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The Rise of ARMs

The Mortgage Bankers Association released some stunning data in early May that may have ominous implications for mortgage servicers. Adjustable-rate mortgages and interest-only products accounted for 63% of mortgage originations in the second half of 2004. After years of predominantly fixed-rate lending - much of it refinancing - the rise of the ARM and IO market likely will be a big factor in the performance of residential mortgage loans going forward.

The MBA survey found that refinancing slipped in the second half of last year, with home purchase lending accounting for 51% of loans in the second half, compared to 41% in the first half.

The MBA's chief economist noted that the shift to ARMs is nothing new when long-term interest rates start rising. In fact, it happens at the end of every refinancing boom, he said. But the MBA also noted that the shift to ARMs was sparked by a much smaller rate increase than would typically have been expected based on previous experience.

That, and the rise of IO lending, suggest that consumers are choosing loan products that minimize the monthly payments, especially in the early years of a loan, in order to stretch their buying capacity. This isn't surprising, given the run-up in home prices in many of the nation's most popular housing markets, especially on the East and West Coasts. A lower monthly payment helps homebuyers afford more house, and for people trying to enter the market in such high-cost areas as California, New England and the mid-Atlantic, IO and ARM loan products help to ease the sticker shock by keeping monthly payments down.

But traditionally, delinquencies and defaults on ARMs have been much higher than on fixed-rate loans. And while the IO market is relatively new, it is also anticipated that defaults on these loans will exceed defaults on fixed-rate products.

As the shift of products being originated changes, lenders will have to be prepared for the loan administration challenges likely to accompany the rise of hybrid loans, ARMs and IO products. So far, the MBA's quarterly delinquency survey has not shown much of an impact from these trends, but as the loans season, lenders will begin to get a feel for what impact the IO and ARM market are having on their portfolios.

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