Despite the flatter curve, ARM production has not and is not expected to decline in the near term, analysts said. In fact, the Mortgage Bankers Association reported last week that ARM share of applications is still at a historically high 46% by dollar volume.
Citigroup Global Markets reports that there are three primary factors buttressing ARM supply: teaser rates, home price appreciation and borrower comfort with ARM product. Lenders have increased the initial rate discounts, or teaser rates, on ARM products just to maintain mortgage pipeline volumes, according to the report. Additionally, borrowers have switched from fixed rate to ARMs over a one-year period through 3Q04 as home prices rose significantly by 12.4%. Borrowers have also become more comfortable with the reset risk in ARMs.
Citigroup researchers stated that while they expect home appreciation to slow significantly at a certain point, most indicators suggest that the housing sector will not weaken considerably over the near term, adding that "the housing market could continue without a substantial downturn through 2005 or even longer." They report that if home price appreciation remains reasonably robust this year, the movement from fixed-rates to ARMs that has contributed to comparatively fast fixed-rate, low coupon issue - such as 5s - speeds could continue throughout 2005. Also, since other factors boosting speeds - such as cash-out activity - also rely on home price strength, fast low-coupon seasoning should generally persist for another year, said analysts.
Other analysts have said that ARM rates remain attractive even to the fixed-rate borrower. Bill Berliner, MBS analyst at Countrywide Securities, said that hybrid ARM rates have not risen significantly, so there is still incentive for borrowers in the fixed-rate sector to move into ARMs. Additionally, hybrid ARM rates usually track intermediate swap rates, which have not underperformed nearly as much as short rates over the past few months.
For instance, Berliner said that the two- 10-year Treasury spread has flattened more than 30 basis points since last December. By comparison, the five- 10-year Treasury spread has only flattened by 12 basis points over the same period, and the spread between 5- and 10-year swaps has narrowed by a similar amount. The favorable ARM rates, which track intermediate-term rates, have been passed through to consumers.
On the demand side, Lehman Brothers said that despite concerns about GSE portfolio growth, the agency hybrid sector is not expected to suffer. Additionally, supply-demand imbalances are unlikely to occur because, in the most plausible scenario - where GSE portfolio size remains unchanged - reinvestment of paydowns should be sufficient to absorb a substantial percentage of agency hybrid supply. Furthermore, even if GSEs do not add hybrids to their portfolio in the near term, the overwhelming bank demand for the product is expected to prevent spreads in the sector from widening.
Lehman also noted that GSE demand for hybrids has been strong recently. For instance, analysts estimate that Fannie Mae's ARM portfolio has increased by greater than $50 billion while the fixed rate portfolio decreased significantly by $80 billion.
Lehman analysts added that even if the GSEs do not maintain hybrid exposure in the near term, banks would provide a backstop bid and sap up hybrid supply. Hybrids make a more ideal match for bank liabilities, which have an approximate two-year duration. Banks have been adding exposure to the sector recently, as evidenced by banks retaining approximately $50 billion of the $80 billion to $90 billion monthly hybrid originations on their balance sheets. Additionally, Lehman cited that banks securities portfolios have reflected a 15% swing favoring hybrids over the past year.
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