CHAPTER 5CHAPTER 5ADJUSTABLE RATE & VARIABLE ADJUSTABLE RATE & VARIABLE PAYMENT MORTGAGESPAYMENT MORTGAGES• MORTGAGE LENDER’S DILEMMA (1970’s)MORTGAGE LENDER’S DILEMMA (1970’s)

– RAPID INCREASES IN INFLATION (CAUSED RAPID INCREASES IN INFLATION (CAUSED “MATURITY CAP”)“MATURITY CAP”)

– INCREASED COMPETITION FOR INCREASED COMPETITION FOR DEPOSITORS’ SAVINGSDEPOSITORS’ SAVINGS

• SOLUTIONSSOLUTIONS– ALTERNATIVE MORTGAGE INVESTMENTSALTERNATIVE MORTGAGE INVESTMENTS– SALE OF FRM ORIGINATIONSSALE OF FRM ORIGINATIONS– DEREGULATION OF BANKING INDUSTRYDEREGULATION OF BANKING INDUSTRY

ADJUSTABLE RATE MORTGAGE ADJUSTABLE RATE MORTGAGE (ARM):(ARM):

• A MORTGAGE CHARACTERIZED BY A MORTGAGE CHARACTERIZED BY AN INTEREST RATE THAT CAN MOVE AN INTEREST RATE THAT CAN MOVE EITHER UP OR DOWN DEPENDING ON EITHER UP OR DOWN DEPENDING ON THE AGREED-TO INDEX.THE AGREED-TO INDEX.

• PURPOSE IS TO SHIFT INTEREST PURPOSE IS TO SHIFT INTEREST RATE RISK FROM LENDER TO RATE RISK FROM LENDER TO BORROWER.BORROWER.

ARM STRUCTURE:ARM STRUCTURE:1 ADJUSTMENT PERIOD ADJUSTMENT PERIOD - LENGTH OF TIME BEFORE - LENGTH OF TIME BEFORE

THE INTEREST RATE AND PAYMENT CAN CHANGE THE INTEREST RATE AND PAYMENT CAN CHANGE (MOST COMMON PERIODS ARE 1, 3, 5 YEARS). (MOST COMMON PERIODS ARE 1, 3, 5 YEARS). GENERALLY SHORTER ADJUSTMENT INTERVALS GENERALLY SHORTER ADJUSTMENT INTERVALS MEAN LOWER INITIAL INTEREST RATE.MEAN LOWER INITIAL INTEREST RATE.

2 INDEXINDEX - THE INDEX WILL DETERMINE THE - THE INDEX WILL DETERMINE THE INTEREST RATE AND THEREFORE THE PAYMENT. INTEREST RATE AND THEREFORE THE PAYMENT. THE INDEX IS BEYOND THE CONTROL OF THE THE INDEX IS BEYOND THE CONTROL OF THE LENDER: SIX-MONTH TREASURY BILL, ONE YEAR LENDER: SIX-MONTH TREASURY BILL, ONE YEAR CONSTANT MATURITY TREASURY, THREE/FIVE CONSTANT MATURITY TREASURY, THREE/FIVE YEAR TREASURY, FEDERAL HOME LOAN DISTRICT YEAR TREASURY, FEDERAL HOME LOAN DISTRICT BANK COST OF FUNDS, ETC.BANK COST OF FUNDS, ETC.

3 MARGINMARGIN - A CONSTANT PREMIUM ADDED TO - A CONSTANT PREMIUM ADDED TO INDEX RATE TO DETERMINE ARM INTEREST INDEX RATE TO DETERMINE ARM INTEREST RATE (i.e. INDEX RATE AND MARGIN=ARM RATE (i.e. INDEX RATE AND MARGIN=ARM INTEREST RATE OR COMPOSITE RATE)INTEREST RATE OR COMPOSITE RATE)

4 CAPSCAPS - LIMITATIONS ON INCREASES IN - LIMITATIONS ON INCREASES IN INTEREST RATES, PAYMENTS, MATURITY INTEREST RATES, PAYMENTS, MATURITY EXTENSIONS, AND NEGATIVE EXTENSIONS, AND NEGATIVE AMORTIZATION. PERIODIC CAPS SET LIMITS AMORTIZATION. PERIODIC CAPS SET LIMITS FROM ONE ADJUSTMENT PERIOD TO FROM ONE ADJUSTMENT PERIOD TO ANOTHER. LIFE-TIME CAPS LIMIT ANOTHER. LIFE-TIME CAPS LIMIT INCREASES OVER LIFE OF LOAN. FLOORS INCREASES OVER LIFE OF LOAN. FLOORS SET MAXIMUM REDUCTIONSSET MAXIMUM REDUCTIONS

5 NEGATIVE AMORTIZATION NEGATIVE AMORTIZATION - OCCURS WHEN - OCCURS WHEN PAYMENT CAPS ARE USED + PAYMENT PAYMENT CAPS ARE USED + PAYMENT CANNOT INCREASE ENOUGH TO PAY ALL CANNOT INCREASE ENOUGH TO PAY ALL THE INTEREST DUE ON THE MORTGAGE, THE INTEREST DUE ON THE MORTGAGE, THUS THE OUTSTANDING BALANCE THUS THE OUTSTANDING BALANCE INCREASES. INCREASES.

