Has the Fed found a bet­ter longterm mort­gage prod­uct?

National Mortgage News - - Contents - By brian collins

econ­o­mists at the fed­eral re­serve are sug­gest­ing an in­trigu­ing new al­ter­na­tive to the tra­di­tional 30-year fixed mort­gage that could be bet­ter for con­sumers, more prof­itable for banks, and safer for both.

In a re­cent pa­per, they pro­posed a new mort­gage prod­uct that would al­low home buy­ers to build eq­uity faster than the stan­dard 30-year fixed-rate mort­gage with lit­tle or no down pay­ment. This mort­gage is built around the cost of funds, or COFI, in­dex pub­lished by the Fed­eral Home Loan Bank of San Fran­cisco. It re­duces the in­cen­tive for bor­row­ers to re­fi­nance and the­o­ret­i­cally makes it prof­itable for banks to hold these fixed-rate mort­gages in port­fo­lio.

“The fixed-COFI mort­gage ex­ploits the of­ten-present pre­pay­ment-risk wedge be­tween the fixed-rate mort­gage rate and the es­ti­mated cost of funds in­dex mort­gage rate,” ac­cord­ing to a pa­per writ­ten by Fed­eral Re­serve Board se­nior ad­vi­sor Wayne Pass­more and Alexander von Hafften, a se­nior re­search as­sis­tant at the Fed.

“In ad­di­tion, banks can hold a fixed-COFI mort­gage prof­itably, and their credit risk con­cerns are of­ten mit­i­gated soon af­ter orig­i­na­tion be­cause of rapid eq­uity ac­cu­mu­la­tion.”

In a fall­ing in­ter­est rate en­vi­ron­ment, the COFI mort­gage au­to­mat­i­cally ad­justs so the bor­rower pays less in­ter­est and pays down the mort­gage prin­ci­pal more quickly. Un­der the prod­uct, eq­uity ac­cu­mu­lates faster than tra­di­tional fixed-rate mort­gages and there is less in­cen­tive to re­fi­nance. How­ever, bor­row­ers still re­tains the op­tion to re­fi­nance.

“We be­lieve that many house­holds may pre­fer fixed-COFI mort­gages to tra­di­tional fixed-rate mort­gages,” ac­cord­ing to the Fed pa­per, par­tic­u­larly in cases where the “spread be­tween the fixed rate mort­gage rate and the one-year Trea­sury yield is rel­a­tively high.”

They also ex­pect the fixed-COFI mort­gage will be a “highly prof­itable as­set for many mort­gage lenders.” And this mort­gage prod­uct might also open the door for more renters to be­come home­own­ers.

“We be­lieve that many rent­ing house­holds with­out sav­ings for a down pay­ment may pre­fer fixed-COFI mort­gages to rent­ing,” the pa­per said.

In­dus­try ob­servers said the idea has merit.

“Rem­i­nis­cent of other mort­gage prod­ucts that pri­or­i­tize eq­uity-build­ing, the re­searchers be­lieve and we agree that their new prod­uct ad­vances hous­ing equal­ity be­cause of its eas­ier en­try point (no down pay­ment) and more cer­tain path to eq­uity re­ten­tion,” said a Sept. 7 pa­per by Fed­eral Fi­nan­cial An­a­lyt­ics.

“By choos­ing the fixed-COFI mort­gage, the pa­per says that bor­row­ers will lose the abil­ity to spend re­fi­nanc­ing gains on non-hous­ing items. In­stead, when mort­gage rates fall, they ef­fec­tively au­to­mat­i­cally re­fi­nance and pay less in­ter­est and more mort­gage prin­ci­pal.”

Ed­ward Pinto, a res­i­dent fel­low at the Amer­i­can En­ter­prise In­sti­tute and co-di­rec­tor of AEI’s In­ter­na­tional Cen­ter on Hous­ing Risk, said it “is an in­no­va­tive and well thought out idea.”

His­tor­i­cally, there has al­ways been a dif­fer­ence be­tween the COFI in­dex rate and the 30-year fixed mort­gage rate, ex­cept in a few in­stances.

“The big plus is the po­ten­tial for wealth build­ing,” Pinto said, since the au­thors found the av­er­age ma­tu­rity of fixed-COFI mort­gages to be 23

years, so long as the bor­rower did not re­fi­nance or ex­tract eq­uity.

But some sug­gested it might be too dif­fer­ent from cur­rent prod­ucts to catch on.

“The fixed-pay­ment COFI mort­gage is an in­trigu­ing but quite com­pli­cated prod­uct,” said Glenn Corso, ex­ec­u­tive di­rec­tor of the Com­mu­nity Mort­gage Lenders of Amer­ica and a for­mer pri­vate mort­gage in­sur­ance ex­ec­u­tive.

“I think it would take a tremen­dous amount of bor­rower ed­u­ca­tion to get con­sumers com­fort­able with the prod­uct,” he said. And it will take a “great deal of bank and/or in- vestor ed­u­ca­tion to get lenders com­fort­able with the prod­uct.”

Un­der the plan, a fi­nan­cial in­sti­tu­tion es­sen­tially guar­an­tees the loan will be paid off in 30 years and the bor­rower will never pay more than the ini­tial in­ter­est rate, which is based on the 30-year fixed mort­gage rate.

If the dif­fer­ence, or “wedge,” be­tween the 30-year rate and COFI in­dex rate is 1%, that dif­fer­ence is used to pay down the mort­gage faster. How­ever, in a ris­ing in­ter­est rate en­vi­ron­ment, the lender would have to hedge to pre­serve the bor­rower’s eq­uity.

The Pass­more-von Hafften pa­per lays out how in­sti­tu­tions should hedge against that risk.

How­ever, it’s a com­plex prod­uct, Pinto noted, and there’s ques­tion of whether many fi­nan­cial in­sti­tu­tions will be in­ter­ested in of­fer­ing the fixed-COFI mort­gage. There is also a po­ten­tial hur­dle in the dif­fi­culty of ex­plain­ing it to con­sumers so they can un­der­stand it.

Not ev­ery­one in the in­dus­try, more­over, is en­am­ored by the idea.

Michael Fratan­toni, the chief econ­o­mist of the Mort­gage Bankers As­so­ci­a­tion, said the group is very wary of the fixed- COFI mort- gage prod­uct due to re­stric­tions on pre­pay­ments.

In one ver­sion of the fixed-COFI mort­gage, there is no pre­pay­ment al­lowed dur­ing the life of the 30-year mort­gage. In an­other ver­sion, re­fi­nances are only al­lowed if rates drop by 2% or more, ac­cord­ing to MBA.

“In the cur­rent reg­u­la­tory en­vi­ron­ment, pre­pay­ment penal­ties are sev­er­ally re­stricted,” Fratan­toni said. “I don’t think ei­ther U.S bor­row­ers or the U.S. reg­u­la­tory sys­tem would per­mit these prod­ucts to be widely avail­able. And I don’t think you would see a lot de­mand or takeup in the mar­ket.”

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