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
Periodic Cap
The increased popularity of hybrids is largely due to the cost savings from considerably lower initial interest rate compared to 30-year fixed-rate mortgages without the onerous amortization schedule of a 15-year fixed-rate or balloon payment. Table 2, below, shows the most recent interest rates across the various mortgage products. Borrowers with shorter time horizons are willing to trade the certainty of a 30-year fixed rate mortgage for a more affordable monthly payment. Hybrids fill the void for borrowers who have expectations of selling or refinancing in less than 10 years and mitigate the interest rate risk inherent in traditional 1/1 ARMs. Hybrids are particularly attractive to first-time home buyers who are stretching to qualify for loans or buyers with expectations of trading up in a couple of years.
Table 2
|
National
Average Mortgage Rates, November 2003
|
|
|
30-yr
Fixed Rate*
|
5.94
|
|
15-yr
Fixed Rate*
|
5.28
|
|
1-yr
ARM
|
3.63
|
|
3/1
ARM
|
4.49
|
|
5/1
ARM
|
5.10
|
|
7/1
ARM
|
5.64
|
|
10/1
ARM
|
5.84
|
|
*Week ending 11/7/03 Source: HSH Associates, Mortgage Banking Association |
|
In the primary market, the volume of ARM originations has grown steadily since 1990, except in 1999 and 2002 when ARM originations increased sharply as shown in Figure 1 below. In 2002, of the $2.48 trillion of 1-4 family mortgage originations, 10% or $254 billion were ARMs. According to Fannie Mae, conventional hybrid ARM originations reached $175 billion in 2002, approximately 7% of total mortgage originations.
Figure 1: Agency & Non-Agency
While there has been significant innovation on the origination side of the ARM market, the secondary market remained somewhat static until 2002 when the volume of agency ARM issuance increased by 164% from $47 billion in 2001 to 124 billion in 2002. Figure 2 shows annual issuance of agency ARMs from 1996 to 2002. Most of the growth in agency ARM issuance in 2002 can be attributed to hybrid ARMs. Of $124 billion of agency ARM MBS, 83% or $103 billion were hybrid ARMs in 2002. Growth in hybrids is expected to continue and surpass levels in 2002, particularly given that Ginnie Mae recently announced a new program that will securitize FHA's 3/1, 5/1, 7/1, 10/1 hybrid ARMs and the VA's 3/1 and 5/1 hybrid ARMs as of October 1, 2003. Earlier this year, Fannie Mae announced a new pooling program for 5/1 hybrid arms that established uniform pool-level characteristics in order to promote greater liquidity in the secondary market.
Figure 2: Agency Only
Given the steepness of the yield curve, the most popular hybrid structures in 2002 were 5/1 and 3/1 hybrid ARMs. Figure 3 shows the various hybrid products as a share of total agency hybrid issuance. The volume of 5/1 ARMs issued in 2002 was $57 billion, representing 55% of the total agency hybrid ARM issuance. The volume of 3/1 ARMs was $31 billion or 30% of total agency hybrid issuance. Both 7/1 and 10/1 were less attractive because the cost savings from lower interest rates were modest relative to the 30-year fixed rates.
Figure 3
Throughout the 1990s non-agency ARM securitizations generally ran a distant second to agency ARM production. In 2000, as shown in Figure 4, non-agency ARM production began to accelerate and surpassed agency production in 2002. In terms of hybrid ARM securities, jumbo hybrids skyrocketed from $4.8 billion in 2000 to $65 billion in 2002 as shown in Figure 5.
Figure 4
Figure 5
