Re-ARMing the mortgage market.

Author:England, Robert Stowe

As interest rates rise, more borrowers are choosing to go with an adjustable-rate mortgage (ARM) instead of a 30-year fixed-rate mortgage (FRM)--the loan product that has reined supreme for more than five years. [paragraph] Banks, thrifts and other mortgage originators have responded to this interest from borrowers by offering a growing array of ARMs to meet various segments of the market. At the same time they are keeping a fairly tight lid on underwriting standards as they negotiate the inexplicably complex thicket of regulations that offer several sets of different rules for lenders to use to qualify borrowers for ARMs. [paragraph] "Adjustable-rate mortgages are alive and well," says Brad Blackwell, executive vice president and portfolio business manager with Wells Fargo Home Mortgage, Des Moines, Iowa. In this cycle, as opposed to a decade a go, the appetite for risk by borrowers is much lower. Thus, the extent of the move into ARMs is tempered and borrowers still overwhelmingly favor the 30-year fixed-rate mortgage. [paragraph] PNC Mortgage, Downers Grove, Illinois, is also seeing a shift in favor of ARMs. "If you look at conventional, conforming space, what we've seen over the past few years is anywhere from 3 percent to 5 percent of the business coming in the ARM space, and what I'm starting to see is a small uptick in the market, going from 5 percent to 7 percent," says Peter Boomer, executive vice president at PNC Mortgage.

"Where you're really seeing the shift is in the jumbo mortgages with balances over $417,000," he adds. "While business was about 10 percent to 12 percent in recent years, I'm now seeing that move to the 20 percent to 25 percent ARM," he adds.

Hybrid ARMs are hot

One development attracting consumer interest in ARMs has been the ability of lenders to better tailor loans to borrower preferences. To lock in lower payments longer, borrowers are favoring "longer initial fixed-rate periods than you might have seen 10 years ago," says Blackwell. Borrowers like best the 7/1 and 10/1 hybrid ARMs with the 5/1 ARM following closely behind, Blackwell reports.

PNC's Boomer is also seeing borrowers favor the 7/1 and 10/1 hybrid ARMs--and he sees growing interest in interest-only (IO) ARMs.

"Everybody is poised for a very robust spring market here," Boomer says. PNC Mortgage, which originates loans in all 50 states, was originally concentrated in the Northeast, but has built "a rather extensive mortgage franchise" in California, Washington and Texas, according to Boomer. PNC has more than 25 mortgage offices in California.

Lenders have also taken other steps to limit payment shock when the loan first adjusts. For example, Wells Fargo Home Mortgage has reduced the maximum size of upward interest-rate adjustment that can occur in the first year the loan payment adjusts. In the past, ARMs typically had a 5 percent maximum first adjustment, 2 percent annual cap and 5 percent lifetime cap.

A 5/1 ARM, for example, that began at 3.5 percent could rise to 8.5 percent in the sixth year "if interest rates went up that much in the first five years," says Blackwell. "We thought that was far too risky for the customer. And we've put a 2 percent cap on first adjustment as well," he adds. With this approach, the most the 3.5 percent mortgage can rise to in the sixth year would be 5.5 percent.

The current level of interest in ARMs is a bit of an about-face. Borrower interest in ARMs declined from 2009 through 2011, based on call-report data from bank and thrift portfolio lenders, according to Inside Mortgage Finance.

However, starting in 2012, bank and thrift holdings of ARMs began to rise. In the fourth quarter of 2013, banks and thrifts held $647.42 billion in ARMs on their books. This represented 37.1 percent of the total mortgage portfolio of $1,743 trillion for all banks and thrifts. By comparison, at year-end 2011 the share was lower at 31.9 percent.

The largest ARM producer in 2013 was Wells Fargo Home Mortgage, with $35.28 billion in production, according to Inside Mortgage Finance.

The next four largest ARM originators last year were Chase Home Finance, Edison, New Jersey ($27.06 billion); PHH Mortgage, Mount Laurel, New Jersey ($19.85 billion); Bank of America Home Loans, Calabasas, California ($13.30 billion); and Citi Mortgage, O'Fallon, Missouri ($10.53 billion).

Conventional, conforming ARMs

Frank Nothaft, chief economist at Freddie Mac, is forecasting that the ARM share of conforming originations in the conventional, conforming single-family market will rise to 12 percent this year, up from last year's 9 percent.

"That may be low compared to where it was 15 to 20 years ago, but it is a pretty hefty increase in the share of the market compared to 2013," Nothaft says.

The Federal Reserve Board's Federal Open Market Committee (FOMC) appears to be in agreement on gradually tapering the Fed's monthly purchases of Treasuries and agency mortgage-backed securities (MBS) steadily in the coming months and ending them entirely this fall. This tapering will, along the way, push up interest rates on 30-year fixed-rate mortgages by "as much as a half a percentage point over the course of 2014," Nothaft says.

At the same time, the Fed has made it clear it intends to keep its short-term Federal Funds Rate between 0 percent and 0.25 percent for the rest of the year.

Federal Reserve Chair Janet Yellen, in her debut press conference in March, when pressed on when short-term rates might be raised after tapering concludes, indicated that she expected that could occur six months after that, which market observers suggest would put the rate rise in the spring of 2015. In a subsequent speech in Chicago, she indicated that the subpar U.S. job market would require the Fed to keep rates low "for some time." Based on that outlook, Nothaft is forecasting the market share for ARMs to rise further next year to 15 percent of all conventional, conforming originations.

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