Reprinted with permission from the July 2005 issue
®
Re-examining Possible Strategies
For Hedging Hybrid ARMs
An analysis of hedging tactics reveals the best strategies
for different products and different rate environments.
By Rob Kessel
n SME’s October 2004 edition, I addressed the prospect of delivering a n d h e d g i n g h y b r i d a d justable-rate mortgages (ARMs) in
an article entitled “Several Methods
Are Available To Handle Hybrid
ARMs.” In a classical secondary
marketing sense, I approached the
question of hybrid ARMs with the
following in mind:
■ What delivery alternatives and
relationships are available in the
secondary market?
■ What price, service or operational advantage do delivery alternatives represent, if any?
■ To the extent that more favorable delivery alternatives require
the selling of closed loans on a
mandatory basis, what hedging considerations, instruments and strategies must we contemplate, if any?
Primarily focusing on hedging
hybrid ARMs, the article implied
that a closed, mandatory loan sale
and the commensurate hedging of
loans, not only represented a best
execution practice, but also represented a value proposition worth
pursuing. The article shared a general analysis on how secondary marketing managers (SMMs) determine
likely hedge instruments, an evaluation of those instruments, considerations for using those instruments,
and additional sales alternatives.
Finally, it provided historical data
on earlier Fed
tightening cycles
along with projections on how the
then-beginning
tightening cycle
might impact the
performance of
different hedge inKESSEL
struments employed to hedge hybrid ARMs.
In this article, I will revisit delivery strategies for hybrid ARMs, providing current industry feedback
and successful tactics. I’ll also characterize the latest Fed tightening cycle, discuss how popular hybrid
ARM hedges have performed, and
reconcile hedge performance with
some of the fundamentals outlined
in the earlier article.
Rob Kessel is managing partner at
Compass Analytics LLC in Corte
Madera, Calif., where he is responsible for business development,
marketing and product development. He can be reached at (415)
924-5085.
Delivery strategies
Since last September, we have observed dramatic increases in hybrid
ARM production, particularly Alt-A
and jumbo production with more
liberal underwriting guidelines
and/or larger loan amounts. Only recently has that trend started to slow
I
down as the appeal of option ARMs
continues to grow and the decline in
fixed rates begins to crowd out hybrid ARM originations. Remaining
hybrid ARM originations have also
migrated to shorter fixed interest
rate periods, with two- and threeyear fixed periods comprising
greater percentages of production.
SMMs continue to sell loans in a
variety of manners, including loanlevel best efforts, loan-level closed
mandatory, negotiated forward
closed mandatory and closed bulks.
We have observed both more originators hedging and bulking closed
loans for sale and significantly more
viable bulk bidders entering the
market with strong demand.
The results have been very favorable to sellers, particularly for nonconforming product. Where SMMs
may observe a mandatory/best efforts spread of 12.5 to 37.5 basis
points (bps) on any given investor’s
rate sheet for single loan sales, we
continually observe and hear of originators earning anywhere from 30 to
100 bps over best effort pricing for
the hybrid ARM production sold as
closed loan bulks.
The strong closed bulk bid has also spilled over to other flow-type deliveries, such as forward mandatory
sales (fixed price and amount with
specified terms, such as weighted average coupon and weighted credit
characteristics) and volume-incentive
Copyright © 2005 Zackin Publications Inc. All Rights Reserved.
delivery programs.
In the case of forward
mandatory sales, originators can eliminate the need
to hedge all or part of their
hybrid ARM pipelines but
then need to manage the
delivery of the forward.
Many volume incentive
programs are coupled with
forwards. If an incentive
program is not coupled
with a mandatory forward
trade, originators must still
hedge.
However, in both delivery types, SMMs may lose
some of the premium often
accessible in the cash bulk
auction executions. Unfortunately, the success of
nonconforming hybrid
sales has been at the expense of agency liquidity,
with agency ARM mortgage-backed securities
gaining little liquidity or
momentum as a result.
Successful tactics
Originators who most
consistently maximize
sales proceeds follow
these delivery tactics:
■ Formation of the
originator’s own loan programs and
codes, as opposed to maintaining
multiple investor programs. This requires adopting industry-established
underwriting guidelines, automated
underwriting engines, and/or loan
documents that all bidding investors
will accept.
Although this transition represents
a clear step to efficiency, originators
need to maintain product flexibility
and navigate the learning curve of establishing fungible underwriting
guidelines and documents acceptable
to a reasonable number of investors.
This does not equate to restricting
program flexibility for closed loan
sellers, but does allow originators to
obviate individual loan registration
and tracking.
■ Minimum volume is directly
related to execution. For bulk closed
loan sales, bulks must be at least $3
ders to establish the
strongest demand.
For example, closed
loan bulk sales seeking 10
bids is not uncommon. In
support of the value associated with creating a diverse, strong demand
base, the last six hybrid
bulks our clients traded
had spreads between the
highest bid and lowest
bid, averaging 62 bps,
with a low of 28 and a
high of 91. The cover
(next highest bid) ranged
from as little as five bps
to as much as 30 bps, and
the bid rank was substantially different for each of
the six trades.
million to $5 million but may contain
a mix of Alt-A and jumbo loans with
different fixed periods and interestonly loans.
