Hedging: Rise of Hybrid ARMs Poses Questions about Prepayments.(adjustable rate mortgages)(Brief Article)

In the past several years, hybrid ARMs, which are fixed for a period of three, five, seven or 10 years before resetting as a one-year adjustable-rate mortgage, have become popular with consumers who want to take advantage of a low fixed rate but don't plan to stay in a home for 30 years.

A steep yield curve, with rates at the long end significantly higher than rates on shorter-term loans, has helped push some consumers into hybrid ARM products. The hybrids are less risky than a loan that begins adjusting after one year, allowing the homeowner to take advantage of historically low-fixed rates for a period of years before the first adjustment kicks in.

But how to manage the prepayment risk on these loans? Since the product is relatively new, there isn't much of a track record on how hybrid ARMs perform. To date, lenders and investors have been relying largely on balloon loan prepayment characteristics to estimate how rate-sensitive the hybrid ARMs will be.

Recently, Andrew Davidson & Co., New York, introduced a prepayment model that incorporates the actual performance of hybrid ARMs into its projections. Andrew Davidson & Co. obtained the historical data on the performance of hybrid ARMS from CPR-CDR, a firm formed by a former Countrywide executive in California.

Previously, Andrew Davidson & Co. had relied on models of balloon prepayment behavior before the reset and one- year ARM models after the reset.

While hybrid ARMs and balloons are similar loan types, they do have differences that make a more precise prepayment model useful, according to Eknath Belbase of Andrew Davidson & Co. He said the company developed its hybrid prepayment data in response to an initial lack of information about the performance of these loans.

Balloons have a 30-year amortization schedule, but the entire loan ...