Module 6: Introduction to Nontraditional Mortgage

Products, and the Adjustable Rate Mortgage

UNIT 1: NONTRADITIONAL MORTGAGE PRODUCTS (13 MIN)

PAGE 1: MOD6_GUIDANCE (3 MIN)

In this unit, you’ll learn about:

a brief history behind some of the most popular nontraditional mortgage products;

a review of the risks nontraditional mortgage products posed to the market; and

a discussion of current laws curtailing those risks.

THE FDIC’S INTERAGENCY GUIDANCE ON NONTRADITIONAL MORTGAGE PRODUCT RISK

In 2006, the Federal Deposit Insurance Corporation (FDIC), and other federal government agencies (collectively in

this unit, the Agencies) in charge of regulating mortgage lending issued a final rule: “The Interagency Guidance on

Nontraditional Mortgage Product Risks.” The Agencies developed the guidelines to give federal banks, credit

unions, and other federally regulated financial entities a framework for managing the risk on “nontraditional

mortgage products”.

The interagency guidance defined “nontraditional mortgage products” as all closed-end residential mortgage loan

products that allow borrower to defer repayment of principal or interest, such as interest-only products or

negative amortization products. At the time of the Agencies’ release of these guidelines, the market share of these

types of loans had vaulted them from their position as niche products available to highly qualified borrowers to a

tool by which lenders could get otherwise unqualified borrowers into homes.

Many of these products, in addition to being risky by their nature, were being provided with less stringent income,

asset and credit requirements, or reduced documentation. For example, the 2000s saw the rise of the no-income,

no-asset loan and the stated income loan, both of which required no verification of the borrower’s income.

Additionally, many were being offered in combination with simultaneous second-lien loans, which further diluted

both the borrower’s ability to repay the loan and the borrower’s stake in paying the loan (“skin in the game”).

Taken independently, any one of these practices (reduced documentation, high debt load, exotic loan product)

placed the borrower at a higher risk of default than they would experience on a traditional 30-year fixed-rate

mortgage. The concentration of many different types of risk in one loan product, or loan, is known as risk layering.

“RISK? WHAT RISK?”

The Agencies guidelines called for lenders to put in place risk mitigation procedures to offset the risk layering

which went along with nontraditional mortgage products. The Agencies urged lenders to:

ensure that loan terms and underwriting standards are consistent with prudent lending practices,

including consideration of a borrower's repayment capacity;

recognize that many nontraditional mortgage loans, particularly when they have risk-layering features,

are untested in a stressed environment, and warrant strong risk management standards, capital levels

commensurate with the risk, and an allowance for loan and lease losses that reflects the collectability of

the portfolio; and

ensure that consumers have sufficient information to clearly understand loan terms and associated risks

prior to making a product choice.

In a nutshell:

consider if the borrower can repay the loan while the loan is being underwritten;

ensure, before making the loan, that the institution has adequately prepared in the likely event of the

borrower’s default; and

explain the products to the consumer and disclose the high risk of loss.

In today’s mortgage market, these expectations are par for the course. However, in 2006 these rules were met

with a different attitude. Some telling commentary in response to the Agencies’ guidance:

The American Banker’s Association: It’s not that bad.

“While the banking industry agrees that these products need to be carefully managed, the industry has a

number of concerns about the proposed Guidance. In brief, we believe that […t]he Guidance overstates

the risks of these mortgage products. [Additionally, t]he Guidance's detailed consumer protection

recommendations add a layer of additional disclosure before and around the legally required Regulation Z

disclosures, thereby perhaps creating significant compliance problems.”

Chase Bank: They can just refinance it away.

“Chase supports an overall restriction on qualifying borrowers based solely on aggressive short term

teaser rates. However, Chase also believes that the underwriting standard in the Proposed Guidance (fully

indexed rate, fully amortizing term) is too conservative for many interest only products. Given the five to

seven year average life of a residential mortgage loan, most borrowers using interest only products will

never experience any form of payment shock.”

Lehman Brothers: We know what we’re doing.

“We believe the key is risk layering by the institution. An institution's approach to risk layering should

ideally be based upon historical performance data. If an institution can demonstrate that certain apparent

risk factors (or combinations of risk factors), within definable parameters, do not lead to increased risk of

delinquency, then the Agencies should accept that the institution is layering the risks properly. An open

market will mean that different institutions will develop different methodologies for achieving this goal.”

[FDIC Federal Register Citations — Comments on Interagency Guidance on Nontraditional Mortgage

Products]

PAGE 2: MOD6_RECIPE (6 MIN)

THE AGENCIES’ RECIPE FOR A STABLE MORTGAGE MARKET

The focus of the Agencies’ guidance was on the specific risk elements of certain nontraditional mortgage products,

not solely the product type. Two years after the Agencies released their definition of nontraditional mortgage

product, the Secure and Fair Enforcement Act of 2008 (SAFE Act, reviewed in Module 1) defined a nontraditional

mortgage product as any mortgage product other than a 30-year fixed-rate mortgage. [15 USC §5102(7)]

Thus, nontraditional mortgage products include (but are not limited to):

hybrid adjustable rate mortgages (ARMs);

option ARMs;

reverse mortgages;

balloon payment loans;

home equity lines of credit;

home equity loans; and

40-year mortgages.

The SAFE Act’s definition, together with the Agencies’ guidance, paved the way for future consumer protection

measures in regards to nontraditional mortgage products. More importantly, the Agencies’ commentary on

nontraditional mortgage product use is still valid criticism today.

We’ll go over the Agencies’ rules for mitigating the risk of nontraditional mortgages, and discuss how traditional

and nontraditional mortgage products differ in regards to each factor. Any new rules which have become effective

since the Agencies’ released these guidelines will also be discussed.

Qualification standards

“When an institution offers nontraditional mortgage loan products, underwriting standards should address the

effect of a substantial payment increase on the borrower's capacity to repay when loan amortization begins… an

institution's qualifying standards should recognize the potential impact of payment shock, and that nontraditional

mortgage loans often are inappropriate for borrowers with high loan-to-value (LTV) ratios, high debt-to-income

(DTI) ratios, and low credit scores.

For all nontraditional mortgage loan products, the analysis of borrowers' repayment capacity should include an

evaluation of their ability to repay the debt by final maturity at the fully indexed rate, assuming a fully amortizing

repayment schedule.”

Payment shock is a substantial increase in a borrower’s monthly mortgage payment which increases the risk of

default. Payment shock is associated with adjustable rate mortgages (ARMs), since the monthly payments can

adjust from the initial interest rate at which the borrower was qualified. Payment shock is less likely on a

traditional fixed rate mortgage, as the monthly payments on a fixed rate mortgage do not change. (There may be

payment shock on a fixed rate mortgage if the borrower’s previous mortgage payment, or rent, was substantially

less than the current mortgage payment.)

