Pipeline: Even Insiders Amazed by New ARM Tales

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Borrowers have radically altered the mortgage market by increasingly jumping from fixed-rate loans into a growing menu of adjustable-rate alternatives.

According to one analyst, many of the borrowers moving into ARMs that allow for negative amortization - a product whose growth is an especially hot topic - are doing so to take cash out.

The "cannibalization of the fixed-rate sector by the adjustable-rate sector" left nearly a third of mortgage debt outstanding in ARMs at yearend, said Dale Westhoff, the senior managing director for mortgage research at Bear Stearns Cos.

At a packed conference on ARMs in New York this week organized by the investment bank, speakers said the current risk-layering on ARMs was worrisome. Many said recent innovations like hybrid and option ARMs are here to stay and pointed to the intense competition for ARM assets - though some said a flattening yield curve could reverse the trend of fixed-to-floating refis.

Even borrowers with rates fixed well below market have been prepaying their loans faster than expected by switching into ARMs, Mr. Westhoff said.

The next step, he joked, would be 0% interest-only loans. "I think a lot of borrowers could qualify for this payment - because it's zero."

Glenn Costello of Fitch Inc. struck a similar note, saying that zero-payment offers may already be out there and joking that paying borrowers to take out loans was the next frontier.

It was V.S. Srinivasan, a Bear Stearns senior managing director, who noted the cash-out trend. About 37% of last year's short-reset prime jumbo ARMs were cash-outs, compared with 18% for fixed-rate loans and 15% for hybrids, he said. And within short-term ARMs, so-called MTA loans (negative amortization loans tied to the 12-month Treasury average index) are even more likely to be used to take cash out.

About 30% of the ARMs tied to the London interbank offered rate - few of which offer negative amortization - were for that purpose, while 46% of the MTA ARMs had higher balances than the loans they replaced.

Mr. Srinivasan attributed the trend to borrowers' desire to "tap the equity in their homes and not necessarily increase their monthly payment." Even with the cash-out feature, however, the loan-to-value ratios on these mortgages tend to be fairly low, he said.

Daniel S. Choquette, a senior vice president at Putnam Investments, said it bothered him that "innovations" like interest-only and negative amortization loans are "bastardizing the mortgage market."

"My sense is someone will have serious issues with these investments," he said.

Mr. Westhoff warned that if subprime interest-only hybrids perform poorly, other securitization areas may suffer. The subprime sector "could sneeze and the rest of the market could catch a cold," he said.

The "weakest borrowers are holding the riskiest mortgages," Mr. Westhoff said. Meanwhile, a "consensus" is forming about regional home-price bubbles, he said.

Payment Plans

How often borrowers will take advantage of the negative amortization options amid rising short-term rates is a fiercely debated question.

At Golden West Financial Corp., the product's granddaddy, the amount of negative amortization has been picking up.

In the first quarter, $35 million, or 5%, of Golden West's net interest income was from deferred interest, according to a securities filing by the Oakland thrift holding company. In the previous nine months the amount of loan growth attributed to negative amortization was only $32 million.

If the lagging indexes the loans are pegged to keep rising, Golden West said, it would expect the negative amortization to "trend higher … absent other mitigating factors."

At the conference, Mr. Costello said that though consumers have generally chosen to exercise the negative amortization option 20% to 40% of the time in recent years, in periods of rapidly rising rates that range has been 50% to 75%.

When rates stabilized, those borrowers did not necessarily return to making amortizing payments. "That risk is real," Mr. Costello said.

Thomas McDonagh, the chief investment officer at American Home Mortgage Investment Corp., said, "We find that only two or three times a year are borrowers using the neg-am feature." Christmas is one of those times, he said, though he earlier acknowledged it is "tough to understand" what borrowers will choose to do.

The Melville, N.Y, real estate investment trust requires borrowers to buy mortgage insurance on high-leverage loans, which it supplements with pool insurance, Mr. McDonagh said. Still, he said the option ARM has gotten "a bum rap."

Frederick Cannon, an analyst with Keefe, Bruyette & Woods Inc., said in an interview that increasing competition is leading lenders to allow a higher degree of monthly negative amortization rather than cut rates.

They do so by failing to raise the teaser rates that minimum payments are tied to amid the Fed hikes, he said. "Is pricing becoming irrational? In my view it's becoming irrational, and it's becoming irrational in such a weird way," said Mr. Cannon, who noted the negative amortization at Golden West in a recent report.

Of course, until the loans default, negative amortization provides asset growth, as well as steady interest income, he noted. "From an accounting standpoint it's a wonderful product."

David J. Bishop, an analyst at Legg Mason Wood Walker Inc. who initiated coverage of Golden West with a "hold" rating on Tuesday, said that rising investor and regulatory concerns about option ARMs could hurt the lender's share price.

Don Powell, the chairman of the Federal Deposit Insurance Corp., said in an appearance Monday on CNBC: "I think it's not good and not solid advice for an individual to take out a mortgage with a possibility of owing more five years from now than what the original mortgage was. ... That's not good business."

Mr. Bishop wrote that though competition may hurt margins, Golden West's "underwriting standards will shield it from losses that materially impact earnings growth."

Risk Rethink

Two rating agency officials at the conference questioned two oft-cited sources of comfort.

Pramila Gupta of Moody's Investors Service acknowledged that average FICO scores in securitizations have remained high, but said she was uncomfortable with giving risky loans to borrowers based just on the scores.

Borrowers who have "established a payment history" in the low-delinquency environment of recent years could have inflated scores, Ms. Gupta said. The FICO score "may or may not be representative of their payment ability."

Mr. Costello suggested that those who dismiss a wider threat posed by the regional housing bubbles are underestimating the problem. "I wouldn't describe southern California as little," he said. Fitch stress-tests triple-A subordination levels for loans in Orange County with more than 60% home-price declines, he said.

According to Bear Stearns, 43% to 55% of the collateral for nearly all types of non-agency prime and near-prime hybrid ARM securities issued last year was in California. n

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