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An exotic species.

An Exotic Species

If you ask most purchasers of mortage servicing how they value ARMs, the answer you will probably hear is: "We don't." Many buyers in the market for servicing have little or no interest in ARMs. For example, one of the top five mortgage bankers reports that out of a porfolio of 575,000 loans, only about 1 percent are ARMs. A user-generated database compiled by McDash Analytics of about 4 million loans, consisting of the residential loan portfolio of 25 mortgage lenders, contains only 7.25 percent of ARM loans.

The McDash database is made up of regional and national lenders; approximately half hold servicing portfolios of 100,000 loans or more, and half hold 100,000 loans or less. Approximately 40 percent of the lenders in the database are mortage bankers; 35 percent are thrifts; and 25 percent are banks.

The market's reluctance to buy ARM servicing is based on a number of factors including the perception of high payoffs, higher servicing costs resulting from periodic rates adjustments and the potential litigation expense associated with miscalculation of the rate adjustment. The Government Accounting Office published a study last year in which it estimated that as many as 25 percent of all ARM adjustments are calculated incorrectly.

Although adjustments began to appear in home loans as early as the late 1970s in California as variable-rate mortgages (VRMs) gained acceptance, mortgage loans with adjustable-rate features (ARMs) only emerged as an important market force in the U.S. single-family real estate market in the early 1980s. During that period of extremely high interest rates and an unusually high degree of rate volatility, ARM products offered a more attractive means of financing a home purchase. In addition, ARMs typically offered a discounted initial interest rate, which enabled more borrowers to qualify for the size loan they sought.

As ARMs became more popular in the early 1980s and thrifts became the dominant originators of ARMs, the Federal Home Loan Bank Board (FHLBB) touted ARMs as the preferred means of managing interest-rate risk. In theory, ARMs would largely mitigate the thrift industry's increasingly difficult dilemma of having long-term assets funded by short-term liabilities (savings deposits). This problem was particularly acute in the newly deregulated financial environment, where it was not uncommon for thrifts' short-term cost-of-funds to significantly exceed their yield on the mortgages held in portfolio. It was also thought that an additional advantage of ARMs would be their ability to survive periods of heavy refinancing.

ARM production

The popularity of ARMs engendered a push by lenders who relied on the sale of ARM production to secondary market agencies to have the agencies and the FHA make these products available for secondary sale. The agencies responded, but not aggressively. FHA offered a limited amount of ARM product that had characteristics that were not considered highly attractive. Fannie Mae began purchasing ARMs for portfolio in 1980. Subsequently, Fannie Mae, Freddie Mac and GNMA offered adjustable-rate mortage-backed securities (MBS) backed by ARM product. MBSs have also been offered in a senior/subordinated structure, whereby the thrifts' retention of the junior piece in portfolio also served to insure the senior piece. Lately, the agencies have developed innovative MBS structures that offer better pricing for ARM product than heretofore had been available. Freddie Mac, for example, offers a weighted-average coupon (WAC) ARM program that has allowed mortage lenders greater flexibility in the diversity of ARM products that can be pooled.

Of the approximately 185,000 residential loans originated by McDash participants last year, about 23,000 or 2.4 percent were ARMs.

Characteristics

ARM have been offered in a variety of forms. The basic characteristics of all ARM loans are:

Initial rate - The note rate offered for an initial period, typically one year. When offered at an artificially low rate, it is usually referred to as a teaser rate.

Index - The market-determined interest rate that forms the basis for subsequent are the Federal Home Loan Bank's eleventh district cost-of-funds and U.S. Treasury security constants.

Spread over index (margin) - The increment added to the index that is used to determine the note rate in all but the initial period. This margin typically ranges from 250 basis points to 300 basis points.

Adjustment period - The interval between adjustments of the note rate. Adjustment intervals typically range from one month to five years.

Interest rate adjustment cap - The maximum allowable upward adjustment of the note rate in any single adjustment period, typically 1 to 2 percent per adjustment.

Life-of-loan rate-increase cap - The maximum allowable upward adjustment of the note rate over the life of the loan, usually 6 percent.

An additional feature of certain ARM programs is a convertibility option whereby the borrower can, at a pre-specified time, (for example, after 5 years), convert the loan to a fixed-rate instrument. The fixed rate attainable by the borrower at that time is typically specified as about a half point in excess of the market rate at the time of conversion. The existence of this feature has a number of ramifications, the most important of which is a lower anticipated prepayment rate.

