Synthetic indexes on ARMs created

CDS IndexCo, a consortium of 16 dealers, and Markit, a London-based independent pricing and valuations specialist, have developed a family of indexes on the hybrid adjustable rate mortgage (ARM) market. The Hybrix indexes are cash-settled forward contracts referencing mortgages issued by Fannie Mae and Freddie Mac, and will start trading on March 1.

"This is the first time in the history of the ARM market that you can short ARMs. So, for those investors who want to hedge their books and for those who have a negative view on the ARM market, you now have the ability to express that view,” said Sami Boustany, New York-based executive director at Morgan Stanley, who was speaking during a conference call announcing the product on Tuesday.

Another key characteristic of the product is that it enables investors to take a view on the mortgage market’s convexity, or the degree to which the value of the security changes as interest rates change. “Hybrix is the first product of its kind where the payment is in exchange for taking the convexity risk, whereas in other markets it is paid for taking credit risk,” said Jonathan Margolis, an associate at Goldman Sachs in New York.

The reference portfolio consists of 3/1, 5/1, or 7/1 hybrid ARM pools, where 3/1, for example, refers to a mortgage which has a fixed interest rate for the first three years and adjusts every year thereafter. Trading on the 5/1 Hybrix will begin on March 1, while the 3/1 and 7/1 contracts will trade by the end of September. All contracts are quarterly and will have a four-month contract life. The one-month overlap will provide time for investors to roll forward their positions.