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Article Excerpt
We extend previous research on traditional one-year adjustable-rate mortgages (ARMs) by analyzing the performance of 3/27 hybrid instruments. Under this contract innovation, which first appeared in the mid-1990s, note rates are fixed for three years after which they convert to a traditional one-year adjustment schedule with periodic and lifetime caps. We find high rates of prepayment, particularly at time of initial rate adjustment, and relatively high rates of default, as would be consistent with the payment shock that often affects adjustable-rate loans.
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The U.S. mortgage market continues to evolve, with contract innovations to adapt to economic and business conditions. Adjustable-rate mortgages (ARMs) first appeared after the financial deregulation of 1980, prompted by the inflationary environment of the late 1970s. Today, ARMs are a popular mortgage alternative for many households, especially those requiring larger loan amounts to finance higher priced housing. (1) The ARM share is much higher in the jumbo market compared to the conforming loan segment, reaching as high as 72% of total originations during 1994 and 2000, which are both years with relatively higher rate levels (Nothaft 2003). The relative share of ARMs appears to rise in periods of rising interest rates, as consumers are attracted to the lower initial interest rates relative to fixed-rate mortgages (FRMs). For example, in 1994 during a period of rising market interest rates, ARMs accounted for 39% of all mortgage originations (Mortgage Bankers Association 2004).
Another stylized fact about the ARM product is that it appears to be the preferred instrument for portfolio lenders, because it avoids much of the interest rate risk associated with long-term FRMs. As a result, a much smaller fraction of ARM volume is securitized. Ambrose and LaCour-Little (2001) report that, as of 1999, only about $138 billion in ARM-backed securities were outstanding, as compared to about $1,776 billion in FRM-backed securities. Because ARM loans are mainly held in the portfolios of depository institutions, they can be funded with relatively low-cost liabilities, eliminating asset--liability mismatch during their initial fixed-rate period.
This cost advantage allows lenders to offer lower rates to borrowers who accept a limited horizon for payment stability, either because they do not expect to live in the house for an extended period or because they are comfortable with future interest rate risk. As an example of the rate differential, as of July 30, 2004, the spread between the 30-year FRM rate and a 3/27 ARM rate was 132 basis points (HSH Associates 2004). As an example of balance sheet patterns, as of year-end 2002, Washington Mutual (the nation's largest thrift) reported $111 billion in single-family residential mortgages at a weighted average coupon of 5.97% (a rate suggestive of a high percentage ARMs, though not specifically broken out by financial reporting). Concurrently, their balance sheet showed $106 billion in interest-bearing deposits at an average rate of 2.50%, implying a net interest margin of 347 basis points on that mortgage portfolio.
While ARMs have received significant theoretical and empirical research attention, (2) relatively little attention has focused on one of the latest product innovations: the hybrid mortgage contract that contains features of both traditional fixed- and adjustable-rate instruments. (3) This study addresses that research gap by examining the performance on a set of 3/27 ARMs originated during the mid-1990s across the United States for a major lender's portfolio.
To briefly summarize the loan features, the 3/27 ARM is a common hybrid mortgage that provides borrowers with an FRM for three years following origination, after which it converts to a traditional one-year ARM, indexed to the one-year Treasury note, for the remaining 27 years of amortization. Interest rate adjustments are capped at 2% at first and subsequent adjustments, and there is a lifetime cap of 5% over the initial rate. Other hybrid ARM structures include fixed periods of 5, 7 or 10 years, effectively allowing the borrower a menu of terms over which she may fix initial loan payments. In contrast, under a traditional one-year ARM, the borrower faces a potential payment shock after only 12 months as the contract rate is adjusted to market. (4) Of course, the 3/27 design also exposes the borrower to interest-rate risk, though at a later date. After its introduction in the mid-1990s, the hybrid mortgages gained increasing acceptance, first in the nonconforming, then the conforming and then, most recently, the government segment of the market. (5) Interest rate adjustments are capped at 2% at first and subsequent adjustments, and there is a lifetime cap of 5% over the initial rate.
As with traditional FRMs and ARMs, hybrid ARMs contain the usual explicit and implicit options for the borrower to terminate the mortgage through either prepayment or default. The theoretical and empirical literature on mortgage prepayment and default (both for fixed-rate as well as adjustable-rate instruments) is now well developed so we do not belabor it here. Rather, we simply extend the empirical literature by addressing hybrid ARM performance in general and the effect of the adjustment period in particular.
Data
Our data consist of 2,192 hybrid mortgages originated during 1995 and 1996 by a large national financial institution for portfolio, with performance observed through June 2000. Hence, the data contain loans that are seasoned between...
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