The Mortgage Bankers Association reported last week a significant jump in purchase applications, rising 5.5% and making it comparable to levels seen in 1Q04, while also reporting that the ARM share of mortgage activity increased to an all-time high of 36.6%, or 52% in terms of dollar volume. Analysts said that the figures are "an eye opener" especially considering that the MBA application numbers only reflect prime mortgages.

The unique thing about the record ARM percentage is that it is not driven by the yield curve, but this phenomenon is happening even despite a flatter curve. Analysts said that the rise in ARMs is now a product of rising home prices relative to income, making housing affordability an issue that has caused homeowners to ride down the yield curve. They warn, however, that the shift into ARMs has caused homeowners, including investor property owners, to take on more rate risk, which could potentially result in a serious credit crunch as ARMs reset over longer-term fixed rates.

JPMorgan Securities recently reported that with about 65% of mortgage applications now made up of purchase loans combined with the fact that ARMs currently maintain a record share is consistent with the assumption that the ARM product is now being used primarily as a purchase vehicle. "It is likely that affordability pressures will maintain a very high ARM share despite the flatter curve," wrote JPMorgan analysts, adding that the implication of this is that the fixed-rate MBS sector will continue to lose market share. JPMorgan also points out that net fixed-rate agency MBS supply is expected to be negative in the first-half of the year.

In recent research, Morgan Stanley looked at the impact of the evolution in mortgage products offered to borrowers, specifically the influx of ARMS and IOs into the sector. Analysts noted that, "in spite of our rather drastic mortgage rate scenario for 2005, the greater share of more affordable' loans would act as a cushion." In factoring in the lower monthly mortgage payments afforded by these new products, analysts showed that even if interest rates back up significantly, affordability would not drop by a considerable amount for as long as borrowers have continued access to these products. Furthermore, because of correctly accounting for these cheaper products, affordability has become a reasonably good leading indicator of future average home prices, analysts noted. Morgan Stanley also stated that considering the historical relationship between affordability and future home price growth, analysts estimate that even with mortgage rates backing up, home price growth would only drop from roughly 10% down to 6%.

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