With prepayment levels soaring, real estate investment trusts that invest in adjustable-rate mortgages must either diversify or leave the business.

"The companies that get their assets primarily in the secondary market are in a difficult position," said Tom Maier, managing director at Everen Securities.

Investors have found the supply of ARMs dramatically reduced from that of a year ago, affecting pricing and availability, Mr. Maier said.

Mortgage REITs must "develop asset sources that are closer to the borrower" or must wait for the yield curve to steepen, Mr. Maier said. Some, including Thornburg Mortgage Asset Corp., have developed an origination business to tap into refinancings, he added.

"Stable interest rates would eventually slow prepayments, and a rise in rates would slow them a lot," said Gary Gordon, a securities analyst at PaineWebber Inc. "A fall in rates would keep them stable."

A borrower with an adjustable-rate mortgage is typically "a short-term, price-sensitive customer," he said.

REITs are looking into hybrids-loans that have little or no premium but require the lender to take on rate risk, Mr. Gordon said. But mortgage REITS can buy only short-term securities because Wall Street lends based on short-duration debt, using existing loans as collateral.

Redwood Trust Inc. stopped buying ARMs in mid-1997-for the most part because of prepayment risk-and started buying hybrid mortgages that are fixed for five to seven years and then become adjustable, said Doug Hansen, Redwood president.

Thornburg has bought a lot of ARMs at premiums to par and continues to buy them at lower prices, paying smaller premiums. It also has bought a small amount of fixed-rate loans, but Mr. Gordon said Thornburg is sticking mostly with ARMs and trying to buy seasoned loans to borrowers who have opted not to refinance.

Other mortgage REITs are buying 15-year loans and other fixed-rate mortgages of two to five years.

"Whatever they do, there's always a rate environment where they can get hurt," Mr. Gordon said. "There's no way they can find something that's bulletproof." REITs have to find a way to diversify from adjustable-rate loans, he said.

Adjustables have become "a marginal product in the long run," he added, because a borrower can get "a noticeably cheaper loan with much less risk" at a fixed rate.

"It's not just the home mortgage REIT that is suffering," Mr. Gordon said. "The thrifts will also suffer from the problems with the ARM loan."

Thrifts will have "trouble" maintaining their current sizes and expanding their portfolios, he said, but they can sell out and must do something if adjustable-rate loans "stay out of favor."

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