Fitch Ratings recently released a report that looks into the risk associated with the hybrid ARM product.
"Since today's hybrid ARM products differ from earlier hybrid ARMs, there is not a lot of performance history so there have been a lot of questions, especially as the volume in the sector has increased significantly," said Christine Brunie, the author of the report.
In the report Fitch said that current hybrid ARM loans are different from those originated in the early 1990s when ARM rates were based on the MTA, which is an index based on actively traded U.S. Treasury Securities, or the 11th District Cost of Funds Index (COFI). In contrast, hybrid ARMs issued today are based on a wider variety of indices. Aside from this, the negative-amortization option and the longer reset periods have been eliminated from newer issues.
Fitch also touched on the factors that make ARMs more attractive to borrowers including the fact that a hybrid ARM significantly reduces the borrower's monthly payment and debt-to-income ratio during the fixed period.
One point the report emphasized was hybrid ARM originators are currently offering borrowers an interest-only (IO) feature that permits borrowers to pay interest only for the initial fixed period, which usually matches the fixed period of the hybrid.
Fitch said that this feature is attractive to certain borrowers because it allows them to maximize their monthly cash flow via their tax deduction.
For example, if the borrower has a 5/1 ARM with the interest-only option and the LTV at origination is 70% (excluding housing price increases) the LTV after the interest only period of 60 months will be 70%. However, if the same borrower opts for a principal and interest hybrid ARM, the LTV after the first 60 months will be 64%. This would represent a $48,440 reduction in outstanding principal balance on an initial $540,000 balance.
The rating agency also noted that upon review of the pools, they found that the ARM loans are slightly different from fixed-rate mortgages. ARM loans on average have lower LTVs and both the average loan balances and the percentage of California loans are higher.
Fitch also said it expects the performance on current jumbo hybrid ARMs to be more reflective of 30-year fixed-rate mortgages than ARMs originated in the early 1990s. The rating agency also said that the longer-term, hybrid IO will likely vary from standard hybrid performance because of the lack of increased equity and greater payment shock linked to the potential increase in the reset rate and the amortization impact.