Mortgage Banking July 1995
Michael S. Taliefero
Senior Director
Government Agency Relations
 

What's in an Index?

Mortgage loan applicants are faced today with a wide choice of adjustable rate mortgage loan products, all bearing a variety of characteristics. One of the most critical is the index that causes the ARM's rate adjustment. There are many indexes to choose from: the one, three, or five-year constant maturity Treasury; six-month Treasury; the one, three and five-year Treasury; Federal Home Loan Bank District average cost-of-funds, or COFI; national median COF; and just emerging, the London Interbank Offered Rate.

The most common index probably is the one-year constant maturity Treasury, which closely tracks the average quoted auction yields for Treasuries. The constant maturities are based on Treasury's daily yield curve, which relates the yield on a security to its maturity and is based on closing market bid yields on actively traded Treasuries in the OTC market. The yields are calculated from composite quotations reported by five leading government securities dealers. The constant yield values are taken from the yield curve at fixed maturities, allowing yield estimations for a given maturity even though no security outstanding has exactly that maturity.

The COF indexes are calculated and may be either an average or a median figure, although an average is usually used. Of all of these, the 11^th District COF appears to be popular now because it seems to be doing what the COF indexes were designed to do-- maintain a profitable spread between the cost of lending and the yield from borrowing. It represents the monthly average cost of borrowings reported by members of the Federal Home Loan Bank System in the economically thriving 11^th District, which includes California, Nevada and Arizona.

But not all COF indexes perform the same because the allocation of liabilities among different FHLB districts is not the same. For example, in one district member institutions may make greater use of lower cost FHLB advances, which causes the index to be lower. Others may be in areas of intense competition that forces them to pay higher rates for deposits, which, in turn, makes the COF index go up. To level out these differences, there is a national COF based on the median COF figures reported by all Board Districts.

COFs, however, are lagging indexes. They consist of weighted averages of S&L borrowings that may not closely reflect current market rates. And the index is computed based on the previous month’s financial information, which is not actually applied to the mortgage rate note until a month after it is released. So in effect the COF index is three months behind, even assuming the average cost of liabilities reflects market rates.

Under market conditions, Treasury indexes are more responsive, hence more volatile, than COF indexes. When rates are rising, the lagging nature of the COF indexes tend to lower investor returns because the investor cannot take full advantage of market rates. On the other hand, when rates are falling, the lagging works to the investor’s advantage.

The LIBOR index is the rate that the most creditworthy international banks charge each other for loans. A LIBOR-indexed ARM has yet to gain wide acceptance in the U.S. perhaps because of consumer unfamiliarity with the concept. From a lender’s perspective, a LIBOR index offers the opportunity to tap capital sources in foreign markets where the LIBOR is fully understood and appreciated as a market-responsive index.

So which is better-an index geared to Treasuries, cost-of-funds, or the LIBOR? It all depends on the investor’s objective and comfort level. A word of caution, though, is in order for investors looking to COF indexed ARMs, chiefly because of troubled thrifts. If those thrifts begin to sharply increase their level of GHLB advances, it is expected that the COF would be lower and the yield less.

Indexes must be weighed, too, against an ARM’s other features: initial interest rates, payment caps, interest rate caps, lifetime caps, adjustment frequencies, Margins, and whether negative amortization occurs. All these factors must be considered by mortgage lenders and the secondary market agencies in structuring an ARM product acceptable to consumers and valued highly in the marketplace by investors.

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THE KIPLINGER WASHINGTON LETTER

Circulated weekly to business clients since 1923 – Vol. 71. No. 27

The KIPLINGER Washington Editors

1729 H St., Washington, DC 20006-3938

Dear Client: Washington, July 8, 1994

1. The robust economy means more tax revenue than gov’t expected, reducing projected ’94 budget deficit from $250 billion to $190 billion and maybe $150 billion in ’95. But that pace won’t continue through ’96. Spending on Medicare, Medicaid and interest on the debt will keep rising.
2. Defense cuts will level off. Congress will be VERY sensitive about jobs, as it showed by retaining some funding of B-2 Stealth bomber. It will keep some facilities going by spending on ships, planes, weapons.
3. Lawmakers are feasting their eyes on trimming tax deductions… called "tax expenditures" in Congress because they give up gov’t revenue.
4. Biggest are home mortgage interest, health benefits for workers, state and local income taxes, property taxes…$15 to $50 billion each. Will be pushed by entitlements commission led by Sen. Kerry, Danforth.
5. Upper-incomers will be the target…Congress won’t risk the wrath of middle-class voters, especially when budget deficits are declining.
6. Rates on certificates of deposit at banks will continue to lag. Consider alternatives: EE savings bonds yield a minimum of 4% if held longer than six months. And two-year Treasuries yield about 6% today. Interest from both is also exempt from state and local income taxes.
7. Risk ratings of mutual funds are unlikely to be adopted by SEC…Securities and Exchange Comm: Devising a formula is difficult.
8. Home buyers will pay more impact fees to cities and counties to finance schools, roads and utilities… average fee is $3000 per house. Some local gov’ts held off in recession but will reestablish the levies. Developers often dicker on fees, arguing services won’t cost that much.
9. Adjustable-rate mortgages are popular again as fixed rates rise. Attraction for home buyers is the low starting rate, as low as 4¼% today. They’re especially popular for those who will move within five years.
10. ARM rates fluctuate with other rates…lots of hybrids are sold. Some have one rate for five to seven years…then a new permanent one. Good idea to understand the index used. One of the most stable is 11^th District Cost of Funds Index, linked to thrifts mostly in Calif. Others fluctuate more quickly, such as as six-month and one-year Treasuries.