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Module 6: Introduction to Nontraditional Mortgage Products, and the Adjustable Rate Mortgage

Unit 1: Nontraditional Mortgage Products (13 min)

PAGE 1: MOD6-1_1GUIDANCE (3 MIN)

In this unit, you’ll learn about:

• the history behind some of the most popular nontraditional mortgage products; • the risks nontraditional mortgage products posed to the market; and • current laws curtailing those risks.

GUIDANCE ON NONTRADITIONAL MORTGAGE PRODUCT RISK

In 2006, the Federal Deposit Insurance Corporation (FDIC), and other federal government 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 same year, the Conference of State Bank Supervisors (CSBS) and the American Association of Residential Mortgage Regulators (AARMR) released parallel guidance for state regulators. This parallel guidance covers mortgage brokers and mortgage companies which are not federally regulated. In this unit, we will refer to the federal agencies, the CSBS and the AARMR as the Agencies.

The guidance defined “nontraditional mortgage products” as all closed-end residential mortgage loan products that allow borrowers 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 changed them from niche products available to highly qualified borrowers to tools 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.

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Additionally, many of these loan products 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 (now required by the Regulation Z ability-to-repay rules);

• 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.

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In a nutshell:

• consider whether the borrower is able to repay the loan as part of the loan underwriting process;

• ensure, before making the loan, that the institution is 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 follows.

The American Bankers Association’s reaction to the interagency guidance:

“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.” Paul A. Smith, Senior Counsel for the American Bankers Association, March 29, 2006.

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JPMorgan Chase Bank’s reaction to the interagency guidance:

“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.” Thomas L. Wind, Senior Vice President and CEO Chase Mortgage and Catherine Eckert, Senior Vice President and Sr. Credit Officer Chase Mortgage, March 29, 2006.

Lehman Brothers’ reaction to the interagency guidance:

“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.” Joseph Polizzotto, Managing Director and General Counsel, March 29, 2006.

Editor’s note — The quotes above are from 2006 and are each part of larger comment letters on the interagency guidance. To read the complete responses, visit the FDIC’s website, and locate the Federal Register Citations — Comments on Interagency Guidance on Nontraditional Mortgage Products.

PAGE 2: MOD6-1_2RECIPE (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 (the SAFE Act, reviewed in Module 1) defined a nontraditional mortgage product as any mortgage product other than a 30-year fixed rate mortgage. [12 USC §5102(7)]

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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 (HELOCs); • home equity loans (HELOANs); 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

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“When a provider 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… a provider's qualifying standards should recognize the potential impact of payment shock especially 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, a provider’s analysis of a 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.”

- Excerpted from the CSBS/AARMR Guidance on Nontraditional Mortgage Product Risks

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 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. [12 Code of Federal Regulations §1026.43(c)(5)(i)]

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

Reduced documentation

“Providers increasingly rely on reduced documentation, particularly unverified income, to qualify borrowers for nontraditional mortgage loans. Because these practices essentially substitute assumptions and unverified information for analysis of a borrower's repayment

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capacity and general creditworthiness, they should be used with caution. As the level of credit risk increases, it is expected that a provider will more diligently verify and document a borrower's income and debt reduction capacity. Clear policies should govern the use of reduced documentation. For example, stated income should be accepted only if there are mitigating factors that clearly minimize the need for direct verification of repayment capacity. For many borrowers, providers generally should be able to readily document income using recent W-2 statements, pay stubs, or tax returns.”

- Excerpted from the CSBS/AARMR Guidance on Nontraditional Mortgage Product Risks

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.

Stated income loans allowed the borrower to state their income, rather than submit documents to the lender to verify their income. 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 borrower’s income or assets.

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 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 the Agencies’ guidance, on collateral dependency.

“Providers should avoid the use of loan terms and underwriting practices that may heighten the need for a borrower to rely on the sale or refinancing of the property once amortization begins.

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Loans to individuals who do not demonstrate the capacity to repay, as structured, from sources other than the collateral pledged may be unfair and abusive. Providers that originate collateral-dependent mortgage loans may be subject to criticism and corrective action.”

