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ARM’s Lose Their Luster

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RISMEDIA, Jan. 18, 2008-Is the hey-day of adjustable-rate mortgages a thing of the past? Freddie Mac released the results of its 24th Annual Adjustable-Rate Mortgage (ARM) Survey of prime loans, which found:

- A decline in ARM share of overall lending, as the interest-rate savings relative to fixed-rate loans has shrunk;
- Smaller lender discounts for introductory ARM rates;
- 3/1 and 5/1 hybrid ARMs are the mostly widely offered products among lenders.

“Disruptions in the capital markets beginning in August and an increase in delinquencies on ARM product has led to a sharp decline in interest-rate discounting and a tightening of credit underwriting on ARMs in recent months,” said Frank Nothaft, Freddie Mac vice president and chief economist. “A year ago, the initial-rate discount on the popular 3/1 and 5/1 hybrid products was about 1.8 percentage points. In our latest survey, the rate discount had virtually disappeared on these products.”

“Delinquency rates on prime ARMs have moved sharply higher over the past year, and are well above rates on prime fixed-rate loans, according to the Mortgage Bankers Association. They have reported that the serious delinquency rate on prime ARMs was 3.1 percent, compared with 0.8 percent for prime fixed-rate loans as of September 30, and with 1.1 percent on prime ARMs one year earlier,” observed Nothaft. “The Federal Reserve found in October’s Senior Loan Officer survey that 41 percent of commercial banks had tightened underwriting standards for prime mortgages during the third quarter, and 60 percent of banks offering non-traditional loans had as well. Tighter underwriting and reduced initial-rate discounts have diminished the appeal of ARMs with consumers.”

The survey, based on data collected December 17 to December 21, found that starting rates for ARMs were close to or above rates a year earlier, even though the Federal Reserve had lowered its federal funds target from 5.25% to 4.25% over the time since Freddie Mac’s previous survey. In contrast, fully-indexed rates had fallen to their lowest levels in three years, resulting in an erosion in the initial-rate discount that had been prevalent in the market during 2005 and 2006. The fully-indexed rate is the rate on the index plus the ARM margin; the margin averaged about 2.75% across ARM products in the survey, very similar to last year’s.

ARMs accounted for 17% of loan applications in October 2007, according to Freddie Mac’s Primary Mortgage Market Survey®, the lowest since June 2003 when fixed-rate loans were near a 45-year low in interest rates and refinance activity was near a peak. Since 1995, the first year that Freddie Mac collected ARM share data, the ARM share has fluctuated between an annual low of 11% in 1998 and a high of 33% in 2004. “Consumers respond to changes in the relative cost of different loan products. As ARMs became more expensive relative to fixed-rate loans during the closing months of 2007, the ARM share of lending declined,” explained Nothaft.

The initial rate on jumbo 1-year ARMs was about one-quarter of a percentage point higher than on conforming 1-year adjustables, the largest gap in seven years, according to Freddie Mac’s surveys. Jumbo loans have a loan amount that exceeds the maximum loan limit for Freddie Mac, currently $417,000 for a one-family home in the 48 contiguous states, and are not eligible for sale to Freddie Mac. The increasing relative cost for jumbo ARMs largely reflects the higher funding costs for all jumbo loans in the wake of the capital market disruptions since August.

Over the last several years, annually adjusting ARMs with an initial fixed-rate period of more than one year, known as hybrid ARMs, have grown in popularity. Within the hybrid category, ARMs with an initial fixed-rate period of five years, known as 5/1 ARMs, have been the dominant choice of consumers. The average initial interest rate on 5/1 hybrid ARMs was 6.00% in the 24th Annual ARM Survey, or about 0.5 percentage points above the rate on the traditional 1-year adjustable, and 0.1 percentage points below the rate on a 30-year fixed-rate mortgage. “A 5/1 hybrid ARM provides the consumer the comfort of knowing that the interest rate will be fixed over the first five years of the loan. However, the interest rate may jump as much as five percentage points on the fifth anniversary. Thus, the product has been popular with families who plan to have the mortgage for five years or less,” Nothaft observed. The 5/1 hybrid was also the most widely available ARM product, offered at more than 90% of lenders canvassed.

Sources: Freddie Mac, Federal Reserve Board

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