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: it’s 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 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? NI/YP/YPVPMTFV ,

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

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8 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 lender’s 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% NI/YP/YPVPMTFV , NI/YP/YPVPMTFV ,

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 lender’s interest rate risk Impact of caps & floors – they will reduce the borrower’s 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