6 DISCOUNTSDISCOUNTS (“TEASER RATES”) - LOWERED (“TEASER RATES”) - LOWERED INITIAL INTEREST RATE (AND THUS PAYMENT INITIAL INTEREST RATE (AND THUS PAYMENT RATE) FROM THAT CALLED FOR BY ADDING RATE) FROM THAT CALLED FOR BY ADDING TO TOGETHER THE INDEX+MARGIN.TO TOGETHER THE INDEX+MARGIN.

7 SPREADSPREAD - DIFFERENCE BETWEEN RATES ARM - DIFFERENCE BETWEEN RATES ARM + FRM ARE INITIALLY OFFERED (USUALLY + FRM ARE INITIALLY OFFERED (USUALLY 200-300 BASIS POINTS)200-300 BASIS POINTS)

REGULATION Z (TRUTH IN-REGULATION Z (TRUTH IN-LENDING) REQUIRES DISCLOSURE LENDING) REQUIRES DISCLOSURE OF:OF:• INTEREST RATE CEILINGINTEREST RATE CEILING

• BOOKLET EXPLAINING ARMSBOOKLET EXPLAINING ARMS

• 15 YEAR HISTORICAL EXAMPLE OF 15 YEAR HISTORICAL EXAMPLE OF HOW RATES WOULD HAVE CHANGEDHOW RATES WOULD HAVE CHANGED

• WORST-CASE EXAMPLESWORST-CASE EXAMPLES

PROBLEMS WITH ARMS:PROBLEMS WITH ARMS:1MORE COMPLEX AND DIFFICULT TO MORE COMPLEX AND DIFFICULT TO

UNDERSTANDUNDERSTAND

2BUDGET UNCERTAINTY FOR BORROWERSBUDGET UNCERTAINTY FOR BORROWERS

3 INCREASED DEFAULT RISKINCREASED DEFAULT RISK

4DON’T NECESSARILY ELIMINATE DON’T NECESSARILY ELIMINATE INTEREST RATE RISK TO LENDER IF INTEREST RATE RISK TO LENDER IF WRONG INDEX IS CHOSEN, MARGINS ARE WRONG INDEX IS CHOSEN, MARGINS ARE TOO SMALL, CEILING TOO LOW, ETC.TOO SMALL, CEILING TOO LOW, ETC.

· see text p. 145 (Exhibit 5-5)see text p. 145 (Exhibit 5-5)

YIELD/RISK RELATIONSHIPS:YIELD/RISK RELATIONSHIPS:• ARM “EXPECTED” YIELD SHOULD BE LESS THAN ARM “EXPECTED” YIELD SHOULD BE LESS THAN

“EXPECTED” YIELD OF FRM DUE TO INTEREST RATE “EXPECTED” YIELD OF FRM DUE TO INTEREST RATE SHIFT.SHIFT.

• ARMS TIED TO SHORT-TERM INDEXES ARE RISKIER TO ARMS TIED TO SHORT-TERM INDEXES ARE RISKIER TO BORROWER - SHORT-TERM RATES ARE MORE BORROWER - SHORT-TERM RATES ARE MORE VIOLATIBLE.VIOLATIBLE.

• SHORTER ADJUSTMENT PERIODS ARE RISKIER FOR SHORTER ADJUSTMENT PERIODS ARE RISKIER FOR BORROWERBORROWER

• INTEREST RATE CAPS LOWER BORROWER INTEREST INTEREST RATE CAPS LOWER BORROWER INTEREST RATE RISK.RATE RISK.

• PAYMENT CAPS THAT CAUSE NEGATIVE AMORTIZATION PAYMENT CAPS THAT CAUSE NEGATIVE AMORTIZATION DON’T REDUCE BORROWER INTEREST RATE RISK.DON’T REDUCE BORROWER INTEREST RATE RISK.

BI-WEEKLY MORTGAGES:BI-WEEKLY MORTGAGES:

Example: Assume a $100,000 Example: Assume a $100,000 mortgage at 8% for 30 years.mortgage at 8% for 30 years.

Loan ProductLoan Product Periodic Payment Periodic Payment Term Term

• 30-year, monthly pmt $733.7730-year, monthly pmt $733.77 360 360 monthsmonths

• Biweekly paymentBiweekly payment $366.89 $366.89 272 272 monthsmonths

Interest saved with biweekly mortgage = Interest saved with biweekly mortgage = $46,300.86$46,300.86

CONVERTIBLE MORTGAGES - CONVERTIBLE MORTGAGES - ARM THAT IS CONVERTIBLE INTO ARM THAT IS CONVERTIBLE INTO FRM AT BORROWER’S OPTIONFRM AT BORROWER’S OPTION• USUALLY CONVERSION ALLOWED USUALLY CONVERSION ALLOWED

BETWEEN 13th MONTH AND 60th MONTH.BETWEEN 13th MONTH AND 60th MONTH.

• CONVERSION FEE IS MUCH LOWER THAN CONVERSION FEE IS MUCH LOWER THAN COST TO REFINANCE.COST TO REFINANCE.

• CONVERTIBLE ARMS USUALLY HAVE CONVERTIBLE ARMS USUALLY HAVE INTEREST RATES 25-50 BASIS POINTS INTEREST RATES 25-50 BASIS POINTS ABOVE NORMAL ARMS.ABOVE NORMAL ARMS.

SHARED APPRECIATION SHARED APPRECIATION MORTGAGES:MORTGAGES:

•LOWER INTEREST RATE FOR LOWER INTEREST RATE FOR EQUITY INTEREST IN PROPERTY.EQUITY INTEREST IN PROPERTY.