Payment shock is particularly pronounced when the initial interest rate is a very low teaser rate. For instance,

option ARMs gave borrowers the option of choosing very low payments each month, instead of paying the full

principal and interest, or even just the interest. Eventually, however, the loan payments must adjust in order for

the loan to be paid off within the amortization period. The difference between the old minimum payment and the

new payment which includes principal and deferred interest is what creates payment shock.

In 2006, the mortgage crisis was already at terminal velocity. The Agencies’ guidance, even had it been followed to

the letter, could not have stopped it. (This is not to say the Agencies were entirely blameless for the mortgage

crisis. Years of laissez faire policies had plenty to do with the meltdown.) However, the recently finalized ability-to-

repay and qualified mortgage rules have belatedly answered the Agencies’ call for ARMs to be underwritten on a

fully-indexed rate and full amortization schedule. [See Module 4; 12 Code of Federal Regulations

§§1026.43(c)(5)(i); 1026.43(c)(5)(i)(B)-(C)]

A more detailed explanation of option ARMs will be provided later in this module.

Reduced documentation

“Institutions are increasingly relying on reduced documentation, particularly unverified income to qualify

borrowers for nontraditional mortgage loans. Because these practices essentially substitute assumptions and

alternate information for the waived data in analyzing a borrower's repayment capacity and general

creditworthiness, they should be used with caution. An institution should consider whether its verification

practices are adequate. As the level of credit risk increases, the Agencies expect that an institution will apply more

comprehensive verification and documentation procedures to verify a borrower's income and debt reduction

capacity…reduced documentation, such as stated income, should be accepted only if there are other mitigating

factors such as lower LTV and other more conservative underwriting standards.”

In 2006, the Mortgage Brokers Association for Responsible Lending, a consumer advocacy group, testified at a

Federal Reserve Board hearing. In a small sample of stated income loans it compared against IRS records, it found

that almost 60% of the stated amounts were exaggerated by more than 50%. So the risk of a stated income was

certainly not imagined.

Many stated income loans and no-income, no-asset loans were technically 30-year fixed rate mortgages, we’ll

speak to the Agencies’ intent in curtailing risk, rather than just the product. Stated income loans allowed the

borrower to state the income, rather than have the lender verify it. Some stated income products required a

verification of assets. Others were flat-out no-income, no-asset (NINA) loans (also called liar loans), meaning the

lender did not verify the income or assets of the borrower.

Lenders played up the stated income loans as a way for self-employed borrowers (whose incomes generally take

more time for underwriters to verify) with good credit to bypass the income verification process. This is an

example of risky, but still justifiable mitigation: a higher credit score and lower LTV requirements offset the risk of

taking a borrower’s income at their word.

However, the stated income programs did not stop with prime borrowers. As the entire industry began believing

that housing prices would rise perpetually, stated income loans became more prevalent in the subprime market.

The logic went like this: if the collateral (the property) was going to keep appreciating, the borrower’s income

mattered less and less. They could just refinance out of it. (See the Chase Bank comment from the last page.)

Accordingly, the ability-to-repay rules prohibit the use of no-income, no-asset or stated income loans. All income

and assets must be verified. [12 CFR §1026.43(c)(4)]

COLLATERAL DEPENDENCY AND RISK LAYERING

Collateral dependency

Which brings us to our next bit of Agency guidance, on collateral dependency.

“Institutions should avoid the use of loan terms and underwriting practices that may result in the borrower having

to rely on the sale or refinancing of the property once amortization begins. Loans to borrowers who do not

demonstrate the capacity to repay, as structured, from sources other than the collateral pledged are generally

considered unsafe and unsound. Institutions determined to be originating collateral-dependent mortgage loans,

may be subject to criticism, corrective action, and higher capital requirements.”

The culprits here: the short-term, teaser rate arms, interest only products, and negative amortization products.

Again, it’s a matter of payment shock. Assuming property does not appreciate forever (it doesn’t), relying on the

property as a means of bailing out the borrower is like relying on a match to put out a fire: it doesn’t make much

sense.

Likewise, reverse mortgages also pose a similar, but slightly different risk for borrowers, lenders, and the Federal

Housing Administration’s insurance coffers. Like these short-term adjustable rate time-bombs, the reverse

mortgage places a heavy dependency on the collateral. Too little scrutiny is given to the elderly borrower’s ability

to make tax and insurance payments to avoid default. In the case of reverse mortgages, a default means not just a

few years’ worth of equity lost, but a lifetime’s. We’ll discuss revere mortgages in the next module.

The ability-to-repay requirements do not restrict negative amortization, interest-only payments or balloon

payments. (Its safe harbor provision, the qualified mortgage, does.) However, that doesn’t mean those loan

features aren’t limited — the ability-to-repay rules require, well, the lender to prove the borrower’s ability to

repay the loan, regardless of the presence of these features.

Let’s get back to the risk layering that we started this unit with. The proper way to mitigate the many risks of

nontraditional mortgage products is to offset the risks with more rigorous standards. For instance, if a borrower

has a high debt-to-income ratio, the lender must be able to mitigate that risk with, say, extensive assets. But

instead, what lenders did with nontraditional mortgage products was add risk on top of risk, and charge higher

fees for the products. Charging extra fees may have greased the way for lenders to feel better about offering the

product up front, but it did nothing to offset the risk of the borrower’s default. Or, for that matter, the lender’s risk

of default, a few years down the line.

PAGE 3: MOD6_OVERENC (4 MIN)

OVER-ENCUMBERED

Simultaneous second-lien loans

“Simultaneous second-lien loans result in reduced owner equity and higher credit risk. Historically, as combined

loan-to-value ratios rise, defaults rise as well. A delinquent borrower with minimal or no equity in a property may

have little incentive to work with the lender to bring the loan current to avoid foreclosure. In addition, second-lien

home equity lines of credit (HELOCs) typically increase borrower exposure to increasing interest rates and monthly

payment burdens. Loans with minimal owner equity should generally not have a payment structure that allows for

delayed or negative amortization.”

Piggyback loans were common during the Boom. Many borrowers sought to avoid paying private mortgage

insurance on conventional loans, and opted to get simultaneous seconds. With so little invested in the property,

borrowers had little insulation against price fluctuations — especially ones as violently corrective as we had after

the housing bubble burst. Millions of borrowers lost all of their equity, and went underwater.

With standard HELOCs, the risk is based on the overreliance on collateral. On the one hand, the borrower is able to

tap into equity – on the other, the equity depletes, and the borrower is exposed to economic shocks.

Several studies by various Federal Reserve Banks point to negative equity as a significant factor in a borrower’s

decision to walk away from their homes. [Payment Size, Negative Equity and Mortgage Default, the Federal Bank

of New York; The Depth of Negative Equity and Mortgage Default Decisions, Federal Reserve Board of Governors]

“WATCH YOUR ASSETS”

“While sale of loans to third parties can transfer a portion of the portfolio's credit risk, an institution continues to

be exposed to reputation risk that arises when the credit losses on sold loans or securitization transactions exceed

expected losses. In order to protect its reputation in the market, an institution may determine that it is necessary

to repurchase defaulted mortgages. […] Institutions involved in securitization transactions should consider the

potential origination-related risks arising from nontraditional mortgage loans, including the adequacy of

disclosures to investors.”