Valuation

Techniques used in the valuation of ARM servicing portfolios are similar to those used to evaluate fixed-rate portfolios. The value of the portfolio is computed by projecting revenues, less expenses and taxes, adding in amortization (a non-cash expense) and computing the present value of the expected after-tax cash flows generated by the portfolio over its projected life.

The key differences among valuation parameters between ARMs and fixed-rate mortgages involve assumptions about run-off rates, servicing costs, foreclosure rates and servicing fees. In three of the four primary determinants of the portfolio's cash flow stream, ARM are perceived to be significantly inferior to comparable fixed-rate product. ARMs are typically subject to higher prepayment rates (see Table 1), costlier to service and suffer higher delinquency/foreclosure rates (see Table 2). [Tabular Data Omitted]

Table : TABLE 2

McDash Analytics, Inc. Date as of March 31, 1991 RATIOS FOR THE MONTH OF MARCH, 1991
 CONVENTIONAL
 LOANS
 FRMS ARMS
LOAN COUNT 1,392,121 260,033


DELINQUENCY RATES
 1 Month 2.41% 3.30%
 2 Month .45% .97%
 3+ Months .42% 1.01%
 Total 3.28% 5.28%
IN FORECLOSURE .43% 1.50%
IN BANKRUPTCY .32% .53%
 Total .74% 2.03%
Total Noncurrent 3.71% 6.78%


PAID IN FULLS
Normal .80% 1.37%
Foreclosures Completed .03% .10%
 Total .83% 1.47%


(Data Reprinted with Permission of McDash Analytics)

These disadvantages are not offset by any concessions in the fourth major factor: servicing fees. ARM servicing fees are generally the same as that of their fixed-rate counterparts. As a result, the cash-flow value of ARM portfolios often comes to only 60 to 70 percent of the value of a comparable fixed-rate package, although in certain interest rate environments, the servicing on ARM loans can trade at less than 50 percent of the value of fixed-rate mortgage servicing.

There is some controversy about how quickly ARM loans pay off, but the general consensus is that ARMs pay off at a much more rapid rate than fixed-rate mortgages. There is anecdotal evidence that during the rapid decline in interest rates experienced in the early 1980s, ARM portfolios were paying off at approximately 33 percent per year. Most servicers did not anticipate the high rate of ARM prepayments and were shocked at the surge in prepayments in their ARM portfolios during the 1986 to 1987 refinance boom.

This was the result of a miscalculation of consumers' motives in choosing ARM financing. Rather than being satisfied with a reduction in their note rate (and monthly payment) when rates fell, many ARM borrowers preferred to lock into a fixed-rate loan. Also, borrowers who intended to relocate within two to three years chose to take advantage of teaser rate ARMs rather than commit to fixed-rate product, even in low interest rate environments. However, a substantial portion of ARM borrowers chose to keep their original ARMs; avoiding high refinancing costs while also experiencing a significant reduction in their note rate.

ARM behavior

There are a number of theories to explain the rapid payoff characteristics of ARMs. First, a flat or inverted yield curve would cause fully indexed ARM rates to approach or exceed the rates of fixed-rate mortgages. Because borrowers seem to have a strong, natural preference for fixed-rate financing, this would cause borrowers to refinance into fixed-rate mortgages.

Second, ARM indices, because they are based on averages, tend to lag rate movements when the yield curve shifts downward. During the last major bond rally that ended in early 1987, long-term rates fell so quickly that ARM borrowers found that it was possible to refinance into fixed-rate mortgages at a lower rate than what they were experiencing at the current, fully indexed rate.

Third, ARM borrowers are often more mobile. Many home purchasers who do not expect to remain in a house for more than two or three years find it more cost effective to borrow at an adjustable rate, especially if there is a teaser involved. They believe that by the time the rate adjusts they will have already moved on to a different home and a different mortgage loan.

Finally, under certain circumstances, the borrower may find it advantageous to pay off a fully indexed ARM and refinance into another adjustable-rate loan with an attractive teaser rate even if there are no plans to move. For example, one New England lender is currently offering a one-year ARM with an initial rate of 5.5 percent with a two/six cap. This attractive pricing creates a strong incentive for borrowers to refinance.

