Variable Rate

In recent years, mortgage lenders have been discouraging borrowers from taking out conventional fixed-rate mortgages in favor of adjustable rate mortgages, known colloquially as ARMs. There are many variants of ARMs but they all share one common characteristic-the mortgage rate may change in response to changing market conditions. To persuade borrowers to take these mortgages, the originating institution often provides an artificially low mortgage rate for the first year or so. This initial low rate is aptly described as a teaser rate. Following the Period in which the rate is artificially held below market, the rate adjusts to a market level. Thereafter the rate periodically adjusts to keep pace with market conditions. Such mortgages often have caps on each rate revision as well as lifetime- caps. These caps are intended to protect the mortgagor from excessive changes in mortgage rates.

ARMs are themselves a product of financial engineering but the engineering did not stop with adjustable rates. Indeed, financial engineers have been active in the mortgage markets and have produced an interesting assortment of mortgage variants including graduated payment mortgages, graduated equity mortgages, pledged account mortgages, shared appreciation mortgages, and reverse annuity mortgages. While these latter mortgages represent relatively small segments of the overall mortgage market, they are nevertheless interesting in that they are indicative of the kind of innovative thinking characteristic of financial engineers.

Graduate payment mortgages (GPMs) differ from traditional level-payment mortgages in that not all the payments are the same size even though the interest rate is fixed over the life of the mortgage. The payments start out at a low level and then, at one or more points in time, adjust to a new higher level for some period of time. At some point however, the payments become equal for the remainder of the mortgage. There are a number of variants on this basic theme, but the principal involved is fundamentally the same. The payment schedules associated with GPMs are such that they usually involve a period of negative amortization. Negative amortization implies that the mortgage principal (loan balance) increases because the loan payment fails to cover the periodic inter­est-at least during the early years.

Graduated equity mortgages(GEMs) are the purest form of graduated payment mortgages. In such mortgages, the interest rate is fixed for the life of the mortgage but the monthly payment grows larger each and every month. Such mortgages can be structured so that the payments increase by a fixed dollar amount each month or by a fixed percentage amount each month.

Pledged account mortgages (PAMs) are an interesting example of financial engineering at work. From the mortgagor's (borrower's) perspective they resemble graduated payment mortgages in that the payments get larger over time; but, from the Mortgagee's (lender's) perspective they resemble traditional level payment Mortgages. This dichotomy is achieved by placing a sum of money (usually part or all of the down payment) in a special account that is used as collateral on the mortgage and which can only be used to pay down the mortgage. The mortgagor now makes a payment, this is below that required on the traditional level payment Mortgage with the difference, made up by a contribution from the pledged account. Thus, the mortgagee receives the same sum that would be received had the mortgage been of the traditional level payment variety.

Shared appreciation mortgages (SAMs) were first engineered. in the early 1980s. They were developed in an effort to provide an alternative to the high mortgage rates then prevailing which had been brought about by a long period of accelerating inflation. Such mortgages are characterized by a rate of interest substantially below the market rate and a provision for the mortgagee to share in the profits resulting from any increase in the value of the property either upon the maturity of the mortgage, the sale of the property or some other specified time.

All of the nontraditional mortgages we have considered thus far were engineered to make mortgages more accessible to young home buyers who often have insufficient current income to carry a conventional home mortgage. The last type of nontraditional Mortgage we will consider was designed to service a very different clientele. These mortgages are called reverse annuity mortgage :(RAMs) and are designed for homeowners with substantial equity, in their homes. In these mortgages, the mortgagee (lender) makes periodic annuity-type payments to the mortgagor (homeowner/borrower) and the mortgagor repays this series of loans with a single lump-sum payment at the end. This cash flow pattern is the reverse of that typical in all other types of mortgages and, hence, the name. Reverse annuity mortgages are ideal for elderly people with substantial equity in their homes who require additional income to make ends meet. The reverse annuity mortgage allows these homeowners to monetize the equity in their home. With each payment they receive from the mortgagee, the homeowner's equity declines.

Mortgage lending was, at one time, a very routine affair. Using customer deposits as their primary source of funds, banks and thrifts originated mortgages that they then placed in their portfolios. These mortgages were serviced by the originating institution and held by that same institution until maturity. Of course, with its fund, tied up in existing mortgages, the institution was unable to originate additional mortgages until either (1) it had collected sufficient repayments from existing mortgagors, or (2) attracted additional deposits.

