A COFI break.

The once-dominant ARM product based on the cost of funds of West Coast thrifts has suffered a decline of late. The so-called COFI ARM is getting creamed by other ARM products that consumers find easier to swallow. Whether this break with past popularity will continue is uncertain.

Several major california lenders used to routinely serve COFI - that is, 11th District Cost-of-Funds Index (COFI) mortgages. Higher interest rates in California used to automatically mean high demand for COFI loans. Today, COFI loans face tough competition from a variety of forces, including other ARMs, a consolidating lender market in the COFI stronghold of California and an uncertain interest rate outlook.

This kind of ARM may yet prove one of the lingering staples in the fickle world of mortgage products. Or, instead of being good to the last drop, COFI could be getting a little stale.

The index is based on what the 11th Federal Home Loan Bank District members paid for their cost of funds. The Cost-of-Funds Index was a semiannual index throughout the 1970s. It became a monthly weighted index in July 1981, according to Amy Stewart of the Federal Home Loan Bank of San Francisco.

The index reflects the actual interest expense of the 78 savings institutions in the 11th FHLB District, Stewart explains. Commercial bank members, which outnumber thrifts in the district, are not included in determining the COFI. The FHLBank does not plan to include commercial banks or thrift-and-loan companies (a separate category of small lenders) in the COFI, although consolidation has thinned the ranks of institutions that determine the index.

COFI break

COFI loans are the dominant ARM product in California, accounting for nearly half the adjustable-rate loans and more than one-third of total originations as of late August, according to lenders. The rates are more attractive than fixed-rate loans and many California lenders are willing to promote them to their customers, says Keith Gumbinger, vice president of HSH Associates in Butler, New Jersey. The only significant non-California COFI business is done by Great Western Bank, A Federal Savings Bank of Chatsworth, California; Home Savings of America FSB of Los Angeles and other H. F. Ahmanson subsidiaries that have branches outside of the Golden State.

ARM lenders must sell the features of the loan beyond its low introductory offer, says Sam Lyons, senior vice president of mortgage banking at Great Western. With an ARM, borrowers can qualify for more house, he points out. In August, a COFI ARM, for example, had an introductory rate of 3.95 percent. After three months, the rate rises to 7.26 percent, or 245 basis points more than the Cost-of-Funds Index. Although borrowers see a 331-basis-point rise in their interest rate, the contract rate remains about a full percentage below the interest rate on a fixed-rate loan.

Rising interest rates usually perk up the demand for ARMs. Lenders argue that ARMs are right for homeowners who plan to stay in a house a short while or who expect rates to drop. Borrowers reap the benefits of lower interests costs and no compelling need to refinance because the loan automatically adjusts downward when rates move lower.

Interest rates based on the index of the 11th District cost of funds lag movements in the one-year Treasury index. That [TABULAR DATA FOR FIGURE 1 OMITTED] means that when the Treasury index starts moving up, COFI loans remain attractive, particularly for borrowers stretching to qualify for a mortgage.

"COFI borrowers get a rate break at the front end," says William Mortensen, chairman and CEO, First Federal Bank of California, FSB, Santa Monica, California. For the first-time homebuyer, the major COFI customers, this rate advantage could determine whether they can purchase a house.

"COFI ARMs popularity has not moved east," says Jeffrey Tuchman, president of The Mortgage Shopper, a mortgage research firm based in Pleasantville, New York. He counseled a few customers to refinance out of COFI loans, but no one has ever asked for one. He does not originate any loans, but counsels customers on what loans are right for them and tells them which institution offers the best rates.

"COFI interest rates start as low as 3 percent in some areas of California," Gumbinger said at the time he was interviewed for this article. COFI rates rise to the full contract rate after three months, and then fluctuate monthly. The payment remains based on the initial interest rate.

The bad news is that prepayment penalties can lock borrowers into the loan for at least three years. Also, any changes in rates that would raise payment amounts can sometimes result in increases to the balance of the loan, causing the loan to negatively amortize. Negative amortization has generated bad publicity and can leave a bitter aftertaste for borrowers. Treasury-based ARMs, in contrast, are set for a whole year, even though introductory rates may be set artificially low, says Gumbinger.

By carefully explaining the loan - which involves a low interest rate but the potential for a sharp rise in interest rates - lenders can help homebuyers deal with the changing interest rates and the negative amortization issues.

