Does the spread change when the underlying loan has an ARM in it

The seller eats it unless the wrap note is written with a floating rate tied to the underlying. I've seen notes drafted where the buyer's payment adjusts dollar-for-dollar with the underlying, but that's a hard sell to a buyer who thinks they're getting a fixed rate and usually kills the deal. Most wraps I've seen on ARMs just priced the spread fat enough at origination, like $600-700 a month instead of $400, specifically to absorb a couple of resets before the balloon forces a refi anyway.

What does the wrap note say about rate risk, specifically whether there is a pass-through clause tied to the same index and caps the underlying ARM rider uses?

Because I've read wrap notes drafted both ways and the difference is everything. The ones with proper pass-through language peg the buyer's payment to the same index movement, with a spread floor written in, usually $150 to $200 minimum in the deals I've seen, so the seller isn't quietly subsidizing the buyer starting in month 37 with no remedy.

Honestly the framing of "does the seller eat it" is the wrong starting point. I wouldn't write a fixed buyer-side payment on a wrap with an ARM underneath, period. Index it to SOFR or whatever the underlying is pegged to, cap the buyer's adjustment at say 1.5% per year, and you've got a note that actually mirrors the risk instead of hiding it.

The deals where sellers "just hope" are the ones blowing up in year three when a 6.5% underlying resets to 8.1% and the spread is gone before the morning coffee. I've seen wholesale assignments fall apart at the last second because nobody surfaced that clause until title ran the existing mortgage docs.

Wrote a wrap in Atlanta 2021, underlying was a 5/1 ARM, spread looked fat at closing.

Month 61 the rate jumped and my net went from $340 to $80.

No language in the note tied the buyer's payment to index movement, that was the mistake.

Cost me fourteen months of compressed cash flow before the buyer refinanced out.