While this is not itself a type of nontraditional mortgage product, the secondary market demands for mortgage

products — any, and all, and ever more nontraditional mortgage product! — played a role in how lenders treated

nontraditional mortgage programs. Securitization was the underlying drive behind it. The risk of these

nontraditional mortgage products was diluted by the flow of the money downstream, away from the lender. Risk

layering would not have happened to the same degree if lenders had stake in the mortgages they made. Look

around the market today, for evidence. These products haven’t disappeared altogether. Ask enough loan

originators and someone knows someone who can do almost any type of nontraditional, or even subprime,

mortgage loan. But they aren’t being sold to Fannie Mae or Freddie Mac, and Wall Street isn’t quite ready to take

on that task again (or rather, yet.)

Securitization was part of the reason nontraditional risk was what it was. It is a matter of degree, and regulation.

The more demand for something, such as nontraditional mortgage products, the more suppliers will scramble to

make it. If Newton had made a first law of mortgages, this would be it: a market in motion stays in motion unless

acted upon by a force – in this case, regulators. The ability-to-repay rules effectively draw a line in the sand for

what Fannie and Freddie (or their successor) will buy. And there goes most of the demand.

PROTECT THE CONSUMER

Consumer protection issues

“While nontraditional mortgage loans provide flexibility for consumers, the Agencies are concerned that

consumers may enter into these transactions without fully understanding the product terms. Nontraditional

mortgage products have been advertised and promoted based on their near-term monthly payment affordability,

and consumers have been encouraged to select nontraditional mortgage products based on the lower monthly

payments that such products permit compared with traditional types of mortgages. In addition to apprising

consumers of the benefits of nontraditional mortgage products, institutions should ensure that they also

appropriately alert consumers to the risks of these products, including the likelihood of increased future payment

obligations. Institutions should also ensure that consumers have information that is timely and sufficient for

making a sound product selection decision.”

The last risk, and perhaps the first risk, of nontraditional mortgage products is its effect on consumers. Consumers,

who, it’s true – ought to know better than to sign something which indentures them to a property under terms

they cannot pay. However – if they ought to know that, lenders and loan originators similarly ought to know that

they are also responsible for the products and services they sell. The nature of the product and service must be

disclosed to make it a fair, and equitable transaction. Unfortunately, asymmetry of information is often the norm

with financial products and services. Mortgages – even traditional 30-year fixed mortgages, but especially

nontraditional mortgages that change in function and form from month to month — are complex. The function of

disclosures is to unravel the complexity so parties on both sides can agree to the same terms, for the same

product.

Since the Agencies released this guidance, myriad disclosure laws have been passed, mostly involving the Truth-in-

Lending disclosures and the Good Faith Estimate. The Dodd-Frank Wall Street Reform and Consumer Protection

Act also established several new disclosure requirements, and the Consumer Financial Protection Bureau to

advocate on behalf of and inform consumers.

Since so many of these changes to protect consumers are pending, and the mortgage market is still recovering, it

remains to be seen how nontraditional mortgage products will fare in the coming years.

UNIT 2: INTRODUCING ARMS (15 MIN)

PAGE 1: MOD6_ARM1 (4 MIN)

In this unit, you’ll learn about:

the history of the adjustable rate mortgage in the United States; and

how adjustable rate mortgages work.

THE BIRTH OF THE ADJUSTABLE RATE MORTGAGE

In the United States, the most common type of home financing is the 30-year fixed rate mortgage (FRM). Up until

the early 1980s, the fixed rate mortgage was just about the only type of mortgage available to borrowers.

Adjustable rate mortgages (ARMs) were not (yet) authorized by the federal regulators.

At the time, the main sources of mortgage funds were financial entities known as savings-and-loans. Savings-and-

loans operated by offering depositors interest on their deposits (that’s the “savings” part), and in turn using the

deposits to lend mortgage money at slightly higher interest rates (the “loans” part) than those paid to the

depositors. For instance, the savings-and-loans would pay a 5.5% interest rate to depositors, and then turn around

and charge 6.5% to a mortgage borrower for a 30-year fixed rate mortgage. The savings-and-loans kept the spread

between the two interest rates as profit, and continued the savings-and-loan cycle.

Prior to the 1980s, federal laws prohibited savings-and-loans from dabbling in other types of consumer finance, so

their sole source of income was mortgage lending. (The one-stop-shop mega banks we’re so familiar with today

were unlawful then.) Thus, by their very structures, savings-and-loans were highly dependent on depositors’ funds

as a source of funds to make loans and stay in business.

However, as we’ve stated, the loans made were 30-year fixed rate mortgages. A lender making a 30-year fixed rate

mortgage is making a commitment to lend money at a fixed interest rate over a long period of time. Depositors, on

the other hand, were being paid interest rates at market rates. Everything worked fine for the savings-and-loans

while their expenses (the interest paid on deposits) were less than their income (interest rate charged on

mortgage loans), but it left savings-and-loans highly vulnerable to interest rate fluctuations. Congress attempted to

mitigate this vulnerability in 1966 by placing caps on the amount of interest a savings-and-loan was able to pay to

depositors. They set this cap higher than the cap placed on commercial banks to encourage depositors to place

their money with savings-and-loans, to ensure the mortgage money continued to flow.

Then, economic conditions in the ‘70s drove inflation sky-high. Savings-and-loans remained restricted by the

interest rate cap. Other financial companies which were not subject to interest rate caps set by the federal

government paid true market level interest. Savings-and-loans depositors began pulling funds from savings-and-

loans in droves, to place their funds in higher-yield investments.

In an attempt to save the moribund savings-and-loans, Congress and regulatory agencies did two things in the

early 1980s:

passed the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA), which:

o allowed savings-and-loans to diversify their investments, i.e., make money through means other

than 30-year fixed rate mortgages; and

o removed interest rate caps on depositor funds; and

adopted regulations allowing savings-and-loans to offer adjustable rate mortgage (ARMs).

In contrast to fixed-rate mortgages, ARMs allowed lenders to float interest rates to the market after a certain

amount of time. By allowing mortgage rates to change according to the market, ARMs shifted inflationary and

economic risk from the savings-and-loan to the borrower. Regulators hoped this would equalize the expenses and

incomes of savings-and-loans, and pull them out of the red.

It didn’t work. Ultimately, savings-and-loans went the way of the dodo; but the ARMs remained. From 1980s and

onwards, the ARM has been available to consumers. It has largely been as deleterious to uninformed borrowers as

it was ineffective in rescuing savings-and-loans.

Editor’s note — The impact of ARMs on borrowers has been memorialized in some colorful language over the years.