This type of loan was initially a slow sell when it was introduced in the early 1980s. There was a long learning curve for borrowers, says Mortensen of First Federal. Borrowers who were used to fixed-rate loans did not understand the concept of adjustable-rate loans at first. Once the loan was explained and became more familiar, however, lenders found they could sell it to borrowers.

"COFI ARMs took off during the mid-1980s when interest rates were high and volatile," says Mortensen. First Federal customers are now sold on COFI themselves, without having a loan officer explain the product.

COFI loans became popular in California because thrifts were the dominant lenders in the state, Mortensen says. California thrifts had been trying to persuade state and federal regulators to permit them to originate adjustable-rate loans since the '70s. Home Savings, Great Western and the other large institutions decided to offer ARMs, not fixed-rate loans, during that time because it offered a means to match assets and liabilities. The institutions were so large they could influence the mortgage market.

In addition, the booming California real estate market of the time was the most active in the nation, Mortensen says. Because California had such a large housing demand, the low initial rates made COFI loans popular with Realtors and other housing players.

A California specialty

Although COFI interest rates are below fixed-rate mortgages and competitive with other ARMs, the reception these loans get outside the 11th Federal Home Loan Bank District can be described only as lukewarm. Lenders say few borrowers can understand the index and even fewer want their loan based on what happens in a faraway state. This reluctance on the part of borrowers has prompted some national lenders and non-California lenders to push other products instead of COFI.

"If the mortgage bankers did a little more marketing and priced these loans differently, COFI ARMs could enjoy the same popularity in the rest of the country as they do in the West," says Gumbinger. California thrift lenders have the advantage because the index is their home-base cost of funds. East Coast lenders prefer Treasury-based ARMs.

COFI loans remain a big part of business at Great Western, says Lyons. Roughly 80 percent of its lending business is in ARMs, and roughly half of its ARM business is in COFI mortgages.

COFI ARMS were first offered in the Northeast when interest rates peaked some years back. At that time, California thrifts, most notably Home Savings of America, had expanded into the Northeast and were offering the same products they did in the Golden State.

COFI hasn't taken hold on the East Coast, however. While mortgage brokers and mortgage bankers carry some COFI inventory for customers who request it, there's not much call for it, Gumbinger says.

"It's a hard sell for people when they don't understand it," says Russ McCormick, a loan officer for Mortgage Choice of Durham, North Carolina. He personally likes the product, calling it "one of your better ARMs," because it's more stable than an ARM loan indexed to Treasury market securities.

McCormick services an area - the Research Triangle - where most people are affluent and have double incomes, so the loan's appeal to people who have trouble qualifying for a mortgage is not needed. High turnover rates at the region's hospitals, universities and other businesses do make adjustable-rate mortgages generally attractive to homebuyers.

Competition from other ARMs has eroded the COFI market. Mark Zandi, chief economist with Regional Financial Associates, West Chester, Pennsylvania, says that growing demand for ARMs and efforts by California thrifts to keep their costs down might benefit the COFI market.

"COFI ARMs are strictly a California phenomenon," says Joe McKenzie, a statistician with the Federal Housing Finance Board. This popularity has waned somewhat, however, as mortgages based on other indices become more popular. Mortgages based on short-term Treasuries and the London Interbank Offered Rate (LIBOR) or the Federal Funds rate are displacing COFI in popularity. These loans can be either served up straight or blended with fixed-rate loans and turned into hybrids.

A shrinking COFI market

Consolidation may hurt the COFI market, says Zandi. Two California thrift institutions were acquired in July. Washington Mutual Savings Bank of Seattle acquired Irvine, California-based American Savings Bank FA, one of the top mortgage lenders in the state. The parent of First Nationwide Bank of San Francisco is acquiring California Federal Bank FSB of Los Angeles. Analysts expect more acquisitions next year.

The loss of the two institutions also will affect how the COFI is calculated and how many institutions originate these loans. Neither Washington Mutual, which is in the 12th Federal Home Loan Bank District, nor First Nationwide, being a commercial bank, originate COFI.

COFI loans should not be dismissed, though. Amy Stewart of FHLBank says the COFI remains a popular index, judging by the amount of calls the bank receives. The FHLBank's automated phone system tells borrowers and lenders the latest index reading. Investment bankers also follow the index for their capital market programs.

