The Department of Housing and Urban Development published a regulation on the Federal Register last week increasing the initial or periodic interest rate cap as well as the life reset on FHA-insured 5/1 ARM loans. The new rule, effective April 28, raises the periodic cap on FHA-insured 5/1s to 2% from 1% and the life cap to 6% from 5%. The new caps allow the differentiation between the FHA's 5/1 ARM program and its 3/1 program. Currently, only ARMs with initial reset periods of three years or less are allowed a 1% interest rate adjustment. The HUD has also invited interested parties to submit comments on the new rule by May 31.

In the published regulation, the HUD stated that it is aware of the concerns among mortgage lenders and borrowers regarding the 1% limitation on the annual interest rate adjustment for 5/1 ARMs, stating that the concerns center around the fact that the 1% cap does not accurately reflect the realities in the mortgage sector. For instance, HUD said that conventional mortgage lenders do not provide 5/1s with a 1% cap on annual interest rate adjustments, adding that this inability makes the FHA-insured 5/1 ARM less attractive to borrowers and lenders alike since the appeal of the product is driven by the lower initial interest rate.

Furthermore, the HUD also stated that the 1% limitation undercuts HUD's ability to provide mortgage insurance for a full range of ARM mortgages with standing initial interest rates less than for 30-year conventional counterparts. The ruling also stated that increasing to a 2% cap, as well as raising the life cap to 6% for 5/1s, are both consistent with those applicable to seven- and 10-year ARMs.

Countrywide Securities mortgage strategist Paul Jacob said that the change in the 5/1 ARM initial reset is expected to help with investor acceptance of the product, although not as much as if a full 5% initial reset had been allowed. "The increase in the life cap certainly won't hurt, but the hybrid market is much more focused on initial reset caps than on life rate caps," added Jacob.

He explained that from an investor's perspective, the higher initial reset greatly decreases the chance that these investors will run into an interest rate cap before the loan or the bond becomes adjustable. One of the real attractions of the ARM sector from an investor's point of view is having a finite fixed period before turning into a floating rate bond. "The world loves a short duration instrument, which makes the ARM very popular," Jacob said. Having the higher cap, particularly the initial cap, gives investors more certainty that they will have a bond that will perform like a floating rate product when the fixed period ends.

Victoria Averbukh, MBS analyst at Deutsche Bank Securities, said that the change in the caps for the FHA 5/1 ARM would be good for the Ginnie Mae ARM market, although the impact would be limited because issuance in this sector is very small. One problem, she said, is there is more of a variety of ARM caps offered on the conventional side. Aside from this, Ginnie Mae and the FHA target near prime, subprime as well as high LTV borrowers who are being offered a wide array of products such those under the Alt-A label "that are probably more attractive than a straightforward hybrid ARM," she said. In terms of prepayments, Averbukh said that the change would probably not slow down or significantly speed up Ginnie Mae prepayments especially considering the low issuance in the Ginnie ARM sector.

In terms of the effect on the mortgage market in general, the impact would have been more significant if HUD were to initiate an I/O loan program, Countrywide's Jacob said. For instance, Jacob suggested HUD initiate a product analogous to a 5/1 I/O loan, which has become widespread in the conventional and jumbo ARM sectors.

In this case, GNMA prepayments would not be greatly affected, added Jacob. In general, the flatter yield curve has compressed the spread between primary fixed and ARM rates in recent months. "This has, to some extent, reduced the appeal of ARMs for refinancings out of fixed rates, though ARMs remain quite popular for home purchases," Jacob explained. "So, we do not anticipate this to have a significant impact on prepayments. However, if the Ginnie Mae ARM program picks up in popularity, it might reduce supply in Ginnie Mae fixed-rate [MBS]."

Copyright 2005 Thomson Media Inc. All Rights Reserved.

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