McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved CHAPTER5CHAPTER5 CHAPTER5CHAPTER5 Adjustable Rate Mortgages

5-2 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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”

5-3 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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

5-4 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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

5-5 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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)

5-6 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved ARM Characteristics Initial interest rate Adjustment interval Index Margin Composite rate Caps and negative amortization Floors

5-7 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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

5-8 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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 ARM Characteristics Continued

5-9 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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

5-10 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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

5-11 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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

5-12 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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

5-13 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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

5-14 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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

5-15 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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

5-16 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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?

5-17 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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 1 st ARM?

5-18 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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 1 st 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?