Freddie Mac on Tuesday released the results of its 20th annual adjustable-rate mortgage survey, which found that as interest rates on fixed-rate mortgages fell to generational lows, adjustable-rate mortgages have evolved to fit the needs of lenders, borrowers and the capital markets.

“This year marks a milestone for Freddie Mac’s annual ARM survey,” said Frank Nothaft, Freddie Mac chief economist. “In 1984, Freddie Mac debuted the annual ARM survey in conjunction with its primary mortgage market survey. The survey supports what savvy homeowners have known for some time: relative to traditional 30-year FRMs, ARMs provide a viable and affordable home-financing tool, although that comes with additional uncertainty regarding the amount of future mortgage payments.”

Modern ARMs first gained popularity across the U.S. in the early 1980s. At the time, interest rates for fixed-rate mortgages climbed well into the teens, and by 1982 ARMs were already accounting for 41 percent of conventional originations. By mid-2003, the Federal Reserve Board’s policy committee had cut the federal funds target to 1 percent, the lowest federal funds rate in 45 years. As a result, mortgage rates for both FRMs and ARMs fell dramatically and have remained low. And since short-term Treasury yields are not far from the 1 percent mark, lender compensation for annually adjusting ARM loans are constrained by periodic interest-rate caps that average 2 percent (or less for FHA loans), creating asymmetric risk.

Given the uncertainty of future short-term interest rates and consumer desire for less frequent payment adjustments, “hybrid” ARMs have become more popular over the past decade and now account for the bulk of ARM originations. Hybrid ARMs have an extended initial fixed-rate period of between three and 10 years, and then switch to an annually adjusting ARM. Both lenders and consumers also changed their preferences to one-year ARMs benchmarked to the London Inter-Bank Offering Rate (LIBOR). Based on unpublished data from Freddie Mac’s PMMS, nearly half of ARM lenders offered one-year LIBOR-indexed loans.

“Not only were conforming one-year ARMs less popular,” noted Nothaft, “but jumbo one-year ARMs and FHA ARMs also experienced a decline in the share of lenders offering the product. Instead, hybrid ARMs were the prominent alternative to FRMs. Allowing for a longer period before the first rate-adjustment, hybrid ARMs still are cost effective, especially to homeowners who plan to move or refinance in the next few years.” In addition, the margins between one-year ARMs and hybrid ARMs are nearly indistinguishable, meaning that when rate-adjustments take hold, the interest rate difference between the two works out to be about the same (assuming Treasury rates don’t significantly change over the extended period).

By early 2004, rate discounts from the initial fully indexed rate (that is, the value of the index plus the margin) on one-year ARMs had once more appeared. Typically, lenders offer reduced initial interest rates below fully indexed rates in order to “entice” loan applicants into choosing ARMs. In the last couple of years, this discount had been absent in the market as the prospect of Fed easing increased the likelihood of future rate declines. But with a growing number of economists forecasting a rise in interest rates by the end of the year, the downside risks seem to be limited for shorter-term adjustment periods. Longer-term adjustment periods, however, still carry premiums over their corresponding indexed rates.

Freddie Mac purchases mortgages from lenders and packages them into securities that are sold to investors.

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