Printer Friendly

Balloons on the rise.


American homeowners are putting out "for sale" signs and moving their families at a faster pace than ever before. This upswing in homeowner mobility is tied to many factors including the opening of new job markets, the decline of existing markets, increasing corporate relocations and changing societal attitudes toward employment.

This more mobile lifestyle means homebuyers are moving more frequently and remaining in each spot for shorter periods.

Most Americans still finance their home purchases with 30-year mortgages, although most homes are sold before these loans are ever paid off. In fact, the typical homeowner now moves in less than eight years.

Mortgage lenders have responded to this trend by designing new mortgages that specifically appeal to the modern homebuyer. These non-traditional mortgages often boast shorter lives and lower monthly payments than conventional 30-year loans.

The successful introduction of balloon mortgages represents the latest innovation in the realm of residential mortgage products. Although commonly used for second and commercial mortgages, balloon loans have only recently made their debut as a financing tool for first mortgages. Balloon mortgages, originated with five-and seven-year maturities, make sense for homeowners who do not expect to live in the same location for a long time. As might be expected, the greatest concentration of balloon mortgages has been originated in the active California housing market. Another advantage of balloon mortgages is they require lower mortgage payments than 15-year loans. Balloons typically include a provision allowing the homeowner to refinance at maturity into a fixed-rate loan. Thus, in one sense, balloons are hybrid structures that incorporate features of both fixed-rate and floating-rate mortgages. Unlike ARMs - another low-cost alternative to fixed-rate mortgages (FRMs) - a borrower's monthly payments are known with certainly, out until the balloon maturity date, from the moment the loan is originated.

Fannie Mae and Freddie Mac have introduced MBS programs to facilitate the securization of balloon mortgages into pass-through securities. These two programs have rapidly gained popularity and acceptance with fixed-income investors and have experienced dramatic growth since their recent introduction.

The investment characteristics of balloon MBSs - high credit quality, short average lives and the higher yields typically associated with mortgage-related product - make them suitable to meet a wide variety of investor's portfolio objectives. Commercial banks have demonstrated the strongest appetite for these securities to date.

Securitization of seven-year balloons has far outstripped five-year balloon MBS production. Although Freddie Mac was the first agency to issue seven-year balloon MBSs, Fannie Mae's CX program has become the fastest growing, most liquid, seven-year program. Fannie Mae has securitized about $3.8 billion of seven-year balloons since the launch of its MBS program in October 1989.

These programs continue to increase in size each month, both in terms of pass-through issuance and the number of participating lenders. In June 1990, Freddie Mac launched a five-year balloon MBS program to compete with Fannie Mae's seven-year program. Although still relatively young, Freddie Mac's new MBS program appears to be a hit, especially among investors with a regulatory incentive to purchase securities that mature in five years or less. Given the competitive relationship between the agencies, we expect to see the introduction of other innovative structures and programs.

Mechanics of balloon mortgages

Balloon mortgages are similar to traditional, 30-year, fixed-rate mortgages (FRMs) that have fixed note rates and 30-year amortization schedules. However, balloon mortgages have much shorter maturities - most mature in five or seven years. Balloon mortgages, unlike 30-year FRMs, do not fully amortize over their short life-times, thus they require homeowners to make a balloon payment at the end of the final month to repay all outstanding principal. In order to pay off the maturing balloon loan, homeowners have the option of either raising the necessary cash or refinancing the balance with a new mortgage. The size of this final payment will be very large relative to the original loan balance. Given a 30-year amortization schedule, only about 5 percent of a seven-year balloon loan will be paid off by the end of the seventh year. In other words, a homeowner with a $100,000 mortgage will face a $94,649 payment on the balloon date. The final payment will be even larger for a $100,000 five-year balloon loan. With that mortgage product, a borrower will face a $96,574 balloon payment at the end of the 60th month.

Lower monthly payments

Balloon mortgages offer homeowners an attractive, low-cost financing alternative to 30-year FRMs because their mortgage rate is based on the shorter term of the loan. Lenders and agencies prefer mortgages with shorter maturities because they are cheaper to finance and expose the holder to less interest rate risk. As a result, the rate on balloon mortgages may be as much as 50 basis points lower than 30-year FRMs and 25 basis points lower than 15-year FRMs.

