Sunday, April 4, 2021

ARMs: A Quick Look

Adjustable-Rate Mortgages (ARMs) are a viable financing option for both single, multifamily and owner-occupied commercial property owners. Ever since their formal establishment by Title VII of the Garn–St Germain Depository Institutions Act of 1982, ARMs have offered the opportunity to link mortgage payments to marketplace activity. Coupled with the rate collars, ceilings and floors, these financial instruments have the potential to lock in the conditions of a favorable interest rate market, at interest rates that are typically lower than a fixed-rate mortgage. In the world of retail real estate, lower rates can translate into increased purchasing power. For the real estate investor, however, rate fluctuations and potential for sustained above market-rates usually tends to also lead to an early refinance. With the January 3, 2022 deadline for ARMs to decouple from the LIBOR index imposed by Fannie and Freddie, now is an opportune time to take a look at ARMs and their role in the mortgage market.

ARMs: A Definition

Adjustable rate mortgages are mortgages with monthly payments that track a chosen index. These payments can adjust monthly, yearly or after a couple of years, with the most frequent adjustment period being annually. Although it is possible for an ARM to adjust after the first month or year, in which case it is a traditional ARM, most ARMs are hybrids. Hybrid ARMs have an initial period during which the rate is fixed, after which the mortgage converts into an adjustable mortgage with fluctuating payments. Hybrid ARMs are popular, because they come with an initial “teaser rate” during the fixed period that is typically lower than the prevailing rate for fixed mortgages. This lower rate allows the borrower a period of adjustment that could result in either refinance, liquidation or increased preparation for the impending larger payments. There are also Interest-Only (I/O) ARMs, which have an initial period during which only the interest of the mortgage is paid before the adjustment period begins, and Payment Option or Option ARMs, which allow the borrower to pick a fixed payment during the initial period of the mortgage, before the adjustment period begins. Both of these products, however, fell out of favor after the mortgage crisis of 2009 due to concerns around retail consumer suitability.

Below is a list from of the most popular hybrid ARM products:

1-month ARM: First adjustment after one month, then adjusts monthly
6-month ARM: First adjustment after six months, then adjusts every six months
1-year ARM: First adjustment after one year, then adjusts annually
2/2 ARM: First adjustment after two years, then adjusts every two years
3/1 ARM: First adjustment after three years, then adjusts annually
5/1 ARM: First adjustment after five years, then adjusts annually
3/3 ARM: First adjustment after three years, then adjusts every three years
3/5 ARM: First adjustment after three years, then adjusts every five years
5/5 ARM: First adjustment after five years, then adjusts every five years
5/6 ARM: First adjustment after five years, then adjusts every six months
7/1 ARM: First adjustment after seven years, then adjusts annually
10/1 ARM: First adjustment after 10 years, then adjusts annually
15/15 ARM: First and only adjustment after 15 years

As is apparent, there is a variety in the length of both the fixed rates and the adjustment periods offered amongst hybrid mortgages.

ARM Indices 

All ARMs, be they hybrid or traditional, are tied to an index that regulates payment fluctuations during their adjustment periods. Below is a list of the most popular list of indices to which most ARMs are attached, along with an explanation of their functions:

T-Bill: The yield resulting from the weekly auctions of one-year Treasury-Bills held by the US Treasury.

Prime: The rate set by the Federal Reserve that most commercial banks charge their creditworthy customers for lending products.

Constant Maturity Treasury (CMT): The derived yield of a mix of Treasury securities, with various maturities, including T-bills, T-notes, T-bonds and off the run securities, adjusted to a one-year term.

Monthly Treasury Average (MTA): The average of the last 12 values of the CMT, adjusted for lag effect.

The 11th District Cost Of Funds Index (COFI): The rate savings institutions pay depositors for checking and savings accounts in the 11th Federal Home Loan Bank District. This district includes banks in Arizona, California and Nevada.

London Interbank Offered Rate (LIBOR): The interest rate charged among London-based banks for borrowing transactions between them. This rate is set by a panel of global banks and is based on their global currency trading estimates.

Secured Overnight Financing Rate (SOFR): The volume-weighted median of transactions taking place in the overnight U.S. Treasury repo market.

Each of these indices has their strengths and weaknesses, with the T-bill being one of the more volatile, due to its dependence on weekly auctions, Prime being the most expensive and the COFI being more stable, but less popular after the housing bubble of the late 2000’s. One thing is for certain--after prolonged concerns of overreliance and clear instances of manipulation, LIBOR is no longer the index of choice for mortgages in particular and dollar-based securities in general. Going forward, SOFR will replace LIBOR as the most frequently used index for ARMs. Although SOFR is a secured rate and more inherently volatile than LIBOR, as it relies on the availability of collateral, it offers two characteristics that LIBOR does not: it is based on markets that use the American dollar and it is not tied to the general creditworthiness of the interbank market. All GSE’s are preparing for the transition to this practice change, which should be completed by January 3rd of next year.

ARM Metrics

When evaluating the performance of any ARM, a number of factors must be taken into consideration. Below is a short list of terms and definitions that are helpful to evaluating ARM yields:

Index Value: The mortgage rate, based on the market index.

Initial Coupon/Teaser Rate: The first rate paid by the borrower until the first adjustment period.

Gross Margin: The amount above the index value paid by the borrower during the adjustable term of the mortgage.

Net Margin: The spread paid to the investor after deducting the servicing and guarantee fees or credit enhancements.

Servicing Fees: The rate charged by servicer to service the loan.

Guarantee Fees: The rate charged by MBS servicer to ensure that payments from the mortgage will be supplemented in case of default.

Credit Enhancements: Collateral posted to offset any credit risk from the mortgage.

Reset Frequency: The amount of time between reset periods.

Periodic Rate Collar: The maximum allowable adjustment to the rate paid by the borrower during any one adjustment period.

Gross Life Cap: The maximum allowable rate paid by the borrower during the life of the loan.

Gross Life Floor: The minimum allowable rate paid by the borrower during the life of the loan.

To find the rate of an ARM during its adjustment period, one need only take the initial coupon and add the index value and gross margin, limiting this value by the lesser of the periodic rate collar and gross life cap. If the rate later decreases at some point, the negative index value is added to the gross margin and limited by the greater of the gross life floor or periodic rate collar.

The gross life cap and floor are also helpful in calculating a best and worst case scenario for performance during the life of the loan. Running a maturity value calculation that results from the sum of the fixed period calculation, graduated payment escalations from the teaser rate to the gross life cap, bounded in each period by the rate collar and the adjustment period, assuming that the rate will remain at the gross life cap for the duration of the loan will yield a max value. Performing a similar calculation, graduating the payments down by the rate collar until the loan reaches its teaser rate and then assuming that the loan stays at the teaser rate for the duration of the loan, will yield a worse case scenario. Either one of these calculations can be weighted by the historical performance of the index to which the ARM is tied for a risked-weighted calculation.

Finally prepayments can be assumed to have a 100 PSA, in the absence of any other prepayment data. The PSA or Public Securities Association’s Standard Benchmark is a method calculating prepayments based on a derived prepayment curve. A more in-depth discussion of the PSA can be found here

As the mortgage market continues to move away from LIBOR, a shift in underwriting for ARMs may follow. Understanding the factors that drive mortgage returns, however, gives any investor an advantage when it comes to financing.

That is my take on Adjustable Rate Mortgages. Please feel free to leave your thoughts below.

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