ARMs and HELOCS Could Run Off

The recent dip in long-term interest rates has loan originators revving up their engines, but the new portfolio churning may look different than the refinancing of recent years.

This time, recently originated adjustable-rate mortgage loans and home-equity products may be the ones running off lenders' balance sheets.

The borrowers who are the most likely candidates for refinancing in today's market are people with adjustable-rate loans or high-cost second-lien debt, said Frank Nothaft, chief economist at Freddie Mac.

Home-equity lines of credit, he noted, are typically adjustable and are priced off of the prime rate, typically around three percentage points above prime for high-credit-quality borrowers.

That means many home-equity loans and HELOCs today carry interest rates that are higher than the prevailing rate on 30-year, fixed-rate loans, which hit a 14-month low of 5.56 in the week of June 9.

That could lead some home-equity borrowers to consolidate debt by refinancing their first mortgage in a cash out transaction and rolling their home-equity debt into the first-lien loan. Freddie Mac's quarterly survey of refinancing has already shown an increase in cash out transactions as borrowers consolidate debt or tap into their equity for other purposes, such as home improvements.

If you are a homeowner and you have a home-equity loan or a HELOC, the rate has gone up a lot. And it's probably going to go up another half a point before the summer is out, Mr. Nothaft said.

He anticipates that the Federal Reserve Board will continue raising short-term interest rates at its late June and August meetings.

Like other housing finance experts, the economists at Freddie Mac have increased their forecast for both total mortgage lending and the refinancing share of loan volume in response to the decline in long-term interest rates. Freddie Mac now expects loan origination volume to total about $2.5 trillion this year, a decline of just 8% from last year, with 40% of the total coming from refinancing.

Mr. Nothaft does not believe the good times for loan originators are going to last forever, though.

I do think the decline in mortgage rates we have now is temporary, and we'll see it gradually reverse over the next six months.

He expects the average 30-year FRM rate to end the year at about 6%.

While mortgage rates hit a 45-year low in June of 2003, he noted that the average for all of 2003 was 5.8%. That was also the average for all of 2004 and for the first quarter of 2005, meaning homeowners who wanted to refinance to reduce their rate have had plenty of chance to do so.

Even though rates have gone up and down, we have had a relatively long period when 30-year mortgages have been relatively low and relatively stable.

The Mortgage Bankers Association has also adjusted its forecast of mortgage activity this year to take into account the recent slide in long-term rates. MBA chief economist Doug Duncan said that with the 10-year Treasury hovering around 3.9% in early June, that was a potential tipping point that could spark renewed refinancing. In fact, he said it was possible that refinancing as a share of loan origination would edge up past the 50% mark again.

If it stays down at the 3.9% range, that's sort of a breakpoint where hedgers have to be worried about convexity, he said. At a spread of 150 basis points, it suggests a 30-year mortgage rate of 5.4% is possible.

He also said that this could prompt borrowers with adjustable and hybrid loans to jump into a long-term fixed-rate product.

There are some of these folks that have different kinds of ARMs who are going to say, 'We didn't expect to see rates this low again, but now they are here.'

Mr. Duncan's forecast also calls for the 30-year FRM rate to edge up to about 6% by the end of the year. He expects total mortgage volume to fall just short of $2.6 trillion, with about 40% going to refinancing this year.

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