With the increasing interest in securitizing hybrid ARMs - loans which combine fixed-rate, front-end cashflows and floating-rate, back-end cashflows - comes the development of Forward Mortgage Agreements (FMA), according to a recent Bear Stearns report.

An FMA allows one to distinguish between fixed-rate and floating-rate cashflows. Normally investors have an appetite only for either fixed-rate or floating-rate securities, not a combination of both. By structuring an FMA, underwriters can target investors who are interested in either cashflows.

In a typical hybrid ARM securitization, the collateral is deposited into a REMIC trust, which is similar to any CMO instrument. The cashflow that is generated by the collateral is tranched-up and passed on to front-end, fixed-rate investors. After a period of five years, or on the hybrid ARM reset date, the fixed-rate cashflows switch to being floating-rate cashflows. At this point, the FMA holder purchases the outstanding collateral from fixed-rate investors at par.

This arrangement benefits both parties. According to the Bear Stearns report, the FMA agreement results in the creation of securities similar to fixed-rate CMOs, ABS and CMBS for the front-end, fixed-rate investor, while the FMA holder receives a premium for guaranteeing to purchase the floating rate cashflows on the hybrid ARM reset date at par.

And from a valuation standpoint, the FMA agreement can be considered as an insurance policy where the FMA holder receives an up-front premium payment to guarantee coverage on the agreement's effective date, said the report.

The report also recommends that investors of long-dated securities, specifically federal agencies, insurance companies, banks and re-insurers with a single-A or higher corporate rating, consider holding FMAs.

To account for differences in regulatory and accounting treatment, these FMA agreements have taken various forms.

Depending on how the instrument is viewed, whether as a total return swap, a traditional put option or a combination of a put and call option, accounting treatment for different institutions vary. The variety also comes from differences in the laws that govern insurance companies.

In other words, regulatory and accounting considerations can determine what the ideal FMA structure should be.

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