With more borrowers moving into hybrid adjustable rate mortgages (ARMs), the market is wondering how the trend will impact the widely expected spike in refinancings. Some analysts have suggested that the so-called ARM effect will cause more refinancing risk in 30-year paper versus 15-year product while others say it will increase base speeds across coupons.

According to Street research, the ARM share in the Mortgage Bankers Association (MBA) Refinancing Index has risen steadily over the past several months.

Lehman Brothers reported that the four-week average of the sector's share in the Index is currently about 30%. This is a big jump from the 20% share seen in October to November last year. Other research reports characterize this spike as unprecedented in a refinancing wave. Further, MBA also said that the percentage of ARM originations is twice the level seen in the fall of last year even though the curve is no steeper.

What would this rise in ARM share mean? Consensus seems to be that 30-year sector will be more greatly impacted than the 15-year sector.

Lehman noted that though it would seem that increased ARM share would benefit both products - as ARMs would be taking away some of the supply from these sectors - trends in recent issuance show that 15-year paper has not been a huge contributor to ARM issuance.

"If refinancings into the ARM sector were from 15 years, we would expect an inverse relationship between 15-year issuance (adjusted for the level of pay-downs) and ARM Issuance," Lehman researchers write. "This is, however, not the case. So it appears that refinancing activity into the ARM sector is primarily from 30-year mortgages."

The firm also noted there are still supply concerns in 30-year mortgages, considering that peak issuance late last year was roughly $85 billion. In other words, Lehman does not consider a $10 billion decrease onerous for the sector.

Prepayment differential

Aside from supply considerations, analysts from JPMorgan speculate the ARM effect will accentuate the prepayment differential between moderately seasoned 30-year and 15-year mortgage-backeds as well as hybrid ARMs. JPMorgan also suggests a higher refinancing risk for 30-year paper compared with 15-year paper.

Essentially, the refi incentives tend to be different for 30-year and 15-year borrowers. With the steepness of the yield curve, 30-year borrowers now have as much as a 150 basis point incentive to refinance into an ARM, which would translate to about 7.5% savings in five years. If these borrowers are refinancing (as opposed to purchasing) then they probably would have lived in the home for two to three years already and would likely have a horizon of five to six years, therefore they would not be exposed to reset risk.

By contrast, unlike many 30-year borrowers who usually have a short horizon and are motivated by significant interest-rate savings, a 15-year borrower - who is basically a de-levered borrower - usually implies someone who would like to pay off his mortgage more quickly. This is why, JPMorgan said, refinancing out of 15-years would usually be motivated by interest rate incentive with respect to another 15-year mortgage.

Other analysts said that the ARM effect would not really be a significant aspect in the upcoming wave of refinancings.

"The ARM effect has been pretty consistent over time," said one MBS strategist. "I don't think that, in this latest round, we are going to see considerable refis from the ARM effect, even though ARM rates are very attractive right now."

He added that there has been an incentive to go into ARM since the fall of 2001. Further, despite the attractiveness of the ARM relative to fixed-rate mortgages, there is still some resistance to the product from those who do not want the interest rate risk and from those who do not understand it.

The strategist argues the impact is less considerable and is equal across the board, in all products, affecting speeds in the 5.5% coupon to the 8% coupon.

"What it has almost done is added an extra layer to base speeds," he said "Maybe because of the ARM effect you'll have another five CPR in base speeds. "

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