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Pricing & Hedging 5/1 and 7/1 ARMS

Currently Agency cash window pricing for 5/1 & 7/1 ARMs as well as 10/1 and 3/1 ARMS on a retained basis. However, the 3/1 and 10/1 are not marketable based on the rates and prices posted. Thus, we will concentrate on the 5/1 product.

Here is sample pricing for 5/1 ARMS posted today for Agency and Correspondents:

      Rate        Price            SRP        Total

Agency                             5.25%    100.69                .75         101.34

Correspondent               5.25%    102.37                 0           102.37

Difference                                                                                    1.03 better released

Hence, the released execution is better than the retained unless one values servicing retained and sold to the agency for over 1.75 points - not likely.

Another point to make is that while ARMS are slightly better than fixed rate mortgages in the current market, anywhere from .125 to .25% they come with additional risk to the borrower and limited profitability for the lender. Before the recent runup in rates ARMS provided much better terms for the borrower anywhere from .5% to .75% lower rates. With the increased pressure from the FED tightening these products currently do not provide a great alternative to borrowers, although one should be ready in the event they become the product of choice.

Hedging ARMs is similar to hedging fixed rate products here at MCM. We measure the OAS duration, convexity, and OAS SRP value and shock the exposure and then measure and apply the correct coverage to offset the exposure.  One thing to keep in mind is that ARMS tend to have a higher fallout rate than fixed rate products and they are more sensitive to rate declines. For example, a pipeline of ARMs may have an expected closing rate of 80% if the market for 30 year remains flat but may decreased to 60% rather quickly given a rate reduction on 30 year fixed. Thus, they require more option-based coverage than fixed rate products. Another key point in hedging ARMs is that one must use liquid premium rate 15 yr. and 5 yr. treasury futures options to hedge them so you remain in the same yield curve ballpark. That is, you remove the yield curve inversion risk.

On another note, 5yr CD rates are around 2.15% today so adding a nice margin to that and pricing a 5/1 ARM provides a very good portfolio product. Even a 2.5% margin is only 4.65% - significantly lower than what we are seeing from loan buyers.

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