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CHAPTER 5

CHAPTER 5. Adjustable Rate Mortgages. FRMs and Lender Considerations. Maturity gap Banks borrow short and lend long Lenders assume all interest rate risks in a FRM contract Unexpected change in the risk-free interest rates Inflation and real rate Uncertainty about risk premia

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CHAPTER 5

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  1. CHAPTER5 Adjustable Rate Mortgages

  2. FRMs and Lender Considerations • Maturity gap • Banks borrow short and lend long • Lenders assume all interest rate risks in a FRM contract • Unexpected change in the risk-free interest rates • Inflation and real rate • Uncertainty about risk premia • Credit spread • Liquidity premium • In high inflation environment, CPM hard to qualify due to mortgage “tilt effect”

  3. Price level adjusted mortgage • PLAM helps the lender to deal with inflation risk • Mortgage balance and payments go up at the rate of inflation • New payment computed using adjusted balance • Interest rate constant

  4. Shared Appreciation Mortgage • Lender agrees to lower mortgage rate and participates in property appreciation as a compensation • Appreciation shared upon home sales or mortgage maturity • Lender does not share depreciation • Example • 8% FRM plus 50% of the appreciation vs. • 10% FRM with no shared appreciation • Q: At 4% inflation, what are the expected yields at 10 year expected stay? • Assuming all loans are interest-only with 10 year term at 80% LTV

  5. Shared Appreciation Mortgage • Issues: • It might take years for lenders to receive compensation • Lenders are concerned about how well home will be maintained • Moral hazard problem • Tax deductibility • Treatment of Qualified Major Home Improvement (QMHI) • http://library.hsh.com/?row_id=59

  6. ARM Characteristics • Initial interest rate • Adjustment interval • Index • Margin • Composite rate • Caps and negative amortization • Floors

  7. ARM Characteristics • Initial interest rate • Sometimes called the start rate or the contract rate or interest. • If lower than prevailing rates sometimes called a teaser rate of interest • Accrual rate (to compute interest payment) might be higher than teaser rate • Payment shock • Adjustment interval • usually six months or one year

  8. ARM Characteristics Continued • Mortgage interest rates indexed to other market interest rates • 6 month, 1 year, 3 year, 5 year treasury • LIBOR • Prime rate • Weighted average cost of funds • National average of existing loans

  9. ARM Characteristics Continued • Margin - a constant spread, or premium in addition to the index • Composite rate = index + margin, sometimes called the market rate • Caps - maximum increases allowed in payments or interest rates between adjustment intervals • Payment caps; • interest rate caps; • Initial adjustment cap / annual cap / lifetime caps

  10. ARM Characteristics Continued • Negative Amortization due to payment caps • Additions to the outstanding loan balance • Q: Can interest cap create negative amortization? • Floors - maximum reductions in payments or interest rates between adjustment intervals

  11. Adjustable Rate Mortgages • Hybrid ARMs (3/1, 5/1, 7/1, and 10/1) • Longer initial reset period • Interest Only Hybrid ARM • I.O. for initial reset period • I.O. Option ARM • Borrower choice • Pay interest only • Pay interest & some principal • Pay less than interest: negative amortization • typically specifies maximum negative amortization allowed • Fully amortizing payments required in future

  12. ARMs and Interest Rate Risks • As the lender assumes less interest rate risk, the borrower assumes more interest rate risk • Lender passes fluctuation in costs of funds to the borrower • ARMs do not eliminate all interest rate risks for the lenders

  13. 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

  14. ARMs - Other Considerations Continued • Short term indices are riskier to borrowers than long term indices • Shorter adjustment periods are riskier to borrowers • Caps on payment / interest rate adjustments favor the borrower • Small floors favor the lender • Negative amortization is risky for the lender

  15. ARMs - Other Considerations • From the perspective of a lender, relative to FRMs, for ARMS: • Interest rate risk is lower • Default risk is higher • Total risk premium is (usually) lower • At time of origination, the expected yield on an ARM is usually lower than on a FRM

  16. Three ARMs: An Example • All have 30 year maturity, annual adjustment, 1 year T-bill index, 2% margin, 2 discount points • ARM1 : no caps • ARM2: 7.5% payment caps; no interest caps; negative amortization allowed • ARM3: 2% (annual) and 5% (lifetime) interest rate caps • Q: Which ARM is riskier for the lender?

  17. Example Continued • If the expected interest rates in year 2-5 are 10%, 13%, 15%, and 10%, and the three ARMs have starting interest rates of 8%, 9% and 11%, what are the payments and mortgage balances? • Q: Why is the payment in year 5 different from year 2 for the 1st ARM?

  18. Example Continued • APR for ARMs assumes that the future index rate over the life of the ARM will be the same as the index at origination. • Q: What is the APR for the 1st ARM? • Q: Can APR be lower than introductory rate for ARM? If so when? • Q: What is the effective yield/cost for the mortgages if the borrower stays 5 years?

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