Higher Interest Rates Drive ARMs; A Majority of Adjustable-Rate Mortgages Are Not Being Securitized

Adjustable-rate mortgages made up about one-third of total mortgage origination in 1999. Because of the continued rise in fixed-rate mortgage rates, many are predicting this trend to continue well into 2000.

The borrower, rather than the lender, drive the interest in ARMs, which made up only 8% of origination volume in 1998. "It's the fact that mortgage rates have gone up so sharply from their lows a little over a year ago that people don't want to lock in those long rates for 30 years," said Art Frank, head of mortgage-backed securities research at Nomura Securities. "They would rather take an ARM and have the option of refinancing when rates go down."

Frank noted that a year ago, Fannie Mae 6s were the current coupon, and now Fannie Mae 7.5s are, and that 150 basis point increase has driven borrowers to ARMs.

Michael Hoeh, head MBS portfolio manager at Dreyfus Corp., attributes ARM popularity to high housing turnover. "A higher housing turnover that's taken place in the U.S. economy over the last couple of years further gives homebuyers the incentive to take the 5-1, or the 3-1 type adjustable mortgage because they know they'll only be in their home for five years or less," he said. "So that's made that whole product a lot more popular from the homeowner's standpoint."

What has made the secondary market become particularly interested in the rising popularity in ARMs is that a majority of these loans are remaining unsecuritized in bank and thrift portfolios.

"So we see people adding often unsecuritized ARMs as a substitute for buying short CMOs," said Frank. "That certainly contributed to the lower level CMO issuance in the later part of 1999."

He added that the ARMs a have a short enough duration that banks will just keep them in their assets after originating them.

Hoeh agreed. "Clearly, they have a very easy source to bring in product and they have high liquidity, if they ever want to reduce their portfolio size at any point in time," he said. "Since [the banks] are natural buyers of adjustable rate mortgages for their own portfolio, it makes sense that they're going to retain as much as they can of the origination rather than selling into securitizations."

However, those ARMs that do enter securitized pools are still in rather strong demand although "there's not a deluge of ARMs in the securities market," said Frank.

And while there is demand, the number of banks keeping ARMs is certainly slowing it down. "We have seen over $1 billion a month of Ginnie Mae ARMs, that are going to come way back from zero in the fourth quarter of 1998, and we're still seeing a fair amount of production," said Hoeh.

If interest rates remain above 8% for the remainder of the year, both Hoeh and Frank agree that adjustable-rate mortgages may make up a more sizeable percentage of total origination than last year.

"If rates go down 100 [basis points], it will be significantly below 30%, and if rates go up 100 from here, it will be significantly above the 30% level," said Frank. "It really depends on where fixed mortgage rates go. When rates are very high relative to their recent history, mortgagers will pick ARMs and that's the dominant factor."

"If we remain in this type of interest rate environment, it's definitely going to continue," added Hoeh.