Given the recent yield curve dynamics, there has been talk about the potential for ARM-to-fixed refinancings. Based on their analysis, Lehman Brothers does not expect a reversal of the recent structural shift towards hybrids.
Lehman focused on the drivers of ARM originations and the bottom line, analysts said, is that the yield curve shape has little bearing on the share in ARM originations. This is supported by the fact that ARM share increased even with the curve flattening dramatically in the past 18 months.
In terms of refinance volume, the level of activity does have a strong influence on the ARM origination share. For instance, in the steep curve environment of early 2003, refinancing activity was strong, and so the share of ARMs in originations was much lower, Lehman said. Some of the recent increases in ARM share are the result of reduced refinancing activity. Analysts expect that if rates remain low and refinance activity picks up, ARM share could decrease some. In fact, Lehman expects that, in the near term, the share of refinancing loans could rise to 50% to 55%, with the share of ARMs in gross supply declining to the low 40% area from recent roughly 50% levels.
The factor preventing a structural shift back to fixed mortgages is that leveraged mortgages are still attractive. In fact, Lehman analysts report, even with the bear flattener, the incentive to take out a levered mortgage has not decreased significantly. Lehman analysts add that the payment differential between a hybrid IO and a 30-year fixed is still around 30%. In addition, MTA loans - which allow borrowers to increase leverage and reduce monthly payments even further - are becoming more readily available. So while the latest rally and seasoning of the hybrid universe has exposed hybrids to a greater refinance incentive, "the continued attractiveness of levered loans, and their widespread availability in hybrids and not in fixed rates, should draw refinancing ARM borrowers back into the sector," analysts noted. Lehman anticipates that net ARM supply should be little changed.
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