The combination of a lower mortgage rate and a 30-year amortization schedule can substantially reduce a homeowner's monthly payment. Table 1 provides a comparison of mortgage payments on a seven-year balloon, a 15-year FRM and a 30-year FRM using current market rates. The lower payments available with balloon mortgages clearly can translate into big savings for homebuyers. Monthly payments on a 10 percent balloon mortgage are $37 less than a 10.5 percent, 30-year, fixed-rate mortgage. Similarly, payments on a 10 percent balloon mortgage are $212 less than a 10.25 percent, 15-year, fixed-rate mortgage. Two factors contribute to the significantly higher payments on 15-year fixed-rate loans: their mortgage rate is up to 1/4 percentage point higher and the original loan balance must fully amortize over 15 years.

Table : Table 1 Payments on a $100,000 Mortgage
 Type of Mortgage Monthly
 Mortgage Rate Payment
7-year Balloon 10.00% $878
15-year FRM 10.25% $1,090
30-year FRM 10.50% $915

Balloon mortgages can be originated with buydowns to lower the initial payments even further. This feature allows a home seller, typically a builder or developer, to establish a fund at the time of closing to subsidize a homeowner's mortgage payments for some given number of months. Fannie Mae's seven-year balloons can be structured with a 2-1 annual buydown. The initial loan rate cannot be more than 200 basis points less than the final rate and coupon resets cannot exceed 100 basis points per year. Buydowns influence the rate at which homeowner's tend to prepay their mortgages. Borrowers will have a smaller incentive to refinance to the extent they are making below-market payments.

Balloon mortgages are extremely attractive for homeowners who expect to move before the balloon payment comes due in the 60th or 84th month. Such individuals can benefit from lower monthly payments, while not worrying about the final lump-sum payment. As might be expected, balloon mortgages have become very popular in the mobile California housing market where homeowner turnover is relatively high. The second highest geographic concentration of these mortgages is in the Northeast.

Balloon mortgages are also gaining increased acceptance in the $15 billion per year relocation market. These borrowers are often high-salaried, fast-track employees who tend to move frequently. The short life of balloon mortgages makes them especially suitable for the relocation market. These highly mobile borrowers spend between three and four years, on average, in each residence. Freddie Mac estimates that about 400,000 people relocate each year as a result of their jobs.

Optional refinancing feature

One potential drawback to balloon mortgages is the possibility that homeowners will be clobbed by the final payment if they don't move before the loan matures. Both Fannie Mae and Freddie Mac have addressed this problem by structuring their balloon mortgages with optional refinancing features that give borrowers the right to extend the term on their mortgages rather than face large balloon payments. At the end of seven years, borrowers have the right to refinance their maturing Fannie Mae balloon loans into a 23-year, fixed-rate mortgages at the prevailing mortgage rate. Similarly, homeowners also have the option of extending their five-year Freddie Mac balloons for another 25 years. The new rate on the final 25-year mortgage term will be pegged at 50 basis points more than the prevailing Freddie Mac 60-day, required net yield. These options significantly reduce the risk that homeowners will not able to raise enough cash on their balloon payment dates.

This refinancing option gives borrowers a relatively simple and inexpensive way to roll their mortgage debt. Homeowners who meet certain requirements will not have to requalify for the extended mortgage and lenders will only pass on to the borrower a $250 fee, plus some nominal transaction costs. The eligibility requirements are as follows: the borrower must be an owner-occupant, monthly payments must be current, the rate on the new mortgage may not exceed the previous rate on the balloon mortgage by more than 5 percent, and the borrower must give written otice of his intent to refinance prior to the balloon payment date.

Balloon pass-throughs

The secondary market for balloon MBSs continues to grow as Fannie Mae and Freddie Mac accelerate the production of their respective pass-through securities. For investors in balloon MBSs, it is important to realize that all outstanding balloon mortgages will be removed from their pool at the end of their five- or seven-year lives, whether or not the borrower elects to exercise the refinancing option. In other words, the final maturity of a balloon MBS will never extend past the original five- or seven-year maturity of the underlying loans.