Veteran loan originators may remember when ARMs were called “topless mortgages” as it seemed their ceiling

rates were set so high as to be meaningless. Other equally colorful names included the “Reverse Interest and

Principal for Optimum Fast Foreclosure (RIPOFF) loan” and the “Zero Ability to Pay (ZAP) loan.”

The face of the ARM has changed over the years, most markedly during the Millennium Boom.

20 years after ARMs became part of the American mortgage landscape, the housing market was experiencing an

unprecedented boom. Fueled by low interest rates and speculative fever, housing prices were skyrocketing.

Mortgage lending standards are lax, in part due to demand from investors for ever more securitized mortgages,

and in part due to the hubristic belief that prices would always rise, and therefore the collateral (the property),

rather than the borrower, would carry the loan.

When demand for mortgages peaked in mid-2005, Wall Street had perfected its vertically expanded system for

gathering, bundling and reselling mortgages through the MBB market to millions of investors worldwide. Of

course, all these bonds were dependent on new mortgages. The most infamous of these new mortgage products

were “subprime mortgages.” But the multitude of creative new types of ARMs were also created — or revived —

during this era. If the borrower could not afford a mortgage, it was the mortgage’s fault, not the borrower’s!

In the history of adjustable rate mortgages, we discussed that FRMs guarantee a rate over a long period of time.

Lenders necessarily build into the FRM interest rate the cost of keeping an interest rate “locked-in” at that interest

rate for 30 years. ARMs tend to have lower initial rates because the initial “fixed rate” (if any) is shorter — a matter

of a few months to a few years, rather than 30 years. Thus, otherwise unqualified borrowers were able to afford

mortgages. ARMs offered low initial interest rates to qualify and very low payment schedule options for up to ten

years.

Currently, ARMs use is at low ebb due to continued fallout from the financial crisis which has impacted lenders’

risk aversion. However, interest rates are at historic lows. In the next few years, any borrowers who take out ARMs

will be at the mercy of the rising interest rates of the next few decades.

In order to adequately inform borrowers of the impact ARMS may have on their payments, loan originators must

be aware of the existence, and workings of these products.

PAGE 2: MOD6_POPARM (5 MIN)

THE PURPOSE AND POPULARITY OF ARMS

An adjustable rate mortgage (ARM) calls for periodic adjustments to both the interest rate and the dollar amount

of scheduled payments. This is in contrast to a fixed-rate mortgage (FRM), which has a fixed interest rate, and fixed

scheduled payments.

In addition to the market factors which created demand for all types of mortgages, ARMs are typically very popular

when housing prices are high, or FRM interest rates are high. In the past, ARMs allowed borrowers to leverage the

lower interest rate on an ARM, or even the initial teaser rate, into a higher purchasing price.

In addition to the greater purchasing power an ARM initially provides a borrower, ARMs may attract borrowers

who plan on:

moving within the fixed period of the loan;

refinancing the loan into a lower rate after they improve their credit; and/or

using the money saved by the lower ARM interest rates in higher-yield investments.

Unfortunately, these plans didn’t always bear out. During the Millennium Boom, many loan originators fell into the

trap of advising their borrowers to obtain a very short-term ARM with the expectation of refinancing into a fixed-

rate loan before the fixed rate period ended. But when it came time to refinance, the house securing the property

had lost value, or the borrower had lost their job. Additionally, the terms on some of the more “creative” ARMs

also contained time-bombs which, when the time came for a refinance, blew up in the borrower’s face.

We’ll discuss these different products in the new unit. Let’s talk about the basics of how ARMs work.

ELEMENTS OF AN ARM

All ARMs contain these four items:

an introductory interest rate;

an index;

a margin; and

an adjustment interval.

The introductory interest rate

The introductory interest rate is the initial rate on the ARM. The introductory interest rate is sometimes called a

teaser rate. The introductory interest rate stays fixed for a set amount of time, called the introductory period. The

introductory period can be anywhere from a month to ten years, depending on the type of ARM. Lenders may set

the introductory interest rate at a discount of the index, or however it chooses, depending on whether it wants to

attract borrowers for ARM loans. In most cases, however, the introductory interest rate is lower than the rate

which will be experienced during the remainder of the loan.

In the past (and certainly during the Millennium Boom), many lenders underwrote borrowers’ loan applications

based on this introductory interest rate. When the introductory interest rate adjusted, borrowers were often

unprepared for the increase in payments, a phenomenon known as payment shock. However, the ability-to-repay

rules which will become effective on January 10, 2014 will require lenders to underwrite borrowers based on a

fully-indexed rate (discussed shortly), or the highest rate which may be possible on the ARM during the first five

years of its term.

The index

The index is the first of two components which determine the adjusted interest rate after the introductory period.

An ARM is said to be “tied” to an index. The index is basically a rate to which the loan adjusts. As the index rises

and falls, so does the ARM’s interest rate.

ARM interest rate adjustments can be tied any one of a variety of indexes. Each index adjusts based on different

criteria, set by the “owner” of the index. Common indexes for ARMs are:

• 11th

District Cost-of-Funds Index (COFI);

• 12-month Treasury Average; and

• London Interbank Offered Rate (LIBOR).

The COFI is compiled monthly and based on the previous month’s cost of funds actually incurred by lenders. Given

that the COFI is set monthly, it is appropriate for ARMs since it is a short-term benchmark.

The 12-month Treasury Average is released as a weekly average by the Federal Reserve Board. It is based on the

average yield on Treasury securities with 12 months of their maturity remaining. This yield is based on the amount

paid by winning bidders on Treasury Securities in the over-the-counter stock market.

The LIBOR was set by banks in London, England, and released daily. Every day, five London banks give an estimate

for their cost of funds. The average of these five estimates is rounded to the nearest 1/16 and used as the LIBOR

index rate.

The more frequently its affiliated index changes, the more erratic is the interest rate on an ARM. Thus, interest

rates tied to the 11th

District Cost of Funds Index or the 12-month Treasury Average are more stable than those

tied to the LIBOR.

Regardless of which index is used, the purpose of the index is the same: it is meant to be a proxy of the change in

the cost of lending for a lender.

Regulation D requires the index used to be:

readily available and verifiable by the borrower and beyond the control of the creditor [12 CFR

§1004.4(a)(2)(i); or

based on a formula or schedule identifying the amount the interest rate or finance charge may increase,

and the circumstances under which a change may be made to the interest rate. [12 CFR §1004.4(a)(2)(ii)]

Basically, the lender may not arbitrary, and opaquely, make changes to a consumer’s interest rate on an ARM.

Changes are to be made in a transparent fashion.

The margin

The margin is the second component which determines the adjusted interest rate after the introductory period.

The margin is basically the points the lender adds to the index to make its profits. The margin varies per lender, but

usually stays fixed for the life of the loan.

The ARM’s interest rate, after the introductory period, is determined by adding the index to the margin (at set

intervals, and subject to any caps), called a fully-indexed rate.

