In the September issue of Short-Term Prepayment Estimates, Bear Stearns predicted that the hybrid IO product, which recently saw tremendous growth in California, would continue to gain popularity in other parts of the country, particularly among lower-income borrowers.

Bear said that ARM issuance suddently gained momentum in Q3 2003, which they linked to the surge in hybrid IO production in California. The amount of ARM issuance is far beyond what is normally expected, analysts said. In fact, just over the last 12 months, ARM share has been roughly twice the level that would have been expected judging from historical averages. "This is a clear indication of a structural change in the market and we think Hybrid IOs are responsible," analysts wrote.

In the report, Bear Stearns also noted that over 60% of the outstanding hybrid ARMs was originated in California and majority of the latest production was in interest-only loans.Analysts reported that hybrid IOs, which averaged about 5% of originations in California in Q2 2003, rose significantly to over 30% in July 2004.

"Against this backdrop, California provides us with an excellent laboratory in which to study the impact that this transformation in origination patterns is likely to have on the broader mortgage market," said Bear Stearns.

Why are hybrid borrowers shifting to IO loans? The attractiveness of the after tax monthly payment savings provided by the Hybrid IO more than offsets any loss in equity, analysts pointed out. Bear Stearns argues that most borrowers today will likely build equity mostly through annual home price growth and not amortization. This is why the high payment sensitive nature of U.S. Agency conforming borrowers is the basis for the IO product's widespread appeal.

In terms of prepayment speeds, Bear Stearns compared the historical prepay rate on the California  FNMA 5.5%  2002 cohort to the rest of the country. Analysts found that while speeds on these two groups were almost the same through Q2 2003, there was a distinct separation after this period with loans from California paying significantly faster than the rest of the country. Bear noted that the divergence happens at exactly the same time that hybrid IO production took off in California.

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