- Excerpted from the CSBS/AARMR Guidance on Nontraditional Mortgage Product Risks

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 placed a heavy dependency on the collateral. In recent years, the FHA has instituted additional borrower-based criteria for its reverse mortgages, the home equity conversion mortgages (HECMs). It also limited the total amount of money a HECM borrower is able to withdraw at once. This comes in response to data indicating many seniors were defaulting on their HECMs, or pulling out all of the equity only to find themselves unable to make the required insurance and property tax payments. In the case of reverse mortgages, a default means not just a few years’ worth of equity lost, but a lifetime’s.

The ability-to-repay requirements do not restrict negative amortization, interest-only payments or balloon payments. (Their safe harbor provision, the qualified mortgage, does.) However, that doesn’t mean those loan features aren’t limited — the ability-to-repay rules require 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 DTI, 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.

Comprehension check

You must answer this question before you may proceed to the next page.

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Which of the following items was identified as a specific risk element in connection with nontraditional mortgage products?

• Rigorous qualification standards. • Reduced documentation. • Ability to repay analysis.

PAGE 3: MOD6-1_3OVERENC (4 MIN)

OVER-ENCUMBERED

Simultaneous second-lien loans

“Simultaneous second-lien loans reduce owner equity and increase credit risk. Historically, as combined loan-to-value ratios rise, so do defaults. A delinquent borrower with minimal or no equity in a property may have little incentive to work with a lender to bring the loan current and 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 or no owner equity generally should not have a payment structure that allows for delayed or negative amortization without other significant risk mitigating factors.”

- Excerpted from the CSBS/AARMR Guidance on Nontraditional Mortgage Product Risks

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”

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“While third-party loan sales can transfer a portion of the [portfolio's] credit risk, a provider remains exposed to reputation risk when credit losses on sold mortgage loans or securitization transactions exceed expectations. As a result, a provider may determine that it is necessary to repurchase defaulted mortgages to protect its reputation and maintain access to the markets.”

- Excerpted from the CSBS/AARMR Guidance on Nontraditional Mortgage Product Risks

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 products! — 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 –

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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 affordability in the near-term; that is, their lower initial monthly payments compared with traditional types of mortgages. In addition to apprising consumers of the benefits of nontraditional mortgage products, providers should take appropriate steps to alert consumers to the risks of these products, including the likelihood of increased future payment obligations. This information should be provided in a timely manner — before disclosures may be required under the Truth in Lending Act or other laws — to assist the consumer in the product selection process.”

- Excerpted from the CSBS/AARMR Guidance on Nontraditional Mortgage Product Risks

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 Act (TILA) and Real Estate Settlement Procedures Act (RESPA) integrated disclosures (TRID): the Loan Estimate and Closing Disclosure forms. [12 CFR §1026.37; 12 CFR §1026.38]

The Dodd-Frank Wall Street Reform and Consumer Protection Act also established several new disclosure requirements, and the Consumer Financial Protection Bureau to inform and advocate on behalf of consumers.

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Comprehension check

You must answer this question before you may proceed to the next page.

Which of the following statements is true?

• As defined by the 2006 interagency guidance, nontraditional mortgage product is a closed-end residential mortgage product that allows borrowers to defer repayment or principal or interest.

• Risk layering is a type of unlawful discrimination against minorities. • Payment shock is an insubstantial increase in a borrower's monthly payment.

Unit 2: Introducing ARMs (15 min)

PAGE 1: MOD6-2_1ARM1 (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 FRM 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 FRM. 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.

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However, as we’ve stated, the loans made were 30-year FRMs. A lender making a 30-year FRM 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 (the 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:

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• 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 FRMs; and

o removed interest rate caps on depositor funds; and • adopted regulations allowing savings-and-loans to offer adjustable rate mortgages

(ARMs).

In contrast to FRMs, 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.”

MODERN ARM TWISTING

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 were 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 mortgage-backed bond (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

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“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 ARMs, 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, ARM use is climbing. 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: MOD6-2_2POPARM (5 MIN)

THE PURPOSE AND POPULARITY OF ARMS

An ARM calls for periodic adjustments to both the interest rate and the dollar amount of scheduled payments. This is in contrast to an 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. ARMs allow borrowers to leverage the lower interest 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

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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.

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.

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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 became effective on January 10, 2014 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 is 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 COFI 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.

Regulation D requires the index used to be:

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• readily available and verifiable by the borrower and beyond the control of the creditor [12 Code of Federal Regulations §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 arbitrarily 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 consists of 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.