For instance, if an ARM had an index of 4%, and the margin was 2%, the fully-indexed rate would be 6%. If the

index then fell to 2%, the fully-indexed rate would be 4%.

The adjustment interval

The adjustment interval is the time between changes in the ARM’s interest rate. ARMs can be scheduled to adjust

every month, every year, every three years, etc. At the end of each adjustment interval, the interest rate on the

loan will adjust to the current index, plus the margin. Thus, the monthly mortgage payment changes each time the

ARM adjusts.

An ARM with payments scheduled to adjust every year is a 1-year ARM. An ARM with payments scheduled to

adjust every three years is a 3-year ARM.

PAGE 3: MOD6_RATECAP (6 MIN)

RATE CAPS AND OTHER ARM FEATURES

Some ARMs have other features which will impact how the interest rate or payments adjust. These features

include:

an initial interest rate cap;

periodic interest rate caps;

a lifetime interest rate cap;

periodic payment caps;

conversion features; and

prepayment penalties.

A “cap” is a ceiling on the amount of the interest rate, or payment adjustment.

Interest rate caps

The initial interest rate cap sets a limit on the amount the interest rate can change on the first adjustment. A

periodic interest rate cap places a ceiling on the amount an interest rate can increase with each subsequent

adjustment after the first adjustment. A lifetime interest rate cap is the maximum amount an interest rate is able

to increase over the entire life of the loan.

Remember the old joke about the “topless mortgages” we brought up? In response to the potential for never-

ending interest rate increases on ARMs, Congress passed the Competitive Equality Banking Act of 1987 to amend

the Alternative Mortgage Transaction Parity Act. The Competitive Equality Banking Act added a requirement that

all consumer-purpose ARMs secured by liens on one-to-four unit residential dwellings must have lifetime interest

rate caps (thus, defying the derogatory “topless mortgage” term from the ‘80s). Neither the law nor the ensuing

regulation actually set any of the caps, or set guidelines for minimum or maximum allowable caps. [12 USC

§3806(d)]

The most common rate cap arrangements are 5/2/5 or 2/2/6. The first number refers to the initial rate increase

cap, the second number is the future periodic rate increase cap, and the third number is the lifetime rate increase

cap.

For instance, for the 5/2/5 rate cap arrangement:

• the initial rate increase cannot exceed 5%;

• future periodic rate increases cannot exceed 2%; and

• the lifetime rate increase cannot exceed 5%.

Quick quiz

Let’s say your borrower started with a 3.25% fully-indexed interest rate on an ARM for a $200,000 loan. The ARM

adjusts annually, and has a 5/2/5 cap structure. At the first adjustment, the index goes up 3%. At the second year,

the index goes up another 3%. (IMPORTANT: the following example does not include taxes, insurance,

homeowners’ association fees or similar items.)

What is the interest rate on the loan after the second adjustment?

Answer

The interest rate after the second adjustment is 8.25%. The breakdown goes like this:

ARM Interest Rate Monthly Payment (Rounded to nearest dollar)

1st year @ 3.25% $ 870

2nd year @ 6.25% $ 1221

3rd year @ 8.25% $ 1478

3rd year @ 9.25% (without lifetime cap) $ 1614

The first adjustment (the 2nd

year rate) is within the 5% initial interest rate cap. With a 3% index, the interest rate

increases to 6.25%. The second adjustment, also with a 3% index, is limited by the lifetime interest rate cap.

Without the lifetime interest rate cap, the interest rate during the 3rd

year would be 9.25%. Instead, due to the 5%

lifetime interest rate cap, the maximum interest rate of 8.25% is reached in the third year. In this case, the lifetime

cap saves the borrower $136 per month after the third year.

Additionally, some ARMs with interest rate caps have a carryover feature. The carryover feature is contained in

the loan documentation, and allows lenders to “carryover” interest rate increases which exceed the periodic

interest rate increases to the next adjustment.

Quick Quiz

Consider a borrower with a 3.25% fully-indexed interest rate on an ARM for a $200,000 loan. The ARM adjusts

annually, and has a carryover provision in the loan documents. There is no initial year interest rate cap, but the

ARM has a 2% periodic interest rate cap and a 5% lifetime interest rate cap. At the first adjustment, the index goes

up 3%. At the second year, the index goes down 1%. (IMPORTANT: the following example does not include taxes,

insurance, homeowners’ association fees or similar items.)

What is the interest rate on the loan after the second adjustment?

Answer

The interest rate after the second adjustment is 5.25%. The breakdown goes like this:

ARM Interest Rate Monthly Payment (Rounded to nearest dollar)

1st year @ 3.25% $ 870

2nd year @ 5.25% $ 1098

3rd year @ 5.25% $ 1098

The index goes up by 3%, but it is capped by the 2% periodic interest rate cap. The remaining 1% increase is carried

over to the next adjustment period. At the second adjustment, the 1% carryover increase cancels out the 1% drop

in the index. Thus, the interest rate remains 5.25%.

These examples are based on fully-indexed initial interest rates. Most ARMs will start with discounted interest

rates (ones which are not fully-indexed). That means the first adjustment will have to take into account the margin

as well as any change in the index. That highlights the importance of the rate cap structure. If an ARM has a very

low teaser rate, and a 5/2/5 structure, there’s a possibility that the interest rate can increase by up to 5% on the

first adjustment — a payment shock for most borrowers. In such a case, loan originators with borrowers set on an

ARM may search for similar loan products with a lower initial interest rate cap – say a 2/2/6, structure, which

allows for more gradual interest rate increases.

Payment caps

Another type of cap on a loan is known as a payment cap. As the name suggests, this caps the total payments due

on the loan at each adjustment. So, if your borrower had a mortgage payment of $1000, and the loan had a

payment cap of 10%, the maximum the payment could increase with the adjustment would be $100, for a total

payment of $1,100 – regardless of interest rate changes.

However – with payment caps, the additional interest due above the 10% payment cap is not simply forgiven. It is

actually added to the mortgage balance. Thus, payment caps can cause negative amortization, in which unpaid

interest is added to the principal balance of the loan. Some ARMs have both periodic interest rate caps, and

payment caps.

Conversion ARMs

Some ARMs have built-in terms which allow the ARM to be converted to an FRM at some point during the loan

term, and according to the rules set in the loan documents. However, conversion ARMs have some drawbacks:

the interest rate upon conversion may be higher than the average FRM rate offered at the time;

the lender may charge a higher interest rate during the ARM portion of the loan than for other loans

without conversion features; and/or

the lender may charge a fee for the conversion.

Conversion is not mandatory. For example, a borrower who takes out a conversion ARM may choose to adopt a

fixed interest rate five years into the loan term, or may choose to adhere to the traditional ARM terms, including

periodic adjustments to the interest rate and monthly payment.