The role of interest rates

Although the Federal Open Market Committee (FOMC) left short-term rates unchanged at its August and September meetings, Fed watchers believe the committee is poised to raise rates at the first convincing sign that the economy is overheating. The increase in interest rates earlier this year ended any significant refinancing activity. If the Fed decides to raise interest rates in 1997 or even later this year, the action could have even more drastic effects on the housing finance market. This is where the COFI ARM may come in to boost origination volume.

Fixed-rate lending declined sharply as rates rose earlier this year. As a result, the percentage of conventional closed loans for home purchases that were ARMs went from only 16 percent in first-quarter 1996 to 28 percent in the second quarter. COFI loans were one of several ARM products being offered to borrowers during the pickup in interest in adjustable products.

The difference in fixed rates vs. adjustable mortgage rates illustrates their inherent appeal when the yield curve is steep and rates are rising. Fixed-rate mortgages were hovering at the 8 percent level in August, while one-year Treasury-based ARMS were near the 6 percent level, according to Freddie Mac. At that time, the 11th District Cost-of-Funds Index was 4.809 percent. However, actual COFI mortgage rates offered to borrowers were higher, depending on each lender's margin.

COFI fortunes may rise with ARMs

COFI products might benefit from an overall revival in the ARM market. A forecast from the Mortgage Bankers Association of America Economics Department pegs the ARM share of conventional purchase loans next year at 35 percent. That's up sharply from the 25 percent MBA forecast for 1996.

Conventional wisdom holds that ARMs do better in a higher interest rate environment. But Zandi predicts that if the Fed tightens monetary policy, ARMs might look less attractive. The fly in the ointment is that when the FOMC tightens monetary policy, the policy levers it uses are short-term rates - the discount rate or the target for the Fed Funds rate (the rate at which banks lend to each other overnight). Should the Federal Reserve hike these rates, short-term rates would come closer to long-term rates, thus narrowing the spread between ARM rates and fixed-rate loans. Borrowers faced with a very slight difference in interest rates between fixed-loan and adjustable-rate mortgages would likely opt for fixed-rate loans.

If interest rates do rise, the market share of ARMs would be stable, but the real estate market as a whole would suffer, Zandi predicts. In late summer, there was a lot of activity from fence-sitters coming into the market. He expects fence-sitters to be less of a factor by the end of the year, especially if interest rates rise. COFI ARMs might stay stable, however, because California thrifts are loathe to raise rates on certificates of deposit. The COFI index had inched up to 4.839 percent in mid-October.

The largest share of the ARM market has gone to the hybrid mortgage, Gumbinger says. Hybrids are the result of careful cross-breeding between fixed- and adjustable-rate loans, beginning with a fixed-rate portion that can last from three to 10 years. Such a product offers a sense of relative security, Gumbinger suggests.

In general, today's housing market is considered a fixed-rate lending environment, and if fixed rates were to drop still lower in the months to come, it would make it harder to originate ARMs - COFI or otherwise.

On the other hand, the market for ARMs opened up a little midyear, says Sam Lyons, when interest rates began to rise. The economy still appears able to generate a head of steam so the market is not out of the woods in terms of inflationary pressures. Any serious inflation scare will send mortgage rates up further.

Investors' view of COFI

Not all COFI loans are kept in portfolio. The two secondary-market firms - Fannie Mae and Freddie Mac - have sizable COFI inventories, and both make periodic purchases.

Freddie Mac has been purchasing COFI ARMs since 1988, says Jim Cotton, vice president of marketing for Freddie Mac, McLean, Virginia. This is one of many different ARMs the secondary-market firm purchases. Lenders usually sell the loans servicing released.

Demand fluctuates depending on interest rates, Cotton says. The COFI ARM market share was a pretty small 2.3 percent of the total mortgage market during the first quarter and 14 percent of the ARM market. As mentioned, ARMs represented only 16 percent of the total 1996 first-quarter mortgage originations, but jumped to 28 percent the following quarter.

"COFI ARMs are good from an investor's point of view," Cotton says. These loans prepay slower, largely because of prepayment penalties to borrowers, and the COFI interest rates lag rate movements in other parts of the capital markets.