Comprehension check

You must answer this question before you may proceed to the next page.

The ____________ is one of the four elements of an ARM.

• payment shock • harbor • margin

PAGE 3: MOD6-2_3RATECAP (6 MIN)

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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.

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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(a)]

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%.

SCENARIO 1

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?

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

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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.

SCENARIO 2

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%. In 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?

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%.

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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 $1,000, 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 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.

Editor’s note — Loans with the potential for negative amortization are only allowed under general ability-to-repay requirements. They are not permissible in qualified mortgages. [12 CFR §1026.43(c)(5)(ii)]

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

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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.

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 payments are mainly interest 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, consider 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.

Editor’s note — State laws may restrict the charging of prepayment penalties. For example, in California a prepayment penalty may not be charged on a loan secured by an owner-occupied single family residence unless the borrower pays more than 20% of the unpaid balance in any 12-month period.

Additionally, prepayment penalties on consumer purpose loan secured by one-to-four unit residential properties are only allowed on qualified mortgages. [12 CFR §1026.43(g)]

Comprehension check

You must answer this question before you may proceed to the next page.

Which of the following statements is true?

• The four elements of an ARM are the introductory interest rate, the index, the margin and the negative amortization.

• On an ARM, the margin is the initial rate set on the ARM, which stays fixed for a set amount of time.

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• The two components which determine how the interest rate adjusts after the introductory period are the index and the margin.

Unit 3: Different Types of ARMs (10 min)

PAGE 1: MOD6-3_1DIFFARM (3 MIN)

In this unit, you’ll learn about:

• the different adjustable rate mortgage (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;

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• 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 a fixed rate mortgage (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 an 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.

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.

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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 survived the ability-to-repay requirements.

The remaining ARM loans discussed below have been relegated back to their rightful place as niche products for extremely well-qualified borrowers.

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 typically lasts 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 require the borrower to 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. The loan will be recast 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 initial payments.

PAGE 2: MOD6-3_2OPTIONS (4 MIN)

OPTION ARMS

Option ARMs were among the most insidious types of loans offered during the Millennium Boom. Option ARMs are so named because under these loan terms, the borrower was able to 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.

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Each month, the borrower was given the option to make a payment for:

• 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 amount, usually less than the interest due.

If the borrower chose to pay the minimum amount, the unpaid interest due was 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 chose this payment option, their loan recast after a certain number of years (typically every five years) according to the new principal balance due — an amount now greater than the original loan amount. Payment 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.

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

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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.

Comprehension check

You must answer this question before you may proceed to the next page.

With a/n ____________ ARM, the borrower’s monthly payments are applied only to the interest due on the loan, not to the loan principal.

• hybrid • interest-only • fixed rate conversion

ARMS USE AND FORECAST

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 2013, 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, 30th Annual ARM Survey]

The disparity between the 2004 ARM-to-FRM ratio and the 2013 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. 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.

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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.

Hybrid ARMs remained the most popular type of ARM in 2013, with the 5/1 ARM leading the market, followed by the 3/1, 7/1 and 10/1 ARMs. [Freddie Mac, 30th Annual ARM Survey]

However, borrowers still prefer FRMs to ARMs. In 2018, many homeowners traded in their ARMs for FRMs. 94% of the hybrid ARM home loans refinanced by Freddie Mac in the second quarter (Q1) of 2018 were refinanced into FRMs, with only a relatively small 6% going back into another hybrid ARM. [Freddie Mac, Refinance Report Q1 2018]

ARMs have caused concern among government regulatory agencies in past 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 be 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.

These requirements were present in the TRID disclosures when the CFPB took over responsibility for consumer mortgage disclosures.

ARMs are inherently more risky than FRMs, and are often used by borrowers who overextend their finances. Their use fluctuates in reaction to the affordability of counterpart FRMs, and their respective rates.

The average ARM rate rose to an average rate of 4.16% in June 2018, up nearly a full percentage point from 3.21% a year earlier. This bump in ARM rates is a direct result of the Federal Reserve’s (the Fed’s) increase in short-term rates. Similarly, the 30-year fixed rate mortgage (FRM) rate rose in June 2018 to an average of 4.43%, well above a year earlier when it was 3.82%.

