Consulting Corner

Development of the Hybrid ARM Market
By Anne Ching

Hybrid ARMs have undergone explosive growth over the last three years, fueled primarily by a steepening of the yield curve by approximately 290 basis points. Hybrid ARMs first appeared in the marketplace in the early 1980s, but became more prevalent when Fannie Mae and Freddie Mac first began issuing hybrid ARM securities in the early 1990s. Hybrid ARMs gained considerable momentum by the end of the 1990s and surpassed the volume of traditional 1/1 ARM issuance by the end of 1999.

Hybrid ARMs blend the features of both fixed-rate and adjustable-rate mortgages. Hybrid ARMs are initially fixed-rate loans that convert into adjustable-rate loans after a pre-determined period -- typically 3, 5, 7 or 10 years -- and then reset annually at a specified spread to an index over the remainder of a 30-year term. Other salient features of hybrid ARMs include cap structures and indices. Hybrid ARMs are subject to initial, periodic and lifetime caps. The initial cap limits the amount the contract rate of interest can rise at the first reset date. The periodic cap limits the increase in the contract rate at each subsequent reset date. The lifetime cap establishes a ceiling on the amount the contract rate can increase over the life of the loan. The most typical hybrid caps are presented in the table below. Hybrid ARMs have been issued with a variety of indices, with the 1-year CMT as the most prevalent index prior to 2001. There has been a recent trend toward LIBOR-indexed hybrids, which reflects liquidity concerns with respect to the disappearance of the 1-yr T-bill. Fannie Mae recently introduced a LIBOR-indexed 5/1 hybrid program as a way to create more uniformity and liquidity in the market for LIBOR-based hybrid products.

Table 1

Hybrid Type	Initial Cap	Periodic Cap	Lifetime Cap
3/1	2%	2%	6%
5/1	5%	2%	5%
7/1	5%	2%	5%
10/1	5%	2%	5%