The significant growth in the ARM share in mortgage production has a tremendous impact on all sectors in the market. In a recent report, Countrywide Securities Corp. explores this subject by looking at some recent production data.

ARMs clearly comprise a very significant percentage of applications, which is made even more noticeable when refinancings comprise about 60% of new applications, as they do currently. Countrywide noted that the percentage of ARM activity has been above 40% (in dollar terms) since early October 2003, and has not decreased even in the refi uptick seen late this winter. Previously, ARMs dropped as a percentage of total applications in periods of high refi activity, as it did during last spring's refi wave.

In the report, Countrywide focuses on two key factors: the current amount of ARM issuance relative to last spring's refinancing wave and how increased production in the sector has affected other products in the market.

To study these factors, the firm compared Countywide's pipeline from the end of last June to the end of last month. Analysts looked at these periods due to the timing (the middle of the refi waves) and the comparable sizes of the pipelines (which were within 10% of each other).

Results show that conforming and non-conforming ARMs comprise a much larger part of the pipeline - more than double - compared to last year. Simultaneously, conforming fixed-rate production in the pipeline dropped and non-conforming loans have increased. The latter was attributed to the purchase market that saw a high level of real estate prices and larger loan balances.

In terms of pipeline composition, Countrywide compared their pipeline numbers for the same periods. The study showed that the ARMs share of the pipeline is increasing. Conforming ARMs currently comprise 174% more of the pipeline than they did last summer, while non-conforming ARMs in the pipeline are more than double (153% of last summer's share). In contrast, 30-year conforming fixed in the pipeline is merely 70% of what it was in June, while non-conforming short-amortization product (20-, 15-, and 10-year loans) is about half of what it was in the previous time period.

According to Countrywide, these proportions suggest that fixed-rate agency volume (including non-conforming fixed-rate balances) currently in the system is less compared to the past periods. Thus the agency passthrough sector seems to be in very good shape from a technical perspective.

On the other hand, the technical picture for ARMs can deteriorate as the pipelines move toward funding, Countrywide said. It remains unclear whether the significant amount of production has been booked in long-term bank portfolios or held in a shorter-term portfolios. They note that a number of bank originators tend to accumulate positions and then become sellers after a certain point; this could portend a large amount of supply in both conforming and non-conforming ARMs over the next few months.

The firm added that if current production trends continue for a considerable period, the composition of the mortgage market will slowly change. These evolving compositional changes will be because of new home sales and housing turnover (ARMs now make up at least half of total production) and refinancings (ARMs comprise roughly 35% of issuance). They suggest that estimating fixed-rate prepayment speeds using application data will become more difficult as the proportion of ARMs outstanding increases; they also note that the mortgage market could become less transparent if bank originators hold their increased ARM production in portfolio and the trend toward higher securitization rates in the mortgage market are reversed.

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