With the growing presence of non-traditional mortgage products, analysts are now studying the potential effects of these new entrants on the market as well as on borrower characteristics and behavior.

Countrywide Securities, for instance, in a recent report said, "it is reasonable to believe that the growth in affordability products has had a positive impact on real estate prices." Analysts define "affordability products" to include interest-only and negative-amortization or payment-option products.

Countrywide noted that in October roughly 55% of the affordability products funded were for purchase loans. Researchers also mentioned that states with the highest percentage of affordability products in October corresponded quite closely with those states that had high levels of real estate appreciation over the last year. October data also shows that payment option loans are used more predominantly as refinancing vehicles compared to interest-only mortgages. These payment-option loans make up about 29% of the balance of purchase transactions using affordability products. Meanwhile, they make up 55% of refinancing loans that used affordability products.

"In our view, payment option or neg-am loans (which can be a more leveraged version of an interest-only loan, depending on the borrower) are more commonly being utilized as a refinancing vehicle," note Countrywide analysts, adding that those attempting to manage monthly payments when buying homes in high-cost regions seem to have a higher inclination to utilize the simpler interest-only loan.

Countrywide also points out that since there is a larger concentration of payment-option loans in refi transactions, it appears that borrowers are not using them as a means to further leverage home purchases.

In the report, analysts add that the increasing presence of these products suggest that traditional measures of affordability - specifically the National Association of Realtors affordability index - are not as meaningful as they have been in the past. With the index using a fully amortizing 30-year loan in its calculation, it underestimates the borrower's ability to "afford" a mortgage.

Separately, an MBS analyst said that LTVs on these so-called affordability products are lower in refinance loans than for purchase, which is consistent with other mortgage products. The key, the analyst said, is in the underwriting. "Assuming that lenders exhibit some degree of caution, I think this a reasonable evolution of these products," he said.

Effect on hedging activity

Recently Lehman Brothers also released a report on the growth in non-traditional mortgage originations and its impact on mortgage hedging.

With the increased strength of the housing market over the last several years, analysts said that there has been a marked shift in mortgage originations towards hybrid ARMs as well as weaker credit mortgages. This is evidenced by the fact that just as recently as five years ago prime fixed-rate mortgages made up more than 90% of the total outstanding MBS. Today, however, hybrids and subprime mortgages comprise over 20% of the market, Lehman said.

Analysts explained that this structural shift is actually a net risk reduction to the market since these atypical mortgages - such as hybrids, subprime and credit-impaired loans - have less duration and convexity needs. Lehman said that because of the current increased share of non-traditional mortgages, overall duration of the mortgage market has decreased by about $225 billion 10-year equivalents and convexity needs for an over or under 50 basis points move in rates has been lessened to about a $100 billion 10-years.

Aside from this, the increase also shifts some of the volatility exposure of the market from longer maturity rates into caps. Lehman estimates that the total amount of duration from caps in hybrids is roughly $80 billion and is expected to extend to $140 billion should rates increase by 100 basis points. This is compared to a duration extension of over $400 billion 10-years for the MBS index. While manageable, the cap risks are not insignificant.

Lehman said that the bad news is this most recent origination trend has increased the level of unhedgeable risks. Analysts explained that weaker credit and hybrid borrowers are more vulnerable to housing market strength. In identical interest rate scenarios, valuation and risk measures are very sensitive to realized and projected home price appreciation. This adds a considerable amount of unknown risk for mortgage hedgers. "The magnitude of this risk is best illustrated by the fact that the market can't even reach a consensus whether home prices are positively or negatively correlated with rates," Lehman analysts said.

The case of the hybrid IO

California is the leading geographic region in hybrid originations and in the use of the hybrid IO product, according to a recent Bear Stearns report. The hybrid IO mortgage, said analysts, effectively increases housing affordability by about 30% under current market conditions. With California's dominant market share in IO originations, Bear Stearns said that the growth of IO collateral has become a driving force in the states recent surge in home prices. Analysts are now concerned about whether the current demand for housing in California is actually sustainable.

"If marginal demand is being fueled by the IO product as we suspect, home price growth becomes contingent on the continued availability of the IO product, continued aggressive primary pricing, the absolute level and shape of the mortgage rate curve and credit performance," wrote analysts, adding that this trend presents a real threat to "the housing juggernaut" even though the sector's fundamentals remain strong.

Another MBS analyst said that the concept of the interest only product is here to stay, with some lenders now offering a fixed-rate version. "Borrowers and investors are more comfortable with it," he said, which he contrasted with the situation from roughly five years ago, when homeowners generally did not feel at ease with refinancing into hybrid ARMs. "We are clearly seeing a shift in the market, and I don't think we are going to go back unless there is a major dislocation [in the market]," the analyst stated. He believes borrowers currently have a lot more options in terms of how they could finance their real estate. "As long as lenders exercise reasonable caution, I think it's a positive development," the analyst said.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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