NEW YORK - At the inaugural Bear Stearns Adjustable Rate Mortgage Conference 2005 held here last week, participants focused on the incredible growth in the sector and investment opportunities resulting from it. However, concern about credit - still a great unknown due to the lack of performance data - kept rearing its ugly head.
"Borrower tastes have clearly changed," said Jeff Mayer, co-head of fixed-income at Bear, adding that ARMs have carved an enduring presence in the market. The numbers certainly support this statement. In Senior Managing Director Steven Abrahams' presentation (see Chart 1), he stated that in 2004, ARMs dominated the non-Agency MBS market with a 65% market share equivalent to $247 billion, up dramatically from 2003 when ARM issuance was at $125 billion or comprised 40% of the market. In 2005, projected volume is $197 billion, which would make up 68% of the non-Agency sector. "Non-Agency ARMs down 20% in volume, would still command a market share of over 65%," said Abrahams.
In Senior Managing Director Dale Westhoff's presentation, he said that borrowers have used ARMs as a "vehicle to homeownership." Data he presented showed how ARMs have "cannibalized the fixed-rate sector," with ARMs currently comprising 21% of outstanding MBS, while 20-year fixed-rates make up 53%. This is compared to numbers as early as 2001 when 30-year fixed-rates cornered 73% of outstanding MBS supply, while ARMs only made up 9%.
The rise in ARMs has various effects on the mortgage market, including the extraction of volatility and duration from the sector. The imminent refinancing spike would also be a predominantly "fixed-rate" event, Westhoff said. While fixed-rate borrowers still have a 50 basis point incentive to refinance, ARM borrowers currently have a negative incentive to refinance because of the yield curve flattening.
Credit implications of rising ARM share were evident in the data presented showing ARM share increasing as one goes down the credit spectrum (see Chart 2). And although the recent growth in non-amortizing mortgage products - referring specifically to IOs and short reset ARMs - has expanded access to credit, they have also introduced risk to the mortgage market as payment shock is expected to hit borrowers on the reset date. Westhoff said that the reset risk is frontloaded, with subprime borrowers purchasing most of the shorter reset products, adding that there have been aggressive assumptions made on income and home price growth.
Westhoff stated that at this juncture, extension is a much greater risk than contraction risk even with the historically low rates. He said that investors have invested in ARMs to outperform the Index but if rates do back up, and the Index extends, portfolio managers would probably look to extend their durations. He added that the current market has extracted mobile borrowers and have put them in ARMs, thus "adverse selection has got to be very severe." Extension risk becomes more of an issue with purchase loans - which have no embedded tenure and have higher LTVs - becoming a dominant force in the current market. Non-Agency purchase loan data presented showed a dramatic rise in ARM and non-amortizing mortgages particularly over the 2003 to 2004 period.
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