Fannie Mae has securitized approximately $3.8 billion of seven-year balloon mortgages since it started its balloon program in December 1989. Pools must have a minimum size of $500,000 and cannot be seasoned more than 12 months. All underlying mortgages are secured by single-unit, principal residences and cannot exceed the standard $187,600 loan limit. Fannie Mae issued nearly $700 million of these securities in June 1990 alone.

Fannie Mae's program has grown at a much faster clip than its Freddie Mac counterpart. Freddie Mac, by the way of contrast, has securitized a total of $700 million 30-due-in-7 mortgages through its PC '95' program. (Monthly issuance of seven-year balloon MBSs is depicted in Chart 1, followed by the distribution of pass-through coupons in Chart 2.) Although both agencies have issued seven-year balloon MBSs with coupons throughout the 8.5 to 10 percent range, most of the production (about 90 percent) has been concentrated in the 9 and 9.5 percent coupons.

Freddie Mac introduced its swap program for five-year balloons earlier this year. Issuance data was not available to us at present because the program is still in its infancy. But most of the recent supply consists of 9 and 9.5 percent coupons. Freddie Mac balloon MBSs currently have a 45/75-day delay (payments made by mortgagors due on Nov. 1 are passed through to MBS holders on Dec. 15). However these balloon MBSs are scheduled for inclusion in Freddie Mac's Gold PC program that began in October. Under the terms of this new program, Freddie Mac balloon MBSs will be issued with a shorter 15/45-day delay. Investors will have the option to convert outstanding balloon MBSs into Gold PC balloons.

Prepayments and cash flow

The actual amounts of principal and interest passed through to the holder of a balloon MBS will be determined by prepayments on the underlying mortgages. Higher prepayment rates will increase the amount of principal returned each month during the security's life and will reduce the amount of principal passed through to the bondholder on the balloon date. As is typical with new mortgage products, there is an absence of historical prepayment data on which to base future prepayment and cash flow projections. Wall Street is currently divided on the issue of prepayment rates, with the result being that the dealer community is advocating a range of prepayment estimates.

It is our belief that balloon MBSs will experience faster prepayment rates than seasoned 15-year pass-throughs in stable interest-rate scenarios. We also expect balloon prepayment rates to be less sensitive to changes in the level of interest rates than similar 15- year mortgages. The appeal of balloon mortgages to mobile homeowners and participants in relocation programs should signal relatively fast prepayment rates on balloon MBSs. Recent studies ("Relos Revisited," Secondary Mortgage Markets, Winter 89/90) have validated the long-held premise that relocation mortgages tend to prepay faster than comparable 15-year mortgages. However, predicting prepayment speeds for balloon MBSs may be a moot point since, as will be seen in the next section, the average lives of these securities are relatively stable across a broad range of prepayment rates.

Average investment lives

As a result of their shorter maturities, balloon MBSs have average-life characteristics that are much different from 15- and 30-year MBSs. At current prepayment levels, balloon MBSs exhibit average lives that are significantly shorter than 30-year MBSs, but only slightly shorter than 15-year MBSs. For example, using prepayment speeds of 133 percent PSA, an unseasoned 9 percent, seven-year balloon MBS has an average life of 5.7 years. That is 1.1 years shorter than a 9 percent Fannie Mae "Dwarf."

The average-life characteristics of balloon MBSs are also less sensitive to changes in prepayment rates than longer 15-year and 30-year pass-throughs. Their five- or seven-year final maturities limit the extent to which these mortgage pass-throughs can extend their terms as prepayment rates overall decrease. At the 0 percent PSA extreme, a 9 percent, seven-year balloon MBS lengthens to 6.8 years, versus 9.4 years for a 9 percent Fannie Mae Dwarf. On the other hand, balloon MBSs do not shorten their terms as much as 15-year pass-throughs when prepayment rates rise. For example, if prepayments increase from 133 percent PSA to 300 percent PSA, the average life of a 9 percent balloon MBS shortens by 1.1 years, compared to 2.0 years for the preceding 9 percent Fannie Mae Dwarf. This average life stability reduces both call and extension risk on the balloon MBSs and should increase their appeal to investors with specific average-life targets.

