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Hybrid ARMs Can Be Your Portfolio’s Flotation Device

By: Grant LacKamp

It has been a record breaking three years since the Federal Reserve anchored the overnight rate at an all-time low range of 0.00 percent–0.25 percent. Not surprisingly, bank margins have since cratered and balance sheets are awash with orphaned cash. While rates will surely rise again, the question of when looms larger with every passing day of fractional interest rates. And do not look to the Fed for clarity. Federal Reserve Board Chairman Ben Bernanke and company are more intent on meandering assurances that rates will remain low for however long they guess it necessary.

During these past three years, mortgage-backed securities have proliferated in bank portfolios due to their enhanced nominal yield and certain, preferred cash flow characteristics. Steady cash flow is a terrific hedge against rising interest rates. Yet most fixed rate MBS will pay slower as rates rise, thus returning an ever decreasing flow of funds to reinvest as rates move north. Balance sheets currently swamped with cash may become parched as MBS prepayments slow and loan demand picks up. Underwater investment portfolios will need a life preserver to help keep afloat. So make room next to that cushion callable for a hybrid ARM. It may be the flotation device you will need later.

The hybrid ARM is a “fixed then floating” mortgage-backed security. While they are issued by Ginnie Mae, Fannie Mae and Freddie Mac in various shapes and sizes, the five year/one year structure is common (they also come under non-agency private label wrappers, which we strongly suggest you avoid). The coupon is fixed for the first five years, then resets annually, at a pegged spread to an index (such as one year LIBOR or CMT). Due to their prepayment profile, hybrid ARMs may be considered the “anti-mortgage backed security” because history shows that prepayments increase as rates rise (try that with any other fixed-rate MBS).

Like traditional ARM products, as interest rates zoom north, prepayments tend to accelerate because John Q. Borrower worries that his monthly mortgage payment may zoom northward as well … so he refinances into a fixed-rate, traditional mortgage to lock his cost. Thus, as interest rates rise and cash flows from conventional, fixed-rate MBS diminish, hybrid ARMs flex their cash flow muscle and prepayments generally increase. Not surprisingly, history shows us that by the time most 5/1 hybrid ARMs reach their first reset dates, principal balances have been paid down to roughly 35 percent to 50 percent of the originally invested balance. This is precisely what bank portfolios seek: significant cash flow to fund loan growth or reinvestment in fixed-income bonds at higher rates. Hybrid ARMs allow the bondholder to pass along a significant amount of the interest rate risk to the mortgage borrower. Can you name a fixed-rate MBS product that does the same?

But what if rates do not rise soon? Does the hybrid ARM still pack a punch? Absolutely … the yield to first reset date is generally 1.5x to 2x the yield of an equivalent term bullet agency. Even so, as with all portfolio products, it is prudent to keep your interest rate conviction in mind when determining which variety of hybrid ARM is the best fit for your portfolio. If you feel that rates may begin to rise earlier, look at the 3/1 ARM or perhaps a seasoned 5/1 piece. Alternately, if your interest rate compass suggests a significant amount of time before there is a substantial move upward, a new issue 5/1, 7/1 or 10/1 may be the preferred structure.

Though nobody knows when the interest rate high tide will rush the shoreline, that wave is out there someplace. Chances are good that it will surface just when you thought your sandcastle was safe. Be proactive and take steps today to ensure your portfolio will provide you with the cash flow you will need to fund loans and increase your margin. Hybrid ARMs can help your portfolio stay high and dry.

Grant LacKamp is in the capital markets group at Country Club Bank, Kansas City.

Copyright (c) February 2012 by BankNews Media