Freddie Mac released its 22nd annual Adjustable Rate Mortgage (ARM) Survey last week. The study found that traditional 1-year ARMs have lost even more market share to hybrid ARMs and that lenders have continued, even increased, initial period discounts to borrowers to keep ARMs viable in the mortgage marketplace despite a flattening yield curve.

Perhaps a brief jargon translation is appropriate here, interspersed with a discussion of Freddie Mac's survey results.

The 1-year ARM is a mortgage in which the rate is set for one year and then adjusts every year thereafter, not willy-nilly, but with standards and restrictions based on indexes and margins. A hybrid ARM is one with a longer term introductory period - three, five, seven, even ten years during which the rate remains at its original level and then adjusts every year thereafter. Borrowers, particularly those who will be stretching to make payments often choose an ARM because the lower payments for the first year or first five years allow them to qualify for a mortgage.



But at present the yield curve is flat. The yield curve is the difference between the return on short term and long term interest rates. At present, economic manipulations such as the many mostly one-quarter percent adjustments the Federal Reserve has made to the Federal Funds Rate over the last months are not, for whatever reason, being reflected by or reacted to by longer term rates. The result is a decreasing difference between long term rates, say ten or 30 years, and those available to borrowers taking loans for 30, 90, or 365 days. As the difference between long term and short term rates lessen, it is said that the yield curve "flattens."

Economists state that a flattening yield curve has ramifications for the entire economy. Of most concern is the history of, what happens when the two indicators have inverted, i.e., long term rates have dropped below short term rates. Without exception since 1969 this has signaled that the financial markets expect a downturn, which would force the Fed to cut rates. Such an inversion has, with a few exceptions, been followed by a recession.

According to the Freddie Mac report, the flattening of the yield curve was clearly evident in the Treasury market over the course of 2005: The rate spread between 10-year and 1-year constant-maturity T-bill yields was 1.5 percentage points at the start of the year, yet ended the year close to zero. During periods of a flat yield curve, the initial interest savings on ARMs becomes small relative to fixed-rate mortgages. As a result, ARMs are less attractive to borrowers.

So, if a homebuyer or homeowner is given the choice between borrowing at 7 percent for a year with the possibility the rate could adjust upwards as much as two or three points at the end of that period or taking a loan at 7.35 percent with the rate locked down for a ten or a 30 year period, the choice should be obvious. The benefits of the fixed rate may, however, be mitigated by the initial loan payment which the borrower might not be able to manage at the higher fixed rate. Such borrowers were either forced out of the market or forced to scale back their home-buying or refinancing plans.

No business wants to lose a customer, so to keep adjustable rate mortgages affordable, lenders discount the initial term to keep a reasonable difference between ARMs, particularly the short term ones, and fixed rate mortgages.

"In the last half of 2000, the last time the Treasury yield curve inverted, the one-year conforming, conventional ARM rate had a discount of about 1.6 percentage points," according to Freddie Mac economist Michael Schoenbeck.. "Yet the ARM share of conventional originations was in the 15 to 20 percent range, well below the shares for much of 2004 and 2005."

Yet, through this past November, ARMs accounted for about 32 percent of loan applications in 2005, according to Freddie Mac's weekly Primary Mortgage Market Survey. Since 1995, the first year that Freddie Mac collected ARM share data, the ARM share has fluctuated between an annual low of 11 percent in 1998 and a high of 33 percent in 2004.

Compared with the 2004 ARM survey, savings on ARMs are now smaller, even with the initial rate discounts from lenders. For example, the one-year adjustable carried a rate that was 1.6 percentage points below a 30-year fixed-rate loan in the last survey, but only 0.9 percentage points lower in the current survey, reflecting the rise in short-term interest rates over the last several months.

Over the last several years, annually adjusting ARMs with an initial "fixed-rate" period of more than one year, known as "hybrid" ARMs, have grown in popularity. Within that product type, ARMs with an initial fixed-rate period of five years, known as "5/1" ARMs, have been the dominant choice of consumers. According to Freddie Mac Chief Economist Frank Nothaft, "In 2005, two-in-five ARMs were 5/1 hybrids."

The Freddie survey, based on responses from 106 ARM lenders during the period of December 19 to December 22, found that starting rates for ARMS would have increased even further where it not for greater initial rate discounts which had the effect of, at least temporarily "unflattening" the yield curve. Lenders during this period, in fact through most of the year, were typically offering a lower initial interest rate than what the fully adjusted rate would be at the time of origination. For example, a 1-year ARM with an underlying index rate of 4.37 percent and a margin (the premium added to the index rate) of 2.77 percent would have a "fully indexed rate" of 7.14 percent. Lenders are, in this example, discounting the rate by 1.92 percent, bringing the initial interest rate to 5.22 percent. These discounts drop as the initial loan period (three, five, or ten years) increase. In our example, given a 4.37 index and 2.77 margin, the discount of 1.92 percent for a one year loan would decrease to 1.04 for a 10/1 hybrid, resulting in an initial interest rate for the latter of 6.10 percent. Using Freddie Mac's Primary Mortgage Market Survey for the week ending December 22, 2005, the interest rate on conventional, conforming, 30-year FRM was 6.26 percent with average fees and points of 0.6 percentage points, or an "effective" rate of 6.39 percent.

The 5/1 ARM, with a lenders discount of 1.34 percent and an initial rate of 5.80 percent probably struck the most favorable balance between affordability and safety (for five years at least) for those who were either unable to afford payments on a 30 year fixed or did not plan to hold on to their house or their mortgage for more than five years.

In last year's survey, the discount on 1-year ARMS averaged 1.4 percentage points (conventional and Treasury indexed). This year it had increased by a half percentage point to an average of 1.9 points. The average over the last 22 years has been 1.7 percent.

The survey found that 5/1 hybrid was available at four-out-of-five lenders that offered an ARM product, but only 56 percent of the lenders that offered ARMs offer the traditional one-year ARM - the lowest share in the 22-year history of the survey.

Potential homebuyers and existing homeowners opting for a Treasury-indexed ARM amortized over 30 years with a loan amount of about $200,000 can expect initial savings (up until the first rate adjustment) over a fixed-rate mortgage of up to:

  • About $1,630 for one-year conforming ARMs;

  • Almost $990 for 3/1 ARMs;

  • About $1,110 for 3/3 ARMs (wherein the mortgage rate adjusts every three years);

  • Nearly $760 for 5/1 ARMs;

  • Around $510 for a 7/1 ARM.