Another concern among servicers is the higher unit-servicing costs anticipated for ARMs, especially those with negative amortization, short adjustment intervals and the relatively few that have adjustable servicing fees. Early on, many firms had to process ARM loans manually. This resulted in a significantly higher unit-servicing cost. the unit-cost increment was estimated by some at an one-eighth of a point of outstanding principal balance. Today some servicers estimate that ARMs are no more costly to service that fixed-rate product, due to the enhancement of their systems to accommodate ARM requirements.

The majority, however, still believe that unit servicing costs are higher for ARMs than for a comparable fixed-rate loan. Many secondary servicing market participants estimate the difference to be about $15 per loan. Because the majority of ARM loans are newer and have high average balances, the added cost has had a relatively minimal impact on the present value of the servicing.

Servicers perceived potential foreclosure risks associated with ARMs early on. With sufficiently large increases in interest rates, the loan could become unaffordable for the borrower. This risk would be exacerbated if the borrower had been qualified for the loan at an artificially low teaser rate, as was increasingly the case in the mid-1980s. This entails calculating the borrower's ability to meet the monthly payment obligations on the basis of the teaser rate rather than the fully indexed rate. This problem is made worse in the case of negatively amortizing loans, which can eventually reduce the borrower's equity to zero - or less.

Fears about ARM's higher degree of vulnerability to foreclosure appear, in retrospect, to have been somewhat exaggerated. Table 2 indicates that ARMs suffer foreclosure at a rate roughly double that of conventional fixed-rate product. This may be a function of payment shock associated with the ARM rate becoming fully indexed. This is especially a problem if the loan is underwritten on the basis of a teaser rate.

The conventional ARM foreclosure rate is still below that of fixed-rate FHA or VA mortgages. Nonetheless, there remains a fear that a sufficiently adverse interest-rate scenario could generate enough payment shock to cause severe ARM foreclosure problems.

Other factors that impact the valuation of ARM servicing are adjustable servicing fees, convertibility and liability resulting from improper rate adjustments. If the servicing fee fluctuates over time, this must be taken into account when modeling the cash flows. It is our experience that this added uncertainty is usually resolved to the detriment of the seller; the buyer will usually value the portfolio under the worst-case scenario (i.e. at the lowest available servicing fee).

Some ARMs are convertible to fixed-rate instruments. The likelihood is that if a potential purchaser viewed the probability of a conversion to be high, he or she would presumably modify the payoff assumption to reflect those currently being used for fixed-rate mortgages. Unfortunately, so little of this product exists, it is difficult to draw any hard conclusions about how the market actually modifies the evaluation.

Caveat ARM lender

An alarming rise in the number of lawsuits, including class-action suits, has occurred in the past few years based on incorrect ARM rate adjustments. One mortgage company settled a class-action suit for more than $1 million because a computer programmer used the wrong Treasury index from the list of key interest rates published by the Federal Reserve for ARM resets. The error was not discovered until an attorney for the borrowers brought it to the company's attention.

Houston-based Mortgage Consultants of America completed a number of ARM adjustment reviews in the past 12 months and reported an error ratio on ARM adjustments of 23 percent to 27 percent. Even though this ratio appears high, it must be noted that this percentage includes errors favorable to both the borrower and the lender. Of these errors, only about 8.5 percent were material errors requiring a mandated adjustment of more than $50.

Most errors result from the use of inaccurate or inappropriate indexes and incorrect adjustment dates that were found to result from set-up errors and general errors in the servicers' database documentation. Needless to say, when performing due diligence on an ARM servicing portfolio, it is important to analyze the adjustment calculations carefully.

The market

ARM servicing typically appears on the market as a segment of a larger overall portfolio. When separate, pure ARM portfolios do appear, they are typically agency product. Relatively little private investor ARM product is traded. A typical, entirely ARM servicing package would range between $50 million to $100 million in unpaid principal balance.

Although thrifts are by far the largest ARM producers, mortgage bankers are the primary sellers of ARM servicing. A great majority of ARM production volume was originated by thrifts for portfolio investment purposes and was not securitized. Thus, the percentage of total ARM mortgage debt outstanding that is easily tradeable on the secondary servicing market is relatively small, constituting only about 5 percent of servicing transfers, or about $7 billion of an estimated 1989 total servicing transfer volume of about $150 billion. Though thrifts also sell ARM servicing, they tend to sell only the servicing of securitized agency or Fannie Mae portfolio product. Because proceeds from the sale of servicing of whole loans in portfolio cannot be recognized up front, but must be booked over the life of the underlying asset, the sale of the servicing rights to thrifts' ARM loans held in portfolio is virtually never contemplated.