But Cotton echoes other lenders in saying that the low market share of COFI ARMs can be attributed to competition from other ARMs. Even California lenders offer fixed-rate loans that revert to ARMs after three, five or 10 years, with the adjustable portion fluctuating monthly according to the one-year Treasury bill. It doesn't help that margins are wider on ARMs that aren't keyed to the COFI.

"COFI is a slow product from a mortgage-backed security aspect," says Frank Demarais, vice president of product development at Fannie Mae. Through June of this year, Fannie Mae had purchased $850 million in COFI loans for its inventory. It now has $24 billion in COFI mortgages in its coffers. During the same period, Fannie Mae purchased $3.6 billion in Treasury-based ARMs. A total of $1.7 billion in fixed-period, or hybrid, ARMs was purchased during the first half. Fannie Mae has $25 billion in Treasury-based ARMs.

Demarais also has seen a movement by lenders to other ARM indices. COFI loans generally are for portfolio lending, he says, and not sold in the secondary market. Institutions are looking for products that accurately reflect their costs. The fixed-ARM hybrid has picked up significantly, and Fannie Mae is considering developing it as a market segment.

What the future holds is anyone's guess, Great Western's Lyons says, but the future of fixed-rate or ARM lending is tied to interest rate movements. Great Western, like many California lenders, has both mortgage-banking and portfolio lending operations. When rates fall, Great Western concentrates on fixed-rate lending through its mortgage banking operation. When rates rise, it switches to its adjustable-rate portfolio lending operation.

But whether the consumer's taste for COFI loans will linger is much less certain. Most likely there will always be some type of ARM lending going on, but whether COFI will remain a popular item on the menu is up in the air.

RELATED ARTICLE: CALIFORNIA COMES BACK

The rebounding California economy is not a fantasy; it is because of fantasy. The movie business is booming, and the Golden State economy is riding its coat-tails. Economic activity means more jobs and more housing, which has led to tightening of office markets and residential housing in some areas of the state.

While this surge in activity has yet to offset the losses from the aerospace industry, many California officials are pinning their hopes to what can only be termed as movie magic. Much of this growth is centered in the Los Angeles area, but other parts of the state are experiencing increased economic activity.

In addition, the presidential election has caused the Clinton administration to focus on creating jobs in California. Employment will increase by 375,000 jobs per year through 1997, and 232,000 jobs in 1998, according to the UCLA Business Forecast.

The low end of the real estate market has always been stable, but now the higher end of the market is seeing increased activity, say lenders, Most of the activity is in new-purchase mortgages, and reflects an influx of people into the high-growth areas and the fact that higher interest rates effectively killed off any refinancing activity.

"Statistically speaking, there has been an upsurge in ARM lending in California," says Lou Nevins, president of Western League of Savings Institutions. This upsurge includes COFI loans as part of the product blend.

Most of the California lending activity is in new purchase mortgages, Nevins says.

"It really is a good market," says William Mortensen, chairman and CEO of First Federal Bank of California FSB of Santa Monica, about the upturn in lending. The real estate market, while not booming, is strong enough that prices are stabilizing.

This activity has made the California mortgage market more competitive in the '90s than before, he says. Bank of America is now the state's leading mortgage lender, and Minneapolis-based Norwest is a major player.

The California real estate market is reasonably powerful but not as strong as in the past. The Southern California (Southland) economy saw real improvement during the past year, Mortensen says. Property is selling fast, and home prices are rising in some areas.

REO (real estate owned) properties no longer are the dominant product in the housing market, he says. Real estate cycles also are caused by psychology, and because people are more optimistic, they are more secure and thinking about buying a home.

The popularity of COFI mortgages is resurging as the California economy begins to heat up, says Mark Zandi, chief economist with Regional Financial Associates of West Chester, Pennsylvania.

Several Southern California counties should see vigorous economic and employment growth this year, according to a report by Ernst & Young's Kenneth Leventhal Real Estate Group. The accounting firm based its projections on cheaper land and housing in Riverside and San Bernardino counties, which would give both businesses and workers incentive to move from higher-priced Los Angeles and Orange counties.

California has a long way to go to achieve the same level of economic activity it had during the height of the Cold War, but analysts say it has taken the first steps.

David Stahl is a freelance writer based in Silver Spring, Maryland.