Adjustable-rate mortgages (ARMs) are now making their presence felt like never before, with ARMs making up 42.7% by dollar volume of total mortgage applications - an all-time high.

Peter DiMartino, managing director at RBS Greenwich Capital Markets, said that a notable shift has occurred in the way the U.S homeowner views mortgage financing. Historically, borrowers moved into ARMs when interest rates were temporarily high, and then refinanced into a long-term fixed-rate mortgage (usually into a 30-year fixed) when rates fell.

"Homeowners don't necessarily view their homes as a 30-year asset anymore. Demographically, U.S. homeowners usually stay in their homes for only five to ten years before they move on," stated DiMartino. By contrast, previous generations viewed a home as a lifelong asset, perhaps as something to be handed down to the next generation.

"Since Americans don't view their homes as a long-term asset, they don't want to pay up for the back end of that mortgage," he said. Many borrowers today are more focused on managing their monthly cashflows and are therefore unwilling to pay the extra 100 to 150 basis points for a 30-year fixed loan when they could have the hybrid ARM option for less. DiMartino explains that, depending on the size of the mortgage, the difference could save borrowers hundreds of dollars a month in interest expense. This has driven borrowers into ARMs. "As evidence, presently as well as last summer, when rates were at their 40- to 45-year lows, ARM production actually reached record levels, mostly at the expense of 15-year mortgages," said DiMartino.

Freddie Mac Chief Economist Frank Nothaft said that the considerable interest rate differential between fixed-rate mortgages and ARMs has drawn savvy consumers into the product. Hybrid ARM products, particularly 5/1s, are attractive for borrowers with short horizons in terms of staying in their current homes, such as military families and families who are involved in corporate relocation.

"While the fixed-rate index is still at only half of its peak level in June of 2003, the ARM index is 30% higher," wrote JPMorgan Securities analysts in a recent report. "The current ARM-inspired refinancing wave may lead to a very different relative value outcome than in the summer of 2003."

JPMorgan said that with current primary ARM rates close to June levels, it is reasonable to believe that the rise in the ARM Index is due mainly to fixed-to-ARM refinancings, mostly from 30-year product. This suggests that the share of this type of refinancing is now running at roughly 35%, which is obviously taking away from the 30-year to 15-year refinancings. "In a significant break from tradition, 15-year net issuance may actually be negative or only marginally positive in the current refinancing wave," JPMorgan wrote.

This increase in ARM activity has several obvious consequences, including: higher speeds on new 30-years; negative net issuance in the 30- and 15-year sectors; accelerated prepayments on 30-years versus 15-years; and lower duration supply compared to prior refinancing cycles.

Duration supply is expected to be considerably below expectations, resulting in a relatively muted refinancing-related rate whipsaw, said analysts. This is a positive for mortgages as it suggests that basis tightening might happen earlier than expected.

Relative value implications

In terms of relative value, the current environment is quite positive for 15-years while being very negative for ARMs, and neutral for 30-years (which favors high premiums over cusp coupons). Other analysts explained that last summer the market saw many borrowers refinance out of 30-year fixed loans into 15-year product; thus, supply in the 15-year sector increased noticeably, a typical occurrence in a refinancing wave. But with so many borrowers now moving into ARMs, and not so many into 15-year product, this bodes well for current-coupon 15s.

Some of the recent 15-year supply might have served as hedges for ARM originations, said JPMorgan. The lack of a TBA market in ARMs makes hedging of pipelines harder. ARM supply is usually observed closer to the settlement date. In contrast, fixed-rate supply usually hits the market as soon as borrowers lock rates. JPMorgan explained that, as ARM originators hedge their pipelines with 15-year product, it is possible that much of the recent 15-year supply may serve only as a pipeline hedge. Thus in a few weeks, when ARM supply hits, 15-years might tighten sharply as originators buy back their hedges, said analysts.

Analysts have said that the increased importance of hybrids means that investors should look into hybrids when filling intermediate buckets. One drawback is that ARMs are not part of any index. However, non-index driven investors, or index buyers who can buy non-index assets, can look at ARMs as an alternative to buying either a short CMO or to moving into 10-year mortgages, which are becoming more popular with borrowers.

But there remains some risk in moving into the ARM sector. "Even though a large amount of hybrids have been produced in the past few years, you haven't seen what this product looks like in a true bear market, " said an analyst. "Nor do we have a lot of historical data on how these loans, especially longer hybrids, prepay as they approach their reset dates."

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