With the current historical steepness of the yield curve caused by the Fed's continued easing, short-duration mortgages such as ARMs are becoming more and more attractive causing additional prepayment concerns among investors.

In a recent Countrywide Securities report analysts estimated total ARM originations for the first six months of this year to be approximately between $120 billion and $175 billion based on the Mortgage Bankers Association's percentage of ARM applications by dollar amounts.

The report also said the fact that securitized ARMs (both agency and private label) has amounted to $26 billion implies that the percentage of securitized ARMS ranged from roughly 15% to 21%, which is significant for ARMS, while the percentage of fixed-rate mortgages is estimated to be 73% to 80%.

The current popularity of ARMs is driven by the fact that the steepening curve has resulted in increasingly low rates for hybrid ARMs compared to fixed-rate loans.

With a hybrid ARM, a borrower is given a low introductory rate or a teaser rate that is typically below the existing market rate. Depending on the kind of hybrid one has, the rate is reset after a specified number of years to prevailing market conditions. When the curve is steep, ARMs become more attractive because usually in this environment the 10-year rate is high while the one-year rate is low. Thus the difference between the thirty-year fixed-rate and the teaser becomes greater, which means more savings for the homeowner if he were to get the shorter- duration mortgage.

Aside from this, analysts say that the average borrower stays in the same home for less than seven years. So in many cases short-duration mortgages become an attractive alternative that allows borrowers to lock in a better rate than they would have had with a 30-year mortgage.

Investors on the lookout

However, with this increased interest in ARMs, investors are starting to worry about the effect this would have on prepayment behavior.

Last week, Street research addressed these concerns. In their report, for instance, UBS Warburg addressed the question: Do low ARM teasers imply fast 30-year prepays?

UBS said that investors are worried that a significant amount of 30-year borrowers will refinance into 1/1 or hybrid ARMs, and that the low teaser rates being offered on these products will cause the rise in refinancing incentives. Investors fear that this would result in accelerated speeds on new 6.5s.

Apparently this coupon is only marginally refinanceable if it is refinanced into a 30-year loan. However, it looks fully refinanceable if it were refinanced into an ARM, particularly into 3/1 and 5/1 hybrids.

UBS said that the ARM effect would not result in a dramatic increase in 6.5 speeds.

"Even if the teaser rates are very low, the homeowner realizes that he is paying something for that low teaser," said Glenn Boyd, an associate director at UBS. "What he is paying is the lost ability to lock in historically low rates for 30 years, and he is giving himself a huge amount of uncertainty about what his rate is going to be when the first reset comes in. Essentially the homeowner is selling an option."

Though it is true that when the curve is steep ARMs look more attractive than fixed-rate mortgages, it is also true that if the absolute levels of rates are low then fixed-rate products are a better buy.

Since mortgage rates are currently at historical lows, borrowers who intend to stay in their homes for the long term are better off locking in the low rates instead of taking advantage of the teasers being offered.

"The low rates compensate for the fact that we are in a very steep curve environment," said Boyd. "The net effect is that we do expect ARM production to increase but not enough to be significant to the 30-year market."

Minimal impact

With the yield curve steepening by almost 140 basis points since the beginning of this year, analysts expected increased prepayments compared to the beginning of 2001 because of the incentive to move into a shorter-maturity mortgage.

However, analysts from Lehman Brothers believe that the effect of this movement would be limited to 2%-3% CPR.

This conclusion is based on the fact that the steepening is already reflected in prepayments over the last three months, to which analysts from the bank were benchmarking their projections. The average slope of the curve during this period was 290 basis points, which is about 80 basis points less than it is currently.

Amitahb Arora, a vice president at Lehman Brothers, said that to gauge the impact of the additional 80 basis points of curve steepening that has occurred, transition data provided by FHLMC should be considered.

In 1993, when the curve was as steep as it is today, about 52% of the 30-year borrowers refinanced into a new 30-year loan as compared to 64% when the curve was 160 basis points flatter in 1998. This means that there were less 30-year borrowers that refinanced into a 30-year mortgage during the time when the curve was steeper.

Arora said that an extreme view is that there was no additional refinancing on account of the steepness in the curve, but merely a substitution away from 30-year to shorter maturity products. The other view would be that there was no substitution away from 30-year product, but merely about a 20% overall increase in refinancing, all of which went into non-30-year product, which also caused the 30-year share to drop to 56% in 1993.

A mid-way view would imply about a 7-8% incremental refinancing due to the 160 basis point steepening, which translates into 5%-7% CPR for 7s and higher coupons today. Based on these numbers, an 80-basis-points incremental refinancing would have about half of that effect, or 2% -3% CPR.

Other factors

Though the increasing popularity of ARMs is evident, there are certain mitigating factors that should be considered.

According to analysts, ARM IO pricing is much steeper than it is for fixed-rate product. Consumer ARM rates, according to the Countrywide report, "are much more sensitive" to the points paid for no-cost loans and loans with add-ons, thus making it more expensive for people trying to get these types of ARM loans.

This becomes a disincentive for borrowers who are paying a refinancing out-of-pocket, taking out low-or no-documentation loans and those who are doing a cash-out refinancing which usually have an add-on, said the report.

This led the analysts to conclude that although the "so-called ARM effect " has impacted prepayment behavior, the factors mentioned above have somewhat limited the scope of the effect.

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