■ For hedgers, providing the right
perspective about possible hedge performance volatility to management is
critical to long-term success. A key
tactic to avoid unnecessary volatility is
to keep product flowing out the door
on a timely basis to minimize the time
the product is hedged.
■ Establishing relationships with a
sufficient number of competitive investors. Within reason, the more credible alternatives SMMs have in selling
their hybrid production - be it through
forwards, negotiated volume incentives or bulk closed loan sales - the
better their execution. A reasonable
extension of this, when actually selling
bulks or forward production, is to solicit bids from a greater number of bid-
Hedging hybrid ARMs
Notwithstanding the
substantial pick-up available in selling hybrid ARMs
on a mandatory basis instead of best efforts, many
originators are loathe to
take on the possible earnings volatility many associate with hedging hybrid
ARMs. Or they are put off
by the concept of using financial futures to hedge
their production.
Last October’s article covered
common hedge instruments employed by SMMs to hedge hybrid
ARM production and targeted the
two most effective instruments: 15year TBAs (to-be-announced MBS, or
dwarfs) and Eurodollar future (EDF)
bundles, successive Eurodollar future settlements.
After reviewing previous Fed tightening cycles, we drew attention to
the additional risk that hedging
ARMs presented given their more direct relationship to the front end of
the yield curve, the curve formed
when Treasury or interest rate swap
rates are graphed for given maturities, such as overnight to 30 years.
In previous Fed tightening cycles,
longer-term rates did not always move
one-to-one with the Fed funds or
short-term rates. In other words, we
Copyright © 2005 Zackin Publications Inc. All Rights Reserved.
did not experience a parallel move between Fed rate hikes and longer-term
interest rate movements. At some
point in the tightening cycle, we observed the curve becoming flatter.
That is, short-term rates increased
with the Fed funds rate, but rates over
five years either decreased, did not increase, or failed to increase at the
same rate as short rates.
One of our primary reasons in suggesting Eurodollar future bundles
over 15-year TBAs was that we could
more closely match the part of the
yield curve from which hybrid ARMs
are priced and the vehicle with
which we hedged by using Eurodollar future bundles.
Since last September, the Fed has
indeed continued its tightening cycle,
with Fed fund future rates increasing
nearly 1.5% from 1.57% on Aug. 27,
2004, to 3.03% by May 27, 2005. Tenyear swap rates actually declined 45
bps during that period, while fiveyear swap rates increased only 13
bps. In addition, 2/5 swap spreads, or
five-year swap rates less two-year
swap rates, tightened by 93 bps,
while 3/10 swap spreads tightened by
over 111 bps.
Looking at weekly periods with respect to 2/5 spreads, we see 25
weeks of flattening, 10 weeks where
spreads were practically unchanged,
and nine weeks of steepening. This
Fed tightening cycle has predominantly flattened the yield curve.
As expected, while Fed fund rates
increased 114 bps, shorter-term ARM
rates (3/6s) increased by 68 bps, 5/6s
by 23 bps, and 15-year rates by only
five bps.
Given the realization of the antici-
What’s The Best Hedge?
Eurodollar future (EDF) bundles outperformed dwarfs in periods
of flattening and steepening, but underperformed them in periods
of no change. The data is from weekly rolling hybrid ARM hedge
models that track ARM and hedge price movements and hedge
ratios over time and calculate projected hedge performance.
Figures are in basis points.
Nonconforming Nonconforming
3/6
5/6
Rate
Environment
Flattening
No Change
Steepening
EDF
-4
-5
12
Dwarf
-9
-3
15
EDF
-6
-5
18
Dwarf
-9
-2
13
Conforming
3/1
Conforming
5/1
EDF
4
1
-3
EDF
0
-1
8
Dwarf
-1
3
0
Dwarf
-3
1
3
SOURCE: Compass Analytics
pated flattening, how did hybrid
hedges actually perform? For example, did EDF hedges outperform
dwarfs?
The answer is that EDFs outperformed dwarfs across all products in
flattening periods. For nonconforming 3/6 ARMs, EDFs reported an average performance of four bps loss,
compared to dwarf average performance of a nine bps loss, resulting in
EDFs outperforming dwarfs by five
bps. EDFs underperformed across
the board during periods with no
change, and they surprisingly outperformed dwarfs in steeping periods for
five-year, fixed-term ARMs.
What is probably most surprising
is how closely the two hedge instruments tracked each other throughout
the period. While five bps is certainly
not trivial, the similar performance of
the instruments underscores of the
importance of the path that rates take
to get to an end point, as opposed to
the simple difference between a beginning and an end point.
The hybrid ARM market has
proven to be lucrative for an increasing numbers of originators, especially
those who are hedging and selling the
loans on a closed, mandatory basis.
On the hedging side, although we
believe core fundamentals and the
data for this period support heavier
weighting of EDFs over dwarfs,
hedgers employing either or both instruments were quite successful during the period of this analysis.
While hedging and ARM prices still
represent additional volatility relative
to conforming or fixed product, recent participants, especially those
practicing some of the delivery tactics outlined here, have been more
than amply rewarded with actual best
efforts/mandatory spreads and actual
SME
hedge performance.
Copyright © 2005 Zackin Publications Inc. All Rights Reserved.