Higher Agency Loan-Size Limit: A Booster Shot in ARMs?

• Historic home-price appreciation since the onset of the pandemic prompted the U.S. housing agencies to drastically increase loan limits for 2022 — a policy that will qualify more agency mortgage loans for securitization.
• The market for adjustable-rate-mortgage (ARM) securitizations shrank since 2008, but ARMs tend to have higher loan size, and may benefit from the government-sponsored enterprises’ increase in loan limits.
• We reviewed ARM mortgage-backed securities’ (MBS) risk profile relative to that of 30-year fixed-rate MBS and found ARMs had shorter duration, lower spread duration and less volatility and convexity exposure.

The securitization market for U.S. agency adjustable-rate mortgages (ARMs) has been shrinking since the 2008 global financial crisis (GFC). But ARM loans have displayed favorable risk characteristics, with higher loan size, and been mostly retained in banks’ portfolios. The recent loan-limit increase by the government-sponsored enterprises (GSEs), responding to the recent historic home-price appreciation, may give a booster shot to issuance of agency-ARM mortgage-backed securities (MBS).

Issuance of agency-ARM MBS has significantly lagged that of other ARM loans, securitized or not, as shown in the exhibit below. ARM loans re-emerged after the GFC, without the features commonly criticized as risky, such as teaser rates. The new ARM loans also tend to have much lower loan-to-value (LTV) ratios and higher credit scores than pre-crisis ARMs did. But ARM loans originated in recent years have tended to have much higher loan sizes than fixed-rate loans. During 2021, the average loan size requested by ARM-loan borrowers averaged above USD 900,000, while the average fixed-rate loan was around USD 300,000 on average. These high-balance ARM loans usually don’t qualify for GSE securitization due to the loan-size limit, despite their higher creditworthiness.

ARM loans were more likely to be retained in banks’ portfolios

Source: Fannie Mae, Freddie Mac, Ginnie Mae, Mortgage Bankers Association

ARMs have had much higher principals than fixed-rate loans

Source: Mortgage Bankers Association

The exhibit below shows historical loan-size limits set by Fannie Mae and Freddie Mac. The loan-size limit hovered around USD 417,000 for about a decade as U.S. housing prices were recovering from the GFC. As housing prices rose further, the agencies increased the loan-size limit accordingly. Since the COVID-19 pandemic started to reshuffle the U.S. housing market — e.g., booming suburban markets — extremely strong housing-price appreciation increased the agencies loan-size limit 18% to USD 647,200 for a single-family house for 2022.¹ The limit for high-cost areas is going to be USD 970,800, which is 150% of the national limit of USD 647,200 — an arithmetic rule set by the agencies to account for geographic differences. The new much higher loan-size limit may qualify more ARM loans to be delivered to the agencies. We recognize that one headwind against a rise in agency-ARM MBS securitization is the less favorable upfront-fee adjustments for high-balance loans since the 2008 GFC.²

Agency loan-size limit jumped 18% for 2022

Source: Fannie Mae, Freddie Mac

ARM securities have tended to have more favorable risk characteristics than 30-year fixed-rate MBS

Source: MSCI Agency ARM Prepayment Model, MSCI Two-Factor Interest Rate Model

Based on MSCI models, ARM MBS show significantly shorter option-adjusted duration (OAD), as well as lower spread duration, volatility and convexity exposure. This is indeed one major reason banks have been accumulating ARM loans in their own portfolios. Additionally, the duration profiles of ARM MBS are much flatter than those of their fixed-rate 30-year counterparts. As the Federal Reserve may tighten its monetary policy (including tapering quantitative easing) in 2022, a potential rise in rates could extend MBS duration significantly. ARM MBS could provide a shelter to minimize the extension risk, which makes MBS bonds’ duration longer as rising rates slow down prepayment, according to our model.

Could flatter duration profiles be advantageous amid rising rates?

Source: MSCI Agency ARM Prepayment Model, MSCI Two-Factor Interest Rate Model

In summary, on the supply side, the new higher loan-size limit may encourage banks to choose GSE securitization for ARM loans; on the demand side, the more favorable risk characteristics of ARM MBS may prompt investors to increase their MBS holdings in the form of ARMs under the current pressure of potentially rising rates.

¹“FHFA Announces Conforming Loan Limits for 2022.” Federal Housing Finance Agency, Nov. 30, 2021.

²“Loan-Level Price Adjustment (LLPA) Matrix.” Fannie Mae.
“Credit Fees in Price.” Freddie Mac.
The Federal Housing Finance Agency’s Jan. 5, 2022, announcement mostly targets 25-75 basis-point increases for fixed-rate loans, with neutral impact on ARM loans. “FHFA Announces Targeted Increases to Enterprise Pricing Framework.” Federal Housing Finance Agency, Jan. 5, 2022.

Further Reading

MSCI Agency Adjustable-Rate MBS Prepayment Model

A new COVID-19 Regime for MBS?

MSCI Agency Fixed Rate MBS Prepayment Model Version 2.0

A ‘Normal’ Choice of Interest-Rate Model for MBS