EXTRA CREDIT: Borrowers Tiptoe Back Into Exotic Mortgages

Borrowers are starting to tiptoe back into more exotic mortgages.

A flood of bad press and a collapsing housing market scared borrowers away earlier in the year, but the latest data show that may be reversing. Borrowers are beginning to show interest in mortgages that combine elements of fixed-rate and adjustable-rate mortgages known as hybrid ARMs.

Hybrid ARMs offer a fixed interest rate for a set term - usually five years - and then "reset," after which the interest rate is tied to a market-based floating rate and adjusted every six months to a year.

At current rates, loans can shave as much as 1 percentage point off a borrower's interest rate for years, potentially saving thousands of dollars.

Those savings appear to have eliminated some of the stigma that was attached to these non-conventional mortgages. According to Barclays Capital, some 10% of mortgage applications for the week ended Aug. 21 were for adjustable rate mortgages, up from a nadir of less 2.2% for week ended Dec. 26, 2008.

Adjustable rate mortgages have come under scrutiny since the collapse of the U.S. housing market because they can be attractive to shakier borrowers who want a lower payment, but who can't afford a house in the long run when the rates reset.

"I didn't sell [hybrid ARMs] to many people because a lot of them aren't savvy enough to deal with it. I didn't want to be responsible for someone getting underwater or getting put out of their home," said independent mortgage broker Daniel Bell of Richmond, Va.

However, for more financially sophisticated borrowers, these mortgages can be a sensible option.

Bell himself has a hybrid ARM mortgage. "It worked fine for me because my interest rate [now] is 4.5%."

As recently as early May, few were interested in hybrid ARMs. Rates had come down on fixed-rate 30-year mortgages so sharply that getting a hybrid ARM was actually more expensive, even in the short term.

Now that has reversed. Freddie Mac's (FRE) most recent survey shows hybrid ARMs with five years before the first reset are offered at 4.67%, while fixed-rate mortgages are at 5.14%.

The rates would be even more attractive at the lenders which specialize in the hybrid ARM business, said Art Frank, head of mortgage research at Deutsche Bank. The difference can be as much as a whole percentage point, pushing the ARM rate even closer to 4%.

Issuance of bonds backed by hybrid ARMs by government-sponsored mortgage giants Fannie Mae (FNM) and Freddie Mac has jumped as well, hitting $4 billion in July.

In August, $2.9 billion were issued, according to Barclays, and 80% were new loans. That's well below the $19 billion or $20 billion a month that were issued in the boom years, but much more than earlier this year.

Barclays analysts Derek Chen, Nicholas Strand and Wei-Ang Lee said they expect issuance to rise to $5 billion to $6 billion a month in the near future.

Investor appetite for the new hybrid ARM-backed securities has been high, thanks to their relatively high yield.

According to ARM trader Jesse Litvak of Jefferies & Co., the bonds are trading at 105 or 106 cents on the dollar - more than their principle value - and demand hasn't slackened.

The only hold-up seems to be the borrower - who is still a little shy.

(Andrew Edwards covers mortgages and distressed debt for Dow Jones Newswires and can be reached 212-416-2228 or [e-mail].)

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