Adjustable Rate Mortgages

1
Chapter 5

• Adjustable Rate Mortgages

2
Overview

• Adjustable Rate Mortgages and Lender
  Considerations
• Interest Rate Risk of Constant Payment Mortgages
• Price Level Adjusted Mortgage (PLAM)
• Adjustable Rate Mortgages (ARM)
• ARM Effective Yield

3
Adjustable Rate Mortgages and Lender
Considerations

• The need for adjustable rate mortgage instruments
• The interest rate risk of constant payment
  mortgages is tested in 1970s when inflation
  accelerated
• Thrifts (Savings and Loan Associations) borrow
  funds short-term at low rates then invest in
  long-term fixed rate mortgages (Maturity
  mismatch)
• As long as short-term rates are low, this works
  fine
• What happens if short-term rates rise
  (inflationary expectations)
• (1) Maturity mismatch will cause severe problems
• First, market value of constant payment mortgage
  portfolio will be less
• Second, prepayment rate will slow reducing
  revenues from prepayments and penalties
• (2) Tilt effect Inflation fuels future
  inflationary expectations leading to high rates
  and payments on constant payment mortgages
  Affordability problem

4
Interest Rate Risk of Constant Payment Mortgages

• An constant payment mortgage is just like a
  corporate bond its value will change depending
  on the current market interest rates
• Suppose that we own a mortgage loan with the
  following original term 100,000, 30-year, 10,
  monthly payments
• The monthly payment on this loan is 877.57
• After 5 years, the market interest rate is 12
• The remaining (outstanding) balance of the loan
  is 96,574
• What is the market value of the mortgage?

5
Price Level Adjusted Mortgage (PLAM)

• With the PLAM the lender receives the real rate
  of return as the contract rate on the loan
• The lender then receives the premium for
  inflation through an upward adjustment on the
  remaining balance of the loan
• The upward adjustment is equal to the rate of
  inflation over the previous year
• Loan payment pattern depends on the inflation

6
Price Level Adjusted Mortgage (PLAM) Continued
7
(No Transcript)
8
Price Level Adjusted Mortgage (PLAM) Continued

• Major shortcomings of the PLAM include
• A relatively complicated loan instrument for the
  average borrower
• Negative amortization that may occur if an
  individual property price fails to rise with the
  level of general inflation upon which the annual
  adjustments to the balance are made
• PLAMs may not completely solve the maturity
  mismatch problem unless financial intermediaries
  are able to issue price-level-adjusted deposits

9
Adjustable Rate Mortgages (ARM)

• ARM allows the interest rate on the loan to move
  with the market interest rate
• Ability of adjusting the interest rate shifts the
  interest rate risk to the borrower
• The lenders interest rate risk is not completely
  eliminated because interest rate adjustments
  occur in periodic intervals
• The longer the interval the greater the interest
  rate risk
• Borrowers would not assume all of the interest
  rate risk. For that reason there will be caps on
  the interest rate

10
Adjustable Rate Mortgages Continued

• A new loan payment is computed at each reset date
• Composite Rate index margin
• Index
• Interest rate that the lender does not control
• Treasury securities
• Cost Of Funds Index (COFI)
• London Interbank Offered Rate (LIBOR)
• Margin
• Premium added to the index

11
Adjustable Rate Mortgages Continued

• Expected Start Rate
• Index plus margin on loan closing date. This
  rate is lower than Fixed Rate Mortgage (FRM) rate
  since interest rate risk is lower for lender
• Actual Start Rate
• Market driven and likely to be lower than
  expected start rate
• Teaser Rate low rate to attract borrowers
• Reset Date
• When mortgage payment is readjusted
• Negative Amortization
• Payment does not cover the interest due and
  inflates the amount owed. The negative
  amortization may be allowed in the loan agreement

12
Adjustable Rate Mortgages Continued

• Limits or Caps
• Maximum increases allowed in payments, interest
  rates, maturity, and negative amortization
• Floors
• Maximum reductions allowed in payments or rates
• Assumability
• Points
• Prepayment
• Conversion
• Right of a borrower to convert ARM into FRM

13
Adjustable Rate Mortgages Continued

• 3/1, 5/1, and 7/1 Hybrid ARMs
• Longer initial reset period
• The extension of initial reset period will reduce
  the spread between ARM and FRM rates
• Example 100,000 with 6 initial rate for the
  first 3 years, monthly payments, and 30 years
• Payment per month for the first 3 years
• Balance of the loan after 3 years is 96,084
• Payment for the following year assuming a new
  rate of 6.5

14
Adjustable Rate Mortgages Continued

• Interest Only Hybrid ARM
• I.O. for initial reset period
• I.O. Option ARM
• Borrower choice
• Pay interest only
• Pay interest some principal
• Sometimes negative amortization occurs
• Fully amortizing payments required in future

15
Adjustable Rate Mortgages

• Teaser Rate
• Initial rate below market composite rate (index
  margin)
• Market Competition
• Accrual Rate The loan payments are based on
  teaser rate, however, balance of the loan
  increases by difference between market interest
  rate and teaser rate
• Negative Amortization The existence of accrual
  rate will cause negative amortization
• Payment Shock Significant increase in payment
  when there is a reset of interest rate

16
Adjustable Rate Mortgages Yield Rates

• Yields are a function of
• Initial interest rate
• Index margin
• Any points charged
• Frequency of reset date
• Any rate or payment limits

17
Adjustable Rate Mortgage Risks
18
Adjustable Rate Mortgages Yield Risks

• Default Risk
• Can borrower afford new payments?
• Impact of negative amortization
• Pricing Risk
• Allocation of interest rate risk
• Impact on default risk of specific borrowers

19
Adjustable Rate Mortgages Yield Risks

• Basic Relationships
• ARM yield is lower than FRM yield at origination
  otherwise no one would be willing to take
  interest rate risk
• Short-term vs. long-term indices short-term
  rate are more volatile than long-term rates.
  Less risk averse borrowers will prefer ARM based
  on a short-term index
• Shorter reset periods vs. Longer reset periods
  frequent rate adjustments reduce lenders
  interest rate risk
• Impact of caps floors they will reduce the
  borrowers interest rate risk by limiting the
  adjustments
• Negative amortization

20
ARM Examples
21
ARM I Payments / Balances
22
ARM I Payments / Balances Continued
23
ARM I Payments / Balances Continued
24
ARM III Payments / Balances
25
ARM III Payments / Balances Continued
26
ARM III Payments / Balances Continued
27
ARM I Effective Yield
28
ARM III Effective Yield