In, an effort to add liquidity to the secondary mortgage market, Congress sponsored the creation of several organizations, the last of which was the Government National Mortgage Association (GNMA), more popularly known by its nickname Ginnie Mae, which was created in 1968. Since 1970, GNMA has provided a vehicle for the pooling and guaranteeing of mortgages. The GNMA guarantee covers the full and timely payment of both interest and principal. Once pooled and guaranteed, undivided interests in the pools, called pass through certificates or participation certificates, are sold to investors.

Variations of the basic mortgage pass through are also issued by other federally sponsored organizations including the Federal Home Loan Mortgage Corporation (FHLMC), nicknamed Freddie Mac, and the Federal National Mortgage Association (FNMA) nicknamed Fannie Mae, and by a number of private parties-usually large commercial banks. The nature of the guarantee provided by these organizations varies. FHLMC, for example, guarantees the timely payment of interest and the ultimate but not necessarily timely, payment of principal. Private issuers of pass throughs may or may not purchase payment guarantees (insurance). The rest of our mortgage-oriented discussion will concentrate on GNMA pass through.

The pooling process separates the mortgage from the mortgage servicing function. The mortgage originator may keep the servicing rights or may sell them to another institution. The servicing rights have value because of a fee collected by the servicing agent. For example, in the GNMA pool, the servicing fee is set at 44 basis points (calculated on the principal balance) that is deducted from the mortgage interest. Six additional basis points are paid as a fee (premium) to GNMA for its guarantee. Together, these deductions total 50 basis points (one-half of one percent). Thus, a 10.75 percent mortgage coupon will return, if sold at par, 10.25 percent to investors in the pass throughs. This rate is called the pass through rate.

In addition to the revenue derived from mortgage servicing fees, the mortgage originator also derives profit from the points it charges the borrower to originate the mortgage. A point is defined as one percent of the mortgage principal, The funds made available by the sale of the mortgages can be used to originate additional mortgages which, in turn, produces additional revenue from points collected on the new originations and from new servicing fees.

The pooling of mortgages, whether government sourced or privately sourced, has dramatically transformed the mortgage market. It is now routine for banks and thrifts to originate mortgages, pool them, and sell off the pools (either keeping the servicing rights for themselves or selling the servicing rights to another institution). While the pools themselves are large ($1 million dollars is the minimum size and most are considerably larger), the pass through can be purchased in denominations as small as $25,000. Thus, they appeal to many private investors.

Because mortgage , pass through represent undivided claims on the mortgage pool –meaning that each pass through owner holds pro rata claim to all interest and principal repayments-the investor in pass through is subject to both reinvestment risk and substantial prepayment risk. Further, if the investor sells the pass through prior to, to their maturities, he or she is also exposed to considerable interest-rate risk. The source of the interest-rate risk is the same as for any other debt instrument and, therefore, we do not discuss it further. The reinvestment risk and the prepayment risk, however, require a little more explanation. Recall that mortgages are amortizing forms of debt. That is, the investor receives periodic payments that include principal as well as interest. Since the periodic payments on amortizing debt are larger than the periodic payments on nonamortizing forms of debt, the reinvestment risk is greater on pass through than on coupon-bearing Treasury and corporate bonds. The prepayment risk stems from the fact that the mortgagors have the right, which they frequently exercise, to prepay all or part of the mortgage balance. That is, they may pay back the principal before they are required to do so. These prepayments are passed along to the holders of the pass through who must then reinvest. Prepayments occur for a variety of reasons including the sale of the home, a sudden availability of funds for the homeowner, the death of the homeowner, or a refinancing of the mortgage in response to lower interest rates. The last of these reasons accounts for the greatest number of prepayments on mortgages that are written during periods of high interest rates. A great deal of research has gone into modeling prepayment behavior.

From the beginning, the prepayment risk problem has been a bane to investors. In June of 1983, in an effort to address this problem, investment banks, led by the First, Boston Corporation and Salomon Brothers, introduced collateralized mortgage obligations, commonly known as CMOs. Collateralized mortgage obligations were a dynamic innovation and quickly captured a major portion of the mortgage market. While a large percentage of newly originated mortgages are sold off soon after origination, most lending institutions still keep some mortgages in their investment portfolios. These mortgages are supported by customer deposits, including the CDs discussed earlier. For these lending institutions, interest rate mismatches between mortgage assets and CD liabilities are a very real concern. Other holders of mortgage portfolios are also exposed to the various forms of mortgage related risk and the management of these risks has attracted a great deal of attention by financial engineers in recent years.