Investment considerations

Balloon MBSs have a number of attractive investment features that should ensure the continued growth of an active secondary market for these loans.

Attractive yields - Balloon MBSs offer investors the triple-A credit quality and higher yields typically associted with mortgage securities. Fannie Mae 9 and 9 1/2 percent, seven-year balloons are currently trading at yield spreads of more than 85 basis points and 91 basis points, respectively, over the five-year Treasury note. Table 2 indicates that these yields compare favorably to yields on other high-quality, intermediate securities. For example, Fannie Mae seven-year balloons are currently yielding about 70 basis points more than Fannie Mae five-year debentures. Most of the recent balloon production is for settlement two or three months out and is being bid back about 2 basis points per month. As a result, balloon MBSs tend to tighten around 5 basis points as they roll forward into the current month.

Table : Table 2 Yield Spreads on Selected Securities
 Yield Spread over
Security U.S. Treasury note
5-year FHLMC 9% Balloon MBS 54 bp/4-yr
7-year FNMA 9% Balloon MBS 85 bp/5-yr
7-year FNMA 9.5 Balloon MBS 91 bp/5-yr
7-year FHLMC 9.5% Balloon MBS 91 bp/5-yr
5-year FNMA Debenture 20 bp/5-yr
5-year 'AA' Industrial 60 bp/5-yr
5-year 'A' Industrial 70 bp/5-yr
5-year PAC Bond 91 bp/5-yr
15-year FNMA 9% Dwarf 96 bp/5-7 blend

Market liquidity - The combination of heavy issuance and swift investor acceptance has spawned an active secondary market for balloon MBSs. There is excellent market liquidity for both five- and seven-year balloons. The number of dealers trading balloon product has increased sharply during the past six months, enhancing the liquidity of the market even further.

Stable average lives - Balloon MBSs are short-duration assets that can help alleviate the gap problems of thrifts and banks. Balloon pass-throughs are expected to be relatively insentive to changing interest rates and will tend to shorten and lengthen their lives less than conventional 15-year pass-throughs. This stable average-life profile should appeal to investors with asset-liability matching strategies or specific-duration targets. Given these desirable duration characteristics, we expect to see commercial banks and property and casualty companies increase their investment in the balloon market.

Regulatory treatment: thrifts - The thrift liquidity regulations promulgated by the Office of Thrift Supervision (OTS) require thrifts to maintain at least 5 percent of their asset base in liquid assets. The definition of liquid assets includes obligations issued by GNMA, Fannie Mae and Freddie Mac with five years or less remaining until maturity. Five-year balloon MBSs satisfy these requirements because of their short maturities and agency guarantee of principal and interest. Securities that are eligible for thrift liquidity portfolios trade at relatively rich levels. Thus, five-year balloons are currently priced at yield spreads around 54 basis points over the four-year Treasury note.

Regulatory treatment: banks - Seven-year balloon MBSs will receive favorable treatment under the Office of the Comptroller of the Currency's (OCC) proposed investment guidelines. The OCC may require nationally chartered banks to "closely monitor" any MBS asset that extends more than seven years in average life given an instantaneous up-or-down 300 basis point rate shock. Balloon MBSs will easily clear this regulatory hurdle due to their seven-year maturities.

Risk-capital - Balloon MBSs receive preferential treatment under the risk-capital guidelines established by bank and thrift regulators. Both five- and seven-year balloons are assigned a 20 percent risk-weighting; corporate bonds, by contrast, are included in the 100 percent risk-weight class. In other words, investors must reserve five times more capital to hold a corporate bond than a similar amount of balloon mortgage-backed securities. This favorable risk-capital treatment gives balloons a higher return on equity than similar yielding corporate bonds.

Great seasoning effect - Discount balloon MBSs will benefit from a more pronounced seasoning effect than 15-and 30-year MBSs. Due to their shorter maturities, balloon MBSs will accrete to par more quickly than longer securities. After two years of seasoning, for example, a 9 percent seven-year balloon will experience a yield pickup of 18 basis points owing to this effect, compared to 8 basis points and 4 basis points for 15-year and 30-year MBSs, respectively.

