Reprinted with permission from the December 2011 issue
A Hedger’s Guide To ARM
Price Discovery
Lenders that implement the proper analytics and workflow will reap
the benefits of early adoption and wider spreads.
By Bob Gundel
N
otwithstanding recent market
volatility and a drop in rates,
many secondary marketing
managers have contemplated the possibility of higher adjustable-rate mortgage (ARM) production at some point
in the future. 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.
However, there are alternative
sources to ARM pricing. Agency hybrid ARMs are quoted and traded in
terms of zero-volatility spreads (ZSpreads). A Z-Spread over the spotrate 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).
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 as-
set, like an ARM, as opposed to a safer asset, like a Treasury security with
a similar term. A standard quoted ZSpread 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.).
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 the rates.
Pricing models use the Z-Spread
Subscription information is available online at www.sme-online.com.
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 threeyear term) at each cashflow are 3.5%,
3.75% and 4%, respectively.
After discounting the MBS cashflows by the Treasury rate plus the ZSpread, 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 ZSpreads 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 (SMMs)
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, SMMs will continue to
obtain specific MBS and/or cash bids
at the time they are ready to make
best-execution decisions.
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 inCopyright © 2013 Zackin Publications Inc. All Rights Reserved.
strument duration and convexity
(hedge ratios).
When hedging ARMs, the trickiest
and most critical part is determining
ARM loan duration. 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.
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 modeldependent, many traders choose to
calibrate duration and convexity in
their models using consensus values
from the street.
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.
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.
Liquidity risk is the risk that a security cannot be bought or sold fast
enough to prevent or minimize loss-
es. Illiquid markets typically have
wide bid/ask spreads and/or large
price movements.
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 choosing to retain servicing on ARMs or that 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
choosing 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.
The most common ARM hedging
vehicle for larger originators is the interest-rate swap. However, given the
balance-sheet requirements to effectively hedge with interest-rate swaps,
many ARM hedgers choose to use
bundles of Eurodollar futures (EDFs)
Subscription information is available online at www.sme-online.com.
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
are 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.
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.
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.
When ARMs start to pick up market share, hedging ARM pipelines and
delivering mandatory will become
more practical. Even in a thinly tradCopyright © 2013 Zackin Publications Inc. All Rights Reserved.
ed market, price discovery and modeling on ARMs are possible with the
right analytics.
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
Subscription information is available online at www.sme-online.com.
scrambling to implement analytics,
workflow and policies in catch-up
mode. SME
Bob Gundel is hedge manager at Compass Analytics, based in San Rafael, Calif.
He can be reached at (415) 462-7500.
Copyright © 2013 Zackin Publications Inc. All Rights Reserved.