Thursday, February 4, 2010

Behind the Mad Math of Adjustable Rate Mortgages

WSJ's Carrick Mollenkamp explains why some adjustable rate mortgages are going up and others down:

Tens of thousands of homeowners with adjustable-rate mortgages have seen their monthly payments jump or stay high even as they have fallen for other homeowners. This disparity owes to the indexes used to calculate those payments have moved in unexpected ways.

The behavior of these indexes, which have controlled monthly payments on more than $100 billion of adjustable-rate mortgages, means that many homeowners are paying as much as 25% more than homeowners with similar loans. The higher payments, which can total $269 a month on a $250,000 loan, come as many homeowners are struggling to avoid default.

Few homeowners have heard of or understand these indexes, which have acronyms like Cosi, Codi and Cofi, along with the better-known Libor. And few know how they are calculated or what they mean for borrowers...

All of the indexes have one thing in common: They effectively measure the rates banks pay to borrow money. Banks then add about 2.5 percentage points to the rate when they lend the money to borrowers...

Some of the moves in these mortgage indexes are directly or indirectly linked to Wells Fargo & Co., one of the biggest mortgage lenders in the country. Wells inherited some of the mortgages through its purchase of Wachovia, which itself bought Golden West Financial in 2006 just before the housing crisis hit.

In some cases, borrowers could choose which index their mortgage would be tied to. The indexes had historically moved in the same direction at similar times and were presented to customers as nearly identical. Borrowers who got mortgages from Golden West used three indexes to set their payments: Cosi, or the cost of savings index, which was tied to the bank's own deposits; Codi, or the certificates of deposit index, was based on the price of three-month certificates of deposit. A third index overseen by the Federal Home Loan Bank of San Francisco was a lesser-used benchmark.

Cosi accounted for 54% of Golden West's mortgage balance of $121 billion, or $65 billion, as of May 2006 when Wachovia agreed to buy Golden West. Codi accounted for 37% of the Golden West portfolio, or $44 billion. The unpaid balance for the portfolio of loans tied to Cosi and Codi was about $103 billion at the end of 2009.

There was one difference between the two indexes: Codi is based on short-term borrowing costs, which have fallen significantly .... Cosi includes long-term CDs that are paying higher yields, keeping Cosi elevated above Codi.

The net result is that in the most recent postings for the two indexes, Codi was at a super-cheap 0.4875%, while Cosi was 2.35% as of Jan. 14.

Those who are patting themselves on the back by choosing a short-term interest rate index, should heed this warning: In the very near future all interest rates will be headed higher, and eventually, not necessarily right away, short-term rates will trade ABOVE long term rates. This is not the time to hold any type of adjustable rate mortgage, it is a time to lock in fixed rates.

Remember, Nicholas Taleb correctly says every human being should be shorting Treasury securities. If you have an adjustable rate mortgage, you are doing the exact opposite---you are counting on stable to declining rates.

1 comment:

  1. Taleb always recommends shorting, thats his preferred investment strategy. But his investment style is unusual. He is willing to endure many small losses in exchange for one large gain. There are other ways to protect against a "black swan" event.

    I had a floating rate mortgage from 1983 to 2003 and it was less expensive during this period than the fixed rate that was available in 1983, and I was a commercial banker at the time.

    I suggest that each person needs to evaluate their own situation.