As fixed-rate mortgage rates are hovering around 8%, a near two-year high, and typical adjustable-rate mortgage borrowers are looking to lock in on their "teaser rate" a few years longer, many are now turning to a "hybrid" ARM. Furthermore, investors are seeing these loans as a great alternative to balloon loans.

Hybrid ARMs lock in a lower rate for a fixed period of three, five, seven and 10 years before resetting to a higher rate. Both convertible and non-convertible hybrid ARMs have been securitized, and the amount of origination is growing at the expense of the balloon loans.

But some researchers believe the loans are not competing with fixed-rate mortgages. "I think that to a large degree the hybrid ARMs have hurt balloon originations," said Art Frank, director of MBS research at Nomura Securities. "It doesn't really much compete with 15- or 30-year originations, not to any significant degree. The people are looking to lock in a rate for longer than a year. But in most cases, they suspect they won't be in the house a terribly long time, and choose the hybrid ARM."

Instead, the hybrid ARMs are viewed as an alternative to the balloon loan, in which borrowers have a low rate for a certain period of time, and then are forced to pay the remaining amount at once upon the end of the term. In fact, hybrid prepayment rates are often set with those of a comparable balloon, mostly in the seven-year loans.

"At times the yields are analyzed on a balloon basis, that is assuming that the whole thing pays off on the first reset date, which is unrealistic," said Frank. "But it is often run at the same prepayment estimates as the seven-year balloon, but it tends to prepay a little slower than that."

Balloons Declining

Since 1997, the balloons ARM has become a popular securitization vehicle, while balloon origination has fallen sharply, with payouts exceeding new issuance.

In contrast, Fannie Mae 7-1 hybrid ARMs have seen a $500 million issuance-to-payout ratio over the past six months alone.

Five-year hybrids currently have only $2.7 billion left. Seven-year balloons are declining slower, having $29.5 billion left to pay out. "I think that five-year balloons don't have much liquidity any more," Frank said, noting that balloons have slowed down almost to the point where they are no longer being traded.

Because balloon borrowers must refinance if they cannot pay off the remaining amount of their loan at the end of its term, hybrid borrowers have an option to refinance, though many do not. "It doesn't seem that the hybrid ARM mortgager is quite as quick on the trigger to move or refinance as the balloon borrower," said Frank.

He added that after the first reset period in a traditional ARM, borrowers still have many payments remaining. And after that period, the loans become a 1-1 ARM, which trades at a modest premium.

"That enhances the total return," said Frank, suggesting investors seek out hybrids. "If you can buy a 7-1 even-yield to balloons, then it seems like a pretty good deal, because you're probably going to have it at a premium at the seven-year first reset date. And sometimes they've been on a yield-basis cheaper than balloons."

However, Frank warned that the yield rate to balloons does fluctuate on a day-to-day basis.

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