An economist once said, "To err is human, to get paid for it divine." The humor is undoubtedly lost on bankers whose job it is to manage interest rate risk.
Pick up The Wall Street Journal any day and you can read quotes from interest rate experts expressing opposite points of view. And if assessing interest rate movement is tough for professionals, imagine what it is like for consumers.
Over the past two decades the remarkable volatility of interest rates has created heightened awareness of asset and liability management. Systems have been developed to quantify and assess interest rate risk. An ever expanding box of tools has emerged to address the needs of rate-risk management.
Mortgage lending is one aspect of a bank's asset portfolio that has been subject to a multitude of innovations. Over this period, we have gone from the creation of balloon mortgages and ARMs to CMOs and derivatives. Unfortunately, many of these tools require an ever-increasing level of expertise and pose serious considerations of the balance between risk and reward.
The adoption of dual-rate mortgages would help deal with these problems. They are an alternative risk management tool that has little or no downside risk and is within the expertise of most bankers.
A dual-rate mortgage is a loan that is half fixed rate and half adjustable rate. For example, a 30-year $200,000 mortgage is divided at origination into two $100,000 parts; one part has a fixed rate for 30 years, the other a standard one-year adjustable rate for 30 years.
The borrower's cost of money is the average of the two rates. The borrower perceives this as one loan and gets one statement. Premature reductions in principal are applied equally to each part. Aside from the normal variations in amortization present between loans of two different rates, the borrower, by contract, is precluded from paying down one part faster than the other.
Interim-period amortization for two loans with the same term but different rates is not even. That is one reason why the two parts of a dual-rate mortgage need to be treated separately for accounting purposes. The other reason for separate treatment is so that either part may be retained or sold to the secondary market as the originator chooses. A divided sale of servicing rights, however, would not be advisable.
The risk and reward of interest rate exposure are shared equally between the lender and the borrower. Because the rates are averaged, the impact of the adjustable portion to the borrower is mitigated by one half. Thus the impact of rate caps would be far smaller, so they should not be applied. This mitigation would also lessen the probability that the borrower would refinance. Thus a more stable mortgage product is created.
Prepayments will always occur because of relocation or death, but precipitous prepayments from interest rate changes would diminish with dual-rate loans. Whether perceived or actual rate changes were up or down, dual-rate mortgages would reduce the amplitude of those changes. This reduction would lessen the borrowers' likelihood of achieving a financial gain by refinancing. Thus, such mortgages, and securities backed by them, should present less uncertainty to investors.
For the lending officer, the dual-rate mortgage represents an alternative to offer to the consumer, and perhaps an advantage if the competition does not have this program.
From the consumer's view point, the dual-rate mortgage is not as foreign as it might sound.
Many people have already had the experience of a fixed-rate mortgage and an adjustable equity loan. Observation of the blended rate for my own fixed rate mortgage and adjustable equity loan, relative to current market rates, was the genesis of this concept. But, with two separate loans, the consumer still holds all the cards when it comes to refinance options. With the dual-rate mortgage, the bank and the borrower share in the reduction of interest rate risk.
Marketing efforts could point out the benefits the consumer would enjoy from reduced interest rate risk. Will rates go up or down? Should the borrower choose a fixed rate or adjustable? Now there would be an alternative that let the consumer benefit from a combination of both types of loans, in many different interest rate scenarios. Current rates on traditional mortgage products reflect, in part, the fact that the borrower controls all the refinance options.
The reduced option on the part of borrowers with dual-rate loans should translate into competitive rates. Such rates would help achieve consumer acceptance of the concept. The secondary market should reflect those lower rates.
The reduced option held by the borrower would help in asset-liability management, with fixed rate mortgages less likely to be refinanced when rates decline and adjustable-rate mortgages that don't cap out as rates rise. The more stable dual-rate mortgage product should also mean more stable values for mortgage servicing rights.
Some housekeeping items; the dual-rate mortgage would require some changes:
A computer program would need to be developed that accounted for the two parts of a dual-rate mortgage, then combined them for the borrowers' statement.
The unique features of the dual-rate loan, particularly the divisibility, would have to be reflected in the note, APR disclosure, and title work. Title considerations are one more reason why servicing rights should never be divided.
The note must preclude unequal prepayment of either part of the dual- rate loan.
Finally, there is nothing that dictates that the two parts of a dual- rate loan be equal, but I suggest they should be equal. The concept would be more easily understood by the consumer with a consistent fifty-fifty, the reduction in amplitude would be consistent, and there would be greater continuity in the secondary markets.
I have resisted the temptation to offer pricing scenarios because the marketplace would determine price in both the primary and secondary markets. I would theorize, however, that the anticipated disposition of part or all of a dual-rate loan might have impact on pricing. And, a mortgage lender who intends to retain part or all of a dual-rate mortgage might have a pricing advantage over a mortgage banker who needed or wanted to sell the whole loan.
That is the concept of the dual-rate mortgage. The consumer is given an alternate mortgage instrument that can hedge his interest rate risk. The bank acquires a manageable tool to reduce interest rate risk, aid asset- liability management, and create a more stable mortgage product. The start- up costs should be nominal, and the long-term benefits could be considerable.
It's impossible to predict if this type of lending would find acceptance among lenders and borrowers, but evolution is inevitable. There was a time when no mortgage could be made unless it was assumable. The dual-rate mortgage would-I believe for the first time-significantly change optionality. It is therefore is a concept that each mortgage lender should consider.