ECN410-Lecture 8 - Adjustable Rate Mortgages and other AMI - Fall2010

ECN410-Lecture 8 - Adjustable Rate Mortgages and other AMI - Fall2010

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11/7/2010 1 Adjustable-Rate Mortgages An adjustable-rate mortgage (ARM) is a loan on which the periodic contractual interest rate can change over the life of the mortgage the mortgage. The rate is reset periodically to a fixed spread (called the margin) over a benchmark or reference rate. Most common reference rate is short term Treasury rate as determined by current market conditions Other reference rates include a calculated cost of funds or 1 average mortgage rates Why ARMs? Supply side motive: Interest Rate Risk In the early 1980s, lenders were burned by holding long term fixed-rate mortgages while interest rates rose. “Heads I Win; Tails You Lose” game This amounted to an unanticipated transfer of wealth from lenders (savers) to borrowers. Lenders wanted to modify the mortgage contract to share the risk between lender and borrower. ARMs were born! 2 By allowing the contract rate to vary with changes in market interest rates, the price of existing mortgage contracts is less sensitive to interest rate risk.
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11/7/2010 2 Why ARMs? Demand side motive: “Tilt Problem” When inflation is high, lenders need to build in expected inflation into the loan rate. Nominal rate = real rate + risk adjustment + expected inflation rate With an FRM, this means the borrower must make high “real” payments at the start of the loan and low “real” payments at the end of the loan. This makes it hard for borrowers to qualify/afford for loans 3 This is the “Tilt” problem we saw earlier ARMs typically offer lower initial contract rates (why?), and this helps to reduce problems with affordability and Tilt. As of: 9/30/04 As of: 2/14/06 1-year ARM rates were much lower than 30-year FRM rates as of 9 30 04 (170 basis 1-year ARM rates were only moderately lower than 30- year FRM rates as of 2 14 06 4 rates as of 9-30-04 (170 basis points) year FRM rates as of 2-14-06 (70 bp) Why are 1-year ARM rates lower than 15 and 30-year FRM rates? Why are 1-year ARM rates more similar to 15 and 30- year FRM rates in 2006?
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11/7/2010 3 Two things to consider when pricing ARMs versus FRMS Pricing ARMs Yield Curve Most of the time, it costs more to borrow money at a fixed rate for a long time period than for a short time period. Why? Liquidity premium Expected inflation 5 Borrowers usually prepay their loans before maturity. ARMs should be priced more like short term loans 1-year ARM rates reset every 12 months FRMs should be priced more like ____ term loans Pricing ARMs 30-year horizon for 30-year mortgages? 20-year horizon for 20-year mortgages? No! The median homeowner moves after 6 to 7 years Average stay among homeowners is 10 years If there was no refinance risk, price FRMs more like 7-year 6 term loans
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11/7/2010 4 7 Maturity (years) How big a spread would you expect to see between 1-year ARM rates and 20-year FRM rates given this yield curve?
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ECN410-Lecture 8 - Adjustable Rate Mortgages and other AMI - Fall2010

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