However, since lenders may charge extra on the interest rate for the conversion option, a borrower should be

aware before they take on the loan whether or not a conversion option is built into the interest rate. As always,

before opting for the conversion, the borrower is best served by inquiring into the refinance options, which may be

cheaper.

Those were some ARM basics. The function of these features will work differently in some types of ARMs, which

we’ll discuss in the next unit.

Prepayment penalties

Prepayment penalties are special fees required to be paid to the lender when a borrower pays a mortgage off

early. Not all ARMs have prepayment penalties.

Prepayment penalties are usually limited to the prepayments made in the first few years of a mortgage

(incidentally, the same period of time in which interest is paid to the lender). When analyzing whether a borrower

should refinance or allow an ARM to adjust, the prepayment penalty must be considered. Sometimes, the

prepayment penalty is several thousands of dollars.

For example that your borrower has taken out a 3/1 ARM in the amount of $200,000 with an initial rate of 6%. At

the end of the second year, the borrower decides to refinance and pay off the 3/1 ARM. At the time of the

refinancing, the principal balance is $194,936. If the loan has a prepayment penalty of six months’ interest on the

remaining balance, the prepayment penalty would be $5,850.

UNIT 3: DIFFERENT TYPES OF ARMS (10 MIN)

PAGE 1: MOD6_DIFFARM (3 MIN)

In this unit, you’ll learn about:

the different ARM products that have influenced the mortgage market in the last ten years;

new developments regarding ARMs in the mortgage market; and

disclosure requirements for ARMs.

DIFFERENT ARM PRODUCTS

A plethora of ARMs exist, each with different terms. Common types of ARMs, or ARMs popular during the

Millennium Boom include:

hybrid ARMs;

option ARMs;

conversion ARMs; and

interest-only ARMs.

ARMs provide lenders with periodic increases in their yield on the principal balance during periods of rising and

high short-term interest rates.

ARMs are in greater demand when interest rates or home prices rise too quickly. Fewer buyers are able to qualify

for an FRM to finance their purchase. A graduated payment schedule allows buyers time to adjust their income

and expenses in the future to begin the eventual amortization of the loan.

HYBRID ARMS

The hybrid ARM, also known as the “Canadian rollover,” is a fusion of a FRM and an ARM. It’s the “traditional” type

of ARM in which the interest rate is fixed during the initial loan term, then adjusts periodically afterward. Some

Hybrid ARMs are named after the initial fixed period and the adjustment period. The first number in the loan

description references the period of the loan with a fixed interest rate. The second number references the

frequency of adjustments after the initial fixed-rate period (every year).

For example, one of the most common types of hybrid ARMs is the 5/1 ARM. With this type of loan, the interest

rate is fixed for the first five years of the loan, typically at a low teaser rate. Then, the loan adjusts once a year after

that initial period expires.

Other common hybrid ARMs using this naming convention include:

3/1 (fixed for three years, then adjusts annually);

7/1 (fixed for seven years, then adjusts annually); and

10/1 (fixed for ten years, then adjusts annually).

Similar hybrid arms are intended for those with less-than-perfect credit. The initial rate is short to allow the

borrower to qualify for a loan, with the intent of improving their credit and refinancing out of the hybrid ARM after

the initial fixed rate. Common hybrid arms named under this convention are:

2/28 (fixed for two years, adjustable for 28 years); and

3/27 (fixed for three years, adjustable for 27 years).

2/28 and 3/27 ARMs may adjust every six months or every twelve months, depending on the terms of the

mortgage.

Hybrid arms can meet the requirements for qualified mortgages, provided the underlying loan meets all other

qualified mortgage requirements. Thus, this is one of the only types of ARMs which will survive into 2014.

The remaining ARM loans discussed below will be relegated back to their rightful place as niche products for

extremely well-qualified borrowers once the ability-to-repay rules take effect in 2014.

INTEREST-ONLY ARMS

With an interest-only ARM, the borrower’s monthly payments are applied only to the interest due on the loan, not

to the loan principal. This interest only payment schedule is typically for three to ten years. After the interest-only

period expires, the borrower’s monthly payments are adjusted to include both interest and principal. However,

because the borrower did not make any principal payments during the first few years of the loan term, the

principal payments are amortized over a shorter period of time.

For example: A borrower enters into a mortgage agreement with a lender for an ARM which amortizes over 30

years. The terms of the loan provide for that the borrower will make interest-only payments for the first three

years of the loan. After the three-year period expires, the lender will adjust the interest rate according to the

terms of the loan, and recast the loan to amortize the borrower’s payments over the remaining 27-year period.

(Note: some interest only loans also have periodic adjustments to the interest rate during the interest-only

period.)

The longer the interest-only period, the greater the payments will be when the loan recasts.

Consider a borrower taking out a 30-year ARM with a five-year interest only feature. The borrower’s monthly

payment during the first five years of the loan is $625. However, after the initial period has passed, the lender

recasts the loan, raising the interest rate to 5% and amortizing the loan balance over the remaining 25 years of the

loan. The borrower’s monthly mortgage payment jumps to $1,461 in the sixth year of the loan, more than double

the amount of the borrower’s early payments.

PAGE 2: MOD6_OPTIONS (4 MIN)

OPTION ARMS

Option ARMs were among the most insidious type of loan offered during the Millennium Boom. Option ARMs are

so named because under these loan terms, the borrower may choose from several different payment options each

month. Also called pick-a-pay ARMs, option ARMs typically begin with a very low, teaser rate. However, this rate

only holds for a month or so before increasing regularly every month.

Each month, the borrower may choose to pay:

principal and interest under a traditional amortization schedule for the full term of the loan (some Option

ARMs allowed the borrower to choose the amortization schedule for the payment – 15, 30 or even 40

years);

interest only; or

a minimum payment, amounting to less than the interest due.

If the borrower chooses to pay the minimum amount, the unpaid interest due is added onto the total loan amount.

This process in which accrued unpaid interest tacks on to the principal balance is called negative amortization.

When the borrower chooses this payment option, their loan is recast after a certain number of years (typically ever

five years) according to the new principal balance due—an amount now greater than the original loan. Payments

caps do not restrict recast fully-amortized payments.

Additionally, these are still ARMs, so there is a chance that the loan will negatively amortize at ever greater

amounts as the interest rate climbs and the amortization term shortens.

Another danger lies in the timing of the minimum payments. If the borrower makes minimum payments in the last

few years of the loan, they may end up owing a large payment at the end of the loan term. This larger payment is

called a balloon payment.

Some lenders placed negative amortization caps on loans which had the potential for negative amortization. The

negative amortization cap places a ceiling on how high the principal balance was able to grow before a recast. This

recast occurred at this ceiling regardless of any pre-set recast time period. The typical negative amortization cap

was set at 110% or 125% of the original mortgage amount. And, as with other recasts, the payment caps did not

apply.

Option ARMs were often a lure for under-qualified homebuyers during the years leading up to the financial crisis.

