, 3.75% and 4%, respectively.Â
After discounting the MBS cashflows by the Treasury rate plus the Z-Spread, we are able to calculate a price of $103.75 for the 6% MBS. With this methodology in place, it is now possible to gain confidence that Z-Spreads capture market MBS pricing by getting specific forward bids on a periodic basis and evaluating investor cash pricing.
After gaining that confidence, secondary marketing managers can start producing rate-sheet pricing by using Z-Spreads and current yield curves as part of their ARM rate-sheet workflow. From a best-execution point of view, secondary marketing managers will continue to obtain specific MBS and/or cash bids at the time they are ready to make best-execution decisions.Â
Even with a price discovery mechanism in place, there is still the challenge of figuring out how much to hedge, and with what instrument – or, in risk management language, loan pull-through and loan and hedge instrument duration and convexity (hedge ratios).
When hedging ARMs, the trickiest and most critical part is determining ARM loans' durations. To that end, once Z-Spreads have given us ARM loan program and coupon prices, we can take a page from the fixed MBS playbook of determining durations.
Spread it around
With fixed to-be-announced (TBA) pricing supplied from market data providers, we can employ prepayment, term structure (rate) and cashflow models to derive individual security, coupon and delivery month option-adjusted spreads (OAS). We can do the same thing with ARMs – the only difference is that we will use Z-Spreads to derive pass-through prices and ARM prepayment models and settings to derive ARM-specific OAS.Â
The specific ARM coupon OAS values can then be used to derive price curves given rate shock and, consequently, ARM coupon duration and convexity. Because OAS is so model-dependent, many traders choose to calibrate duration and convexity in their models using consensus values from the street.Â
Once this has been done, the model can generate price curves for appropriate ARM durations by loan program and consequently duration, convexity and hedge ratios. With this capability, lenders can determine the appropriate hedge instrument and notional amount to hedge ARM pipelines.Â
Once price curves, duration, convexity and hedge ratios are generated, the next task is to select the appropriate hedge instruments for ARMs. Remember the hedger's objectives: find liquid instruments and limited basis risk. Since there is no liquid TBA market for ARM securities, identifying the appropriate hedge instrument for ARM positions involves a calculated risk, with originators choosing between the lesser of two evils – liquidity risk or basis risk.Â
Liquidity risk is the risk that a security cannot be bought or sold fast enough to prevent or minimize losses. Illiquid markets typically have wide bid/ask spreads and/or large price movements.Â
Basis risk, in contrast, is the risk that the price movements of the hedge instrument and the hedged pipeline are imperfectly correlated, which can lead to excess losses or gains. Because of the additional risk lenders take when hedging ARMs, hedge performance tends to have bigger swings relative to fixed-rate positions.
Lenders that choose to retain servicing on ARMs or who have a separate takeout for servicing can choose to hedge all or a portion of their ARM pipeline with either forward cash sales or ARM MBS. However, since the forward cash and ARM TBA markets are fairly illiquid, adjusting hedge coverage (i.e., pairing out of coverage) to match changing pull-through assumptions during the lock period can lead to excessive hedge costs.
Because of this, many lenders that choose to deliver ARM pools will only hedge a portion of the pipeline with cash forwards and ARM TBAs. As a result, they will choose another hedge instrument to cover the balance of the ARM pipeline – which they can swap out for ARM TBAs or short-term cash sales at the time of delivery.
Back to the futures
Lenders that have sufficient cash readily available can also consider hedging with futures instruments. Those choosing to hedge with futures need to establish a relationship with an introducing broker and then set up an account with a custodian to handle the futures portfolio. Trading futures not only requires an initial outlay of cash for the initial margin, but also may require daily wire transfers for mark-to-market margin, as futures accounts are settled at the end of each trading day.Â
The most common ARM hedging vehicle for larger originators is the interest-rate swaps. However, given the balance-sheet requirements to effectively hedge with interest-rate swaps, many ARM hedgers choose to use bundles of Eurodollar futures (EDF) that trade on the Chicago Mercantile Exchange. EDFs closely mimic the LIBOR index, and hedgers sell consecutive EDF contract terms – commonly referred to as an EDF bundle – with the number of contracts matching the duration of the fixed period of the loan.
Although EDFs are highly liquid, lenders choosing to hedge with this instrument alone will accept more basis risk than cash forwards or ARM MBS. Additionally, EDFs lack convexity, which can lead to additional hedge cost in an adverse market environment.
Lenders that are cash sensitive but willing to accept more significant basis risk can choose to hedge their ARM pipeline with 15-year fixed MBS. Most broker-dealers do not charge initial margin for TBA MBS trading lines. It should be noted that most master forward transaction agreements contain a mark-to-market provision that allows both parties to make margin calls when the counterparty risk exceeds a certain threshold so money can change hands in advance of settlement day in certain market environments.Â
Although 15-year TBAs are highly liquid, the correlation between 15-year TBAs and ARMs is not perfect and can lead to excessive hedge costs, given greater basis risk. Fifteen-year TBA securities capture some convexity, but they still introduce significant basis risk. Many ARM hedgers consider using 15-year TBS in combination with other hedge instruments in order to reduce basis risk while capturing convexity.Â
Many ARM hedgers have observed that a mixed basket of EDF bundles and 15-year TBAs tends to be the preferred hedge for most lenders' ARM pipelines. This strategy provides convexity, with some basis risk. However, because EDFs and 15-year MBS are highly liquid instruments, trading in and out of them is quick and easy, and pricing is competitive.Â
When ARMs start to pick up market share, hedging ARM pipelines and delivering mandatory will become more practical. Even in a thinly traded market, price discovery and modeling on ARMs are possible with the right analytics.Â
Once lenders are confident in their valuations, they can continue to make decisions regarding what hedge instrument to use, as well as which one to use to create the appropriate policies and procedures around risk tolerance, hedge execution and delivery. By planning for the future and taking the appropriate actions necessary to begin hedging ARMs now, lenders will be at the front of the pack rather than scrambling to implement analytics, workflow and policies in catch-up mode.
Bob Gundel is hedge manager at Compass Analytics, based in San Rafael, Calif. He can be reached at (415) 462-7500.