Typical ARM servicing buyers are large servicing operations or smaller shops that have developed specialized systems and therefore have a comparative advantage in servicing ARM product. Many firms do not have the systems in place to service ARMs efficiently. Also, the great uncertainty regarding runoff, additional servicing costs and potential liability resulting from improper rate adjustments keeps many potential buyers on the sidelines.

Pricing

ARM servicing trades at significantly lower prices than comparable fixed-rate product, often selling for prices of only 60 to 70 percent of comparable fixed-rate servicing, depending on the interest rate environment. The major reason for this significant pricing difference appears to be the perceived higher prepayment risk of ARMs and, to a lesser extent, the servicing cost differential. Homogeneous packages of the more common ARMs with popular adjustment periods and indices (for example, one-year ARMs, indexed to Treasury bills), typically attain the best prices. Also, buyers offer higher prices for portfolios in certain geographic areas and for those with convertible options because they expect a lower prepayment rate. In terms of size, small- to medium-size packages of $50 million to $100 million have tended to get the best reception from the market.

Prices for ARM servicing also are considerably more volatile than for fixed-rate product. ARM prices are extremely sensitive to anticipated prepayment rates, which in turn are greatly affected by the level of interest rates and the slope of the yield curve. For example, in the rising interest rate environment of early 1988, ARM portfolios attained prices of four times servicing fees (compared with the 4 1/2 to 5 1/2 times servicing fee multiple for fixed-rate portfolios.) However, when the yield curve flattened and then inverted in late 1988, ARM prices dropped to around two times servicing fees. Although prices for fixed-rate portfolios also fell somewhat, the percentage decline was nowhere near that experienced with ARMs.

By mid-1989, when the yield curve went from inverted to flat, ARM servicing prices went back to the 2 1/2 to 3 1/2 times servicing fee range. The fact that the ARM market is thinner, with fewer potential buyers than the fixed-rate market, also adds to its price volatility. ARM servicing typically sells for about two times service fee today.

ARM prices tend to strengthen when buyers anticipate relatively little runoff (i.e. when they perceive that interest rates will remain steady or rise) and when the yield curve is expected to remain positively sloped. On the other hand, abrupt interest rate declines or an inverted yield curve lead to a high level of ARM refinances. Buyers adjust by increasing their prepayment rate expectations, often to three or four times Public Securities Association (PSA) rate or more. The result is a drop in the value they place on ARM portfolios. A very steep, positively sloped yield curve can also cause prepayment concerns for ARM servicers, because a large spread between a fully indexed ARM interest rate and a current teaser rate may cause borrowers to refinance their existing ARMs into cheaper ARMs.

Conclusion

Since the mid-1980s, ARMs have constituted a large percentage of total, single-family mortgage loan origination volume. In high interest rate periods their share of the market often exceeds 50 percent. By some estimates, the ARM share of total single-family mortgage debt outstanding exceeds 20 percent.

Based on the McDash statistics in Table 1 and Table 2, one may conclude that in certain geographic areas, prepayment rates for ARMs are comparable to prepayment rates for fixed-rate mortgages. During the last 12 months, for example, New York and Texas experienced ARM payoffs at a rate that was actually less than that for fixed-rate mortgages. This data, of course, must be interpreted in light of the level and slope of the yield curve for that time period and the economic condition of the relevant geographic market.

Based on the last 12 months' prepayment data, it appears that for at least certain geographic areas, the market may be underestimating the average life of ARMs. To the extent that this is case, it seems reasonable to assume that an opportunity exists for those willing to commit the necessary resources to become efficient servicers of ARM loans and to develop the information needed to identify pricing anomalies in the marketplace.

Steven Z. Hoff is president and CEO of Hamilton, Carter, Smith Consulting Inc., based in Alexandria, Virginia. The preceding text is adapted from Adjustable Rate Mortgages and Mortgage-Backed Securities published by Business One Erwin.
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Title Annotation:adjustable rate mortgages servicing unattractive to servicers
Author:Hoff, Stephen Z.
Publication:Mortgage Banking
Date:Jun 1, 1991
Words:3254
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