Fewer ARM bond issues likely

Private issuance of securities backed by option adjustable-rate mortgages should fall this quarter after exceeding last year’s pace in the first three quarters of 2006, RBS Greenwich Capital said in a report Monday.

Option ARMs typically allow borrowers to pay less than the interest due each month, with the difference tacked on to their mortgage balances. Issuance this quarter of bonds backed by such loans should fall near a point that would bring the full-year total in line with last year’s $148 billion, Desmond Macauley, a RBS Greenwich managing director, wrote in the report.

Such loans made up 15% of mortgage originations in the first half of this year, up from 8% in the second half of last year, according to data from a Mortgage Bankers Assn. survey released Monday. The increased popularity of option ARMs in the last three years amid record home-price appreciation raised concerns among some investors and regulators about whether lenders were capable of handling the extra risk.

Private, or nonagency, issuance of bonds backed by option ARMs may be trimmed this quarter by lower cash-out refinancing amid slower home price appreciation, fewer home purchases and the appeal of fixed-rate loans, Macauley wrote. His full-year estimate would mean a decline in issuance to $23 billion in the fourth quarter, a 45% drop from the same period in 2005 and a 47% drop from last quarter.

Regulators last month issued guidance to federal banks calling for tighter underwriting and better consumer disclosures on nontraditional loans.

The new guidance, which recommends that lenders offer more information about the terms of nontraditional loans and tighten underwriting standards, will modestly cut into option ARM originations, Macauley wrote. Higher qualification standards may also slow prepayments as they may hinder borrowers “attempting to refinance into another option ARM loan,” he said.

Washington Mutual Inc., the largest U.S. savings and loan, and Countrywide Financial Corp., the largest U.S. mortgage lender, originated fewer option ARM loans in the third quarter, Macauley noted. Washington Mutual’s production of the loans was down 25% from a year earlier at $12 billion, and Countrywide’s origination dropped 49% to $15 billion.

Fannie Mae and Freddie Mac, the two largest U.S. mortgage finance companies, purchase and securitize option ARMs. The fact that they have not kept up with the loans’ popularity is cited as one cause of their loss of market share in recent years. The two government-chartered companies are referred to as agencies.