Low-income borrowers consistently paid the minimum amount due each month. As a result, their debt quickly

snowballed. When their loans were recast after origination, borrowers became overwhelmed with their adjusted

payments. For borrowers who only paid the minimum amount, each recast would result in ever greater fully-

amortizing payments.

NEW DEVELOPMENTS

Different types of ARMs fall in and out of favor with borrowers depending on the state of the housing market or

current interest rates. During the Millennium Boom, overall ARM use was exceptionally high. In 2004, 33% of all

mortgage applications were for ARMs. [Freddie Mac, 23rd

Annual ARM Survey]

Editor’s note — Freddie Mac’s findings are based on its survey of prime loans.

In 2012, ARMs accounted for approximately 10% of all mortgages originated. This is on the lower end of historical

ratios between ARMs and FRMs. Typically ARM use fluctuates between 11% and 30% of all mortgages originated

annually. [Freddie Mac, 29th

Annual ARM Survey]

The disparity between the 2004 ARM-to-FRM ratio and the 2012 ARM-to-FRM ratio is due to the type of borrower

demand unique in 2004. During this time, many under qualified borrowers were anxious to purchase property in

the frenzied real estate market. However, these borrowers lacked sufficient income to make monthly payments on

a 30-year FRM with a principal amount of $400,000. Because of this, many borrowers opted for high-risk ARMs.

They expected the value of their collateral to only increase over the next few years, allowing them to either

refinance or resell the property before their ARMs reset.

However, the value of borrowers’ collateral did not increase over the next five years; instead it dropped drastically.

This prevented borrowers from escaping the obligations of their ARMs after the initial period of the loan. The

implosion of real estate pricing was not just a shock to the real estate market, but to borrowers as well. Borrowers

therefore reacted with much less favor toward ARMs in the years following the Millennium Boom and bust.

The most popular types of ARM with borrowers in 2012 was the 5/1 ARM. This type of ARM has a fixed interest

rate for the first five years of the loan, then adjusts annually after that initial period expires. Other common ARMs

in 2012 were the 3/1, 7/1 and 10/1 ARMs. [Freddie Mac, 29th Annual ARM Survey]

However, many borrowers prefer FRMs to ARMs. In 2012, many homeowners traded in their ARMs for FRMs. Of all

the home loans refinanced by Freddie Mac in the fourth quarter (Q4) of 2012:

• 27% were for shorter than the original loan term;

• 95% were refinanced into FRMs; and

• 83% of hybrid ARMs were refinanced as FRMs. [Freddie Mac, Refinance Activities Report Q4 2012]

Currently, the majority of ARMs originated are tied to the 12-Month Treasury Average. In 2012, 69% of lenders

offered Treasury-tied ARMs. The remaining lenders offer LIBOR-tied ARMs.

Freddie Mac officials have recently predicted ARM popularity will increase in the future. Since current ARM use is

low, this is likely. However, this occurrence may not be beneficial since ARMs are inherently more high risk than

FRMs, and are often used by borrowers who overextend their finances.

ARMs have caused concern among government regulatory agencies over the past few years. In 2011, the Federal

Reserve Bank (Fed) began requiring greater lender transparency with ARMs. Lenders making ARMs and other

variable rate loans to homebuyers were required to provide disclosures that clearly detail the specific time and

circumstances that will change the interest rate or payment schedule of a loan.

The Fed also required disclosures made in plain language, laid out in a spreadsheet or chart format that clearly

illustrates the risks of variable terms associated with the loan.

Under the guidelines, lenders must disclose that borrowers are not guaranteed the ability to refinance to a lower

rate after their loan adjusts. Additionally, lenders are required to plainly state the maximum interest rate possible

on the loan — a kind of “worst case” rate previously buried deep in the jargon of prior loan documents.

PAGE 3: MOD6_DISC (3 MIN)

DISCLOSURES REQUIRED AND OTHER REGULATIONS

The mortgage industry and rulemakers have also acknowledged the need for regulation of ARMs. The Truth in

Lending Act (TILA) and Regulation Z requires that all features of an ARM loan, including the existence of a carryover

feature, be disclosed to a borrower at the time of the borrower’s loan application. Disclosures lenders are required

to provide to ARM borrowers include:

the Consumer Handbook on Adjustable Rate Mortgages;

notice that the loan terms are subject to change, including:

o the interest rate; and

o the loan payments;

information regarding the index to which the loan is tied;

an explanation of how the interest rate and payments are calculated;

an explanation of how the ARM index is adjusted;

a recommendation to the borrower to request additional information about the current margin value and

current interest rate;

notice that the current interest rate is discounted;

a recommendation to the borrower to ask the amount of the rate discount;

the frequency of interest rate and payment adjustments;

any payment caps provided by the loan terms;

the possibility of negative amortization;

the possibility of interest rate carryover;

either:

o a historical example of an ARM, which illustrates the effect of interest rate changes on the

borrower’s payments and loan balance. This example must be based on a $10,000 loan amount

and the past 15 years of index values. A description of negative amortization, interest rate

carryover, interest rate discounts and payment caps must be integrated into this example; or

o the maximum interest rate and payment for a $10,000 ARM under the current loan terms. This

must also disclose the fact that the borrower’s payments may increase or decrease significantly.

instructions for calculating loan payments;

notice of the loan’s demand provision;

a description of notices of adjustments, and the schedule for these notices; and

a notice that the borrower may access disclosure forms for the lender’s other ARM programs. [12 USC

§1026.19]

These avuncular regulations are among the most user-friendly and socially effective rolled-out under amendments

to TILA. Previously, public policy demanded the government refrain from this brand of hand-holding consumer

protection.

Other regulations governing ARMs were put into place under Regulation D, and cited below in the related copy.

Violation of these provisions is considered a violation of the Truth in Lending Act (TILA). Violators are subject to

both administrative enforcement under the TILA, and civil damages. [12 United States Code §3806(d); 12 CFR

§§1004 et seq; 12 USC §3806(c)]

Under Dodd-Frank, the Fed now regulates residential mortgage loan practices to protect the best interest of the

borrower. The Fed has proposed many new residential mortgage loan disclosure requirements to protect the best

interest of the homebuyer with regulations that go well beyond mere full disclosure and transparency. [15 USC

1602 §129B]

Changes from Fannie Mae

Fannie Mae has also observed the risk of ARMs in the past, and became more wary of purchase ARMs near the end

of 2012.

In October of 2012, Fannie Mae tightened standards on the notes they purchase, requiring higher credit scores and

more documentation of income for ARMs.

Changes to ARM transactions included:

• an increase in the minimum Fair Isaac Corporation (FICO) score from 620 to 640;

• the maximum loan-to-value ratio (LTV) for one-unit, principal residence, purchase and limited cash-

out refinances became 90% for both desktop underwriting (DU) and manually underwritten

loans(reduced from 95% and 97%, respectively); and

• the majority of ARM transactions were required to have maximum LTVs of 10 percentage points less

than previously, not falling below 60%.

The buyer DTI maximum was revised to 36%, unless the loan meets credit score and reserve requirements (found

unchanged in Fannie’s Eligibility Matrix), then it may be as high as 45%.

UNIT 4: ARMS CASE STUDY (5 MIN)

THE TRIALS OF LIBOR

The LIBOR is an influential factor in the mortgage market, although many members of the public were unaware

how great its influence was until it became the object of scandal.

The LIBOR, is a benchmark interest rate previously set by the British Banker’s Association (BBA) to estimate the

cost of borrowing between banks, which is an essential practice for banks to maintain liquidity and lend funds to

consumers. Banks needing money borrow it from other banks that have excess cash and then lend it to consumers,

paying one another back and profiting on the additional margin charged to the consumer. Although the LIBOR is

used as a benchmark for setting a vast variety of rates, this is its fundamental purpose.

The BBA is a trade union for British bankers. It is essentially a collective of nearly every bank and financial services

company in the UK that “protects the interests” of the banking organizations. Their role in the LIBOR is essential. In

fact, the LIBOR is often referred to as the BBA LIBOR since it is the members who belong to the BBA that

collectively determine the rate.

THE USD LIBOR

Since the LIBOR is used as an international benchmark for pricing a myriad of financial products and services, a

separate calculation is made for each currency. The U.S. dollar-denominated LIBOR is the most widely used, if for

no other reason than that the U.S. dollar is the dominant currency in global financial dealings.

For the U.S. LIBOR, the big banks, including Citigroup, JPMorgan Chase, Bank of America and Barclays, estimate

how much they will charge one another on the following day for interbank loans. They then submit these best

guesses, based on current market volatility, to Thomson Reuters, an “independent third party,” who calculates the

average and publishes the rate daily.

Since it is an estimate, based on the previous day’s market behavior, the actual rate at which banks charge one

another for short term loans varies, thus the LIBOR acts as a guide but not a rule for interbank loans. As a

benchmark, however, the LIBOR is followed to the decimal.

THE BENCHMARK

The LIBOR is referred to as a benchmark since it is used as a starting point to price other financial products and

services. A common phrase bandied about in the world of finance is “LIBOR plus x percent.”

The rate was considered an excellent benchmark since it was updated daily. The philosophy of the self-regulating

market underpins the LIBOR’s accepted reliability. It is believed that since the banks rely on one another for the

liquidity crucial to their business, no one bank would cook their estimates since their profitability depends on the

accuracy of the rate on any given day.

The second failsafe involved is the so-called law of averages. Since the LIBOR is an average of many banks’

estimates, any gross discrepancies from one estimate to the other will be worked out in the average.

WHY LIBOR?

To answer this question we need look no further than Wall Street.

Of all the financial products linked to the LIBOR, the mortgage market is primarily concerned with the LIBOR-

indexed ARM. The LIBOR was not always the gold standard benchmark for setting ARM interest rates. In fact, it

was not adopted by some lenders for indexing ARMs until the 1990s.

Before LIBOR’s entrance into the ARMs scene, the COFI was the preferred benchmark. The COFI was compiled

every month, as opposed to the daily LIBOR rate, and was based on the average cost-of-funds for mortgage

lenders over a 30-day period. Thus, the COFI was much less volatile and far more accurate than the LIBOR for

pricing home loans based on lender costs for obtaining funds.

Once the mortgage-backed bond (MBB) market began picking up steam in the 1990s, Wall Street investment banks

began groaning that the cost-of-funds index prevented them from properly hedging their investments since the

benchmark was only applicable to mortgage rates and didn’t include any other form of securities. Further, the

MBB market in the U.S. was gaining international favor and global investors were looking for a universal standard

for placing and hedging their bets. The LIBOR was Wall Street’s answer to all of these problems.

In effect, the banks were given carte blanche for pricing these products, all based on their word.

THE BIG DEAL

Scrutiny of the LIBOR was triggered in 2008 when market perceptions of financial risk began soaring, sending

interest rates through the roof, yet the LIBOR remained static and did not respond to the explosion of panic in

financial markets. The anomalous refusal of the LIBOR to adjust upwards during what we now know to be the

greatest global financial crisis since the Great Depression caused many regulators and watchdogs to suspect foul

play.

Many in the mortgage industry have asked, “What is the big deal? If Barclays and the BBA members colluded to

keep the rate artificially low, homeowners placed in LIBOR-indexed ARMs actually saved money, right?”

It is true that the LIBOR debacle uncovered at Barclays has to do with keeping rates on ARMs (and all other LIBOR-

indexed products) artificially low. This occurred leading up to and during the 2008 financial crisis when markets

participants were responding to the finance fiasco by raising rates through the roof to reflect the then astounding

amount of risk in the market. Yet, LIBOR remained unchanged, a deliberate deception supposedly to quell fears of

a pending massive money meltdown and soothe the markets.

This caused a problem because rates on ARMs were held down not just to keep investors confident, but also to

remain enticing to borrowers, which includes homebuyers. Even when it was abundantly clear the real estate

market was inflating into an unprecedented bubble, the lure of easily attainable financing at ungodly-low ARM

rates kept the buyers coming in. This kept the securities bond market machine cranking, which continued to feed

hungry investors lulled into credulity by the golden benchmark.

And what happened to those buyers who all got a sterling “deal” due to the rate manipulation? Many fail to

mention that the deal was had at the cost of grotesquely inflated real estate prices and hybrid adjustable

payments big enough to float the Titanic over the iceberg. Thus, job loss, default, foreclosure, bankruptcy; the rest

is history.

This is the “deal” that Wall Street would like borrowers to think they were getting. In true Wall Street sleight-of-

hand, the rate on the paperwork was kept low to keep the numbers behind the scenes (originations) as high as

possible.

Further reading:

For quotes directly from the bankers who were involved in the LIBOR rate rigging, see the Huffington Post’s June

2013 article, LIBOR Scandal: The Most Outrageous Exchanges Between Traders

(IMPORTANT: This link takes you outside of the course. You will not receive credit for time spent reading

material outside of this course.)

After news of the scandal broke, the main financial regulator in the UK initiated a sweeping review of the LIBOR

process. Several low-level bankers were arrested for their involvement in the LIBOR index fixing. The review also

determined that among the most questionable aspects of the LIBOR was the fact that bankers set the rate

themselves, resulting in an ultimately disastrous conflict of interest.

Thus, the regulator recommended the British Banker’s Association (BBA) be stripped of their duty to run the LIBOR

and that it ought to be handed over to, “an independent third party” — accent on the word independent.

In July 2013, regulators announced that the New York Stock Exchange (NYSE) had won the contract in a bidding

process that also included the London Stock Exchange. Officials in the British government have stated the NYSE’s

governorship of the LIBOR will lead to a safer and stronger business sector.

Exam Questions are highlighted in yellow. Quiz questions are un-highlighted. Bolded text indicates the correct

answer.