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Recently, ARM use has inched higher due to home prices rising faster than the rate of inflation, causing buyers to take on more risk to extend their purchasing power. Since the Fed began increasing the short-term interest rate and ARM rates have responded accordingly, buyers are unwittingly taking on risks homeowners other than the very wealthy cannot absorb. However, the spread between the ARM and FRM rates has diminished to about 0.3%, decreasing the ARM’s appeal, until the next FRM rate increase.

PAGE 3: MOD6-3_3DISC (3 MIN)

DISCLOSURES REQUIRED AND OTHER REGULATIONS

The mortgage industry and rule makers have also acknowledged the need for regulation of ARMs. The Truth in Lending Act (TILA) and its Regulation Z require 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;

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• 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 CFR §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 USC §3806(d); 12 CFR §§1004 et seq; 12 USC §3806(c)]

Under Dodd-Frank, the Consumer Financial Protection Bureau (CFPB) now regulates residential mortgage loan practices to protect the best interest of the borrower. The CFPB has proposed many new residential mortgage loan disclosure requirements to protect the best interest of the

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homebuyer with regulations that go well beyond mere full disclosure and transparency. [15 USC §1602]

Comprehension check

You must answer this question before you may proceed to the next page.

Which of the following statements is true?

• On a 7/1 hybrid ARM, the first number indicates the period of the loan with a fixed interest rate. The second number references the frequency of annual adjustments after the initial fixed rate period.

• The shorter the interest-only period, the greater the payments will be when an interest-only loan recasts.

• With a hybrid ARM, the borrower is able to choose from a principal and interest payment, an interest only payment or a minimum payment each month.

Unit 4: ARMS Case Study (5 min)

PAGE 1: MOD6-CS (5 MIN)

THE TRIALS OF LIBOR

The LIBOR was 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 was used as a benchmark for setting a vast variety of rates, this was 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 old LIBOR was essential. Before the LIBOR scandal broke open, the LIBOR was often referred to as the BBA LIBOR since it was the BBA members who collectively determined LIBOR rates.

THE USD LIBOR

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Since the LIBOR was used as an international benchmark for pricing a myriad of financial products and services, a separate calculation was made for each currency. The U.S. dollar-denominated LIBOR was 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, estimated how much they would charge one another on the following day for interbank loans. They then submitted these best guesses, based on current market volatility, to Thomson Reuters, an “independent third party,” who calculated the average and published the rate daily.

Since it was an estimate, based on the previous day’s market behavior, the actual rate at which banks charge one another for short term loans varied. Thus the LIBOR acted as a guide but not a rule for interbank loans. As a benchmark, however, the LIBOR was followed to the decimal.

THE BENCHMARK

The LIBOR was referred to as a benchmark since it was 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 underpinned the LIBOR’s accepted reliability. It was believed that since banks relied on one another for the liquidity crucial to their businesses, no one bank would cook their estimates.

The second failsafe involved was the so-called law of averages. Since the LIBOR was an average of many banks’ estimates, any gross discrepancies from one estimate to the other would 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 was 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 Cost-of-Funds Index (COFI) was the preferred benchmark. The COFI was compiled every month, as opposed to the daily LIBOR rate, and was

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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 MBB market began picking up steam in the 1990s, Wall Street investment banks began groaning that the COFI 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 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.

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And what happened to those buyers who 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 ARM payments. 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.

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 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. However, an alternative/replacement to LIBOR, the Secured Overnight Financing Rate (SOFR) is supposed to be more reliable. Unlike LIBOR, SOFR relies on actual transactions.

SOFR was officially rolled out in April 2018 and is published daily by the Federal Reserve Bank of New York. The SOFR rate is based on completed transactions, specifically on overnight funds collateralized by Treasury Securities.

SOFR is meant to be more reliable than LIBOR, and thus less open to fraud, meaning greater protection for consumers and homeowners with ARMs.

However, in the short time since its release, SOFR has already reported issues with including the correct transactions in the reported rate. This less-than-promising start has some bankers worried about the rough transition ahead.

While the Fed works the kinks out of SOFR, banks are expected to complete the turnover from LIBOR to SOFR by 2021.

Comprehension check

You must answer this question before you may proceed to the next page.

The LIBOR index rate is based on:

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• The rates banks charged other banks for money. • Completed transactions, specifically overnight funds collateralized by Treasury

Securities. • Short-term interest rates adjusted by the Federal Reserve.