Total rate of return - Many investors prefer to evaluate performance on the basis of total rate-of-return rather than yield. Due to their stable average lives and higher-coupon rates, balloon MBSs can provide pension funds and other wealth-builders with higher returns than some mortgage and Treasury securities. Owing to the expectation that their prepayment rates are less interest-rate sensitive, balloon MBSs are less negatively convex than many other mortgage-related products; balloons will appreciate more in bullish scenarios and depreciate less in bearish situations. As a result of their higher coupons, balloon MBSs also have the likelihood of earning better returns than five-year Treasury notes in stable interest rate scenarios. Balloon MBSs provide investors with an opportunity to capitalize on a potential market inefficiency, since new securities often remain undervalued until investors become fully comfortable with the product. Finally, total-return investors can also benefit from the fact that seven-year balloon MBSs, after only two years of seasoning, will have maturities of five years and can trade as thrift liquidity bonds.

How do balloon MBSs stack up to

comparable investments?

Now that we've identified and discussed some of the investment characteristics of balloon MBSs, let's address the question most frequently asked by investors: Do balloon MBSs offer relative value versus other intermediate securities? Many investors evaluate the relative value of securities in terms of their comparative risk/return profiles. Based on an analysis of yield and average-life uncertainty, we believe balloon MBSs are attractive versus 15-year pass-throughs and planned amortization class (PAC) bonds.

Five-year agency PACs and seven-year balloon MBSs currently trade at yield spreads about 91 basis points more than five-year Treasury notes.

Fifteen-year pass-throughs will extend more than seven-year balloons, as prepayment rates slow. In addition to this extension risk, 15-year pass-throughs also have substantial yield-curve risk. Fifteen-year pass-throughs will be priced off progressively longer points on the Treasury yield curve as their average lives extend. In a steeply slope yield curve, this extension wil reduce the incremental yield over Treasuries. For example, 9 percent Fannie Mae Dwarfs, at the time this was written priced 110 basis points over the five-year Treasury note, but only 96 basis points over the interpolated yield on five- and seven-year Treasury notes. At these levels, investors are compensated only 5 basis points for accepting the extra risks associated with 15-year pass-throughs. Therefore, at current prepayment rates, 15-year pass-throughs look relatively expensive compared to balloon MBSs.

The structured products market has not yet begun to issue CMOs backed by pools of balloon mortgages. It is uncertain at present whether balloons even qualify as REMIC assets. Their short maturities also reduce the potential arbitrage between the underlying balloon collateral and the resulting CMO bonds, creating yet another obstacle to the issuance of balloon-backed CMOs. However, demand for stable intermediate-term assets might rise and the yield curve might continue to steepen to the point where an arbitrage opportunity could entice Wall Street to structure a CMO collateralized by balloons.

We expect the origination and securitization of balloon mortgages to accelerate during the coming months. Balloon mortgages are becoming more popular among homeowners given the recent rise in commitment rates on 30-year, fixed-rate mortgages and the widening spread between short-term and long-term interest rates. Strong investor demand for balloon MBSs should also encourage the continued growth of an active secondary market for these loans.

The unique investment characteristics of balloon MBSs make them appropriate assets for a wide variety of portfolio objectives. Although commercial banks are currently the dominant players in the balloon MBS market, we expect other institutional investors to become involved as this market grows and matures.

Bruce C. Mahood is a second vice president with Smith Barney's Mortgage Investment Strategies Group, New York City.
COPYRIGHT 1990 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1990 Gale, Cengage Learning. All rights reserved.

Article Details
Printer friendly Cite/link Email Feedback
Title Annotation:balloon loans for home buyers
Author:Mahood, Bruce
Publication:Mortgage Banking
Date:Nov 1, 1990
Previous Article:The Soviet mortgage in the storm of reform.
Next Article:Fending off foreclosure: lenders and investors are perfecting ways to throw lifelines to borrowers whose loans are heading for trouble.

Related Articles
Selecting the right mortgage.
Points and a principal residence.
Mortgage brokers and bankers: here's some things to consider before using one.
S & P concerned by trends in U.S. CMBS transactions.
Get the loan you deserve: African Americans can avoid being steered into bad loans by following these tips.

Terms of use | Copyright © 2017 Farlex, Inc. | Feedback | For webmasters