New Index Ushers In |Designer' Mortgages
The creation of adjustablerate mortgages in the 1980s marks one of the key innovations in asset-liability management. But yesterday's discoveries are already yielding to new, more flexible permutations.
In the 1990s, powerful new tools are enabling lenders to create a new generation of "designer" adjustable-rate mortgages. One such tool is the Federal Cost of Funds index, developed by my institution, Great Western Financial Corp., and published by the Federal Home Loan Mortgage Corp.
At the heart of the adjustable-loan revolution in the 1980s was the concept of tying the mortgage rate to an independent index. Adjustable-rate lending already existed - commercial banks had indexed loans to their own prime rate for decades. The new idea - mandated by consumer-protection legislation - was that the mortgage rate had to follow an index beyond the control of the lender.
This stricture at first seemed to put a difficult burden on the lender, but astute managements soon realized that it could work to their benefit.
The first-generation variable-rate mortgages, which had various adjustment mechanisms and indices, were soon cast aside in favor of the second generation of adjustable-rate loans.
These instruments can be divided into two classes. The first class might be called "marginal-rate instruments," primarily indexed to the spot rate on six-month or one-year U.S. Treasury securities. These were naturally attractive to lenders with short-term liabilities, such as money-center banks.
West Coast Concept
The second class might be called "average-rate instruments." This concept started on the West Coast, where thrifts such as Great Western realized that their longer liability structure, composed largely of certificates of deposit, required them to tie their loans to an index that was less volatile than spot Treasury rates.
Thus, the 11th District Cost of Funds index and other average rate indices were born.
The 11th District index is the average cost of savings and borrowings of all thrift institutions in California, Arizona, and Nevada. As such, it includes not only today's CDs, but also those issued months or even years earlier that are still on the books.
This is vital to lenders, because if a loan is prepaid, the lender must be able to re-lend the funds at a rate higher than it is paying on those still-outstanding liabilities.
Clearly, the great flaw of pure marginal-rate instruments is that they may not be suitable for the portfolio of an institution with longer liabilities. They also can lead to shock for borrowers hit with large payment increases when rates spike upward.
The only answer for both borrower and lender is to build in the proper interim and lifetime rate-caps and floors.
However, the adjustable-loan revolution was accompanied by a mortgage-securitization revolution, which forced lenders to also consider the needs of investors in the secondary market.
Avoiding Artificial Restrictions
Since investors often prefer pure market-rate instruments, an entire hedging industry has been spawned on Wall Street to reverse the effect of caps before the marginal-rate mortgage finally reaches an investor's hands. Unfortunately, the Street needs to charge for these services.
In contrast, average-rate instruments attack these problems without the need for artificial restrictions. A slower-moving index, such as the 11th District Cost of Funds or the Federal Cost of Funds, protects the borrower from rate spikes without the need for a cap. The index also shields lenders by closely matching their own cost of funds, and eliminating the need for a rate floor.
The job of the asset/liability manager is to design a mortgage that balances the needs of the borrower with those of the lender and investor. Overall, mortgages indexed to the 11th District Cost of Funds have done this very well. However, the fact that they are indexed to the cost of funds in three Western states has made it harder for them to win acceptance from consumers in the other 47 states.
This had led to an intense effort to discover or create the basis for a third generationof adjustable-rate mortgages - an index with low volatility that closely tracks an institution's average cost of funds and is based on national rather than regional funding costs.
The answer that Great Western found is the Federal Cost of Funds index.
The index is based on a simple insight: the U.S. government funds itself much like a financial institution. It issues a variety of fixed-rate obligations of short, medium, and long terms. However, instead of CDs, it issues Treasury bills, notes, and bonds.
The government generally rolls them over into similar-term instruments as they mature, just as a bank or thrift rolls over its CDs. Thus, the government's average cost of funds should change in a stable, steady manner.
A Winning Mix
Research demonstrated that the inclusion of long-term Teasury bonds in the index would make it adjust too slowly for most purposes. But using the average rate on all outstanding Treasury bills and weighting it equally with the rate on all outstanding Treasury notes produces an average cost of funds that tracks the 11th District Cost of Funds remarkably closely.
The two components of the index, the average bill rate and the average note rate, are published by the U.S. Treasury in the Monthly Statement of the Public Debt of the United States. Freddie Mac is publishing the average of the two rates, which is used to adjust the interest rate on the new mortgages. This has helped to attract other far-sighted institutions, primarily on Wall Street, which are beginning to see additional - and more intriguing - implications.
One of the greatest benefits of the new index is that it is completely transparent. Every issue of Treasury bills and note that make up the index is cataloged and tracked by thousands of market participants, both in the United States and overseas.
They all prefer different mixes of Treasury bills and notes for their portfolios. Thus, a tremendous opportunity exists for Wall Street to repackage Federal Cost of Funds indexed mortgages into tailored tranches to suit the needs of these investors, foreign and domestic.
At the start, lenders will want to maintain this new product in their own portfolios, for which it is ideally suited. But there may soon be enough for the secondary market as well. After all, within weeks of the product's introduction, it surged to more than half of loan volume at the nation's No. 3 lender.