Re-ARMing the Mortgage Market

Mortgage lenders are originating an increasing number of non-conforming ARM products--many of which are going into portfolio. It makes one wonder: When will the securities market return for such loans?


Mortgage Banking

May 2014

By Robert Stowe England

As interest rates rise, more borrowers are choosing to go with an adjustable-rate mortgage (ARM) instead of a 30-year fixed-rate mortgage (FRM)--the loan product that has reined supreme for more than five years.

Banks, thrifts and other mortgage originators have responded to this interest from borrowers by offering a growing array of ARMs to meet various segments of the market. At the same time they are keeping a fairly tight lid on underwriting standards as they negotiate the inexplicably complex thicket of regulations that offer several sets of different rules for lenders to use to qualify borrowers for ARMs.


“Adjustable-rate mortgages are alive and well,” says Brad Blackwell, executive vice president and portfolio business manager with Wells Fargo Home Mortgage, Des Moines, Iowa. In this cycle, as opposed to a decade a go, the appetite for risk by borrowers is much lower. Thus, the extent of the move into ARMs is tempered and borrowers still overwhelmingly favor the 30-year fixed-rate mortgage.


PNC Mortgage, Downers Grove, Illinois, is also seeing a shift in favor of ARMs. “If you look at conventional, conforming space, what we’ve seen over the past few years is anywhere from 3 percent to 5 percent of the business coming in the ARM space, and what I’m starting to see is a small uptick in the market, going from 5 percent to 7 percent,” says Peter Boomer, executive vice president at PNC Mortgage.


“Where you’re really seeing the shift is in the jumbo mortgages with balances over $417,000,” he adds. “While business was about 10 percent to 12 percent in recent years, I’m now seeing that move to the 20 percent to 25 percent ARM,” he adds.


Hybrid ARMs are hot


One development attracting consumer interest in ARMs has been the ability of lenders to better tailor loans to borrower preferences. To lock in lower payments longer, borrowers are favoring “longer initial fixed-rate periods than you might have seen 10 years ago,” says Blackwell. Borrowers like best the 7/1 and 10/1 hybrid ARMs with the 5/1 ARM following closely behind, Blackwell reports.


PNC’s Boomer is also seeing borrowers favor the 7/1 and 10/1 hybrid ARMs--and he sees growing interest in interest-only (IO) ARMs.


“Everybody is poised for a very robust spring market here,” Boomer says. PNC Mortgage, which originates loans in all 50 states, was originally concentrated in the Northeast, but has built “a rather extensive mortgage franchise” in California, Washington and Texas, according to Boomer. PNC has more than 25 mortgage offices in California.


Lenders have also taken other steps to limit payment shock when the loan first adjusts. For example, Wells Fargo Home Mortgage has reduced the maximum size of upward interest-rate adjustment that can occur in the first year the loan payment adjusts. In the past, ARMs typically had a 5 percent maximum first adjustment, 2 percent annual cap and 5 percent lifetime cap.


A 5/1 ARM, for example, that began at 3.5 percent could rise to 8.5 percent in the sixth year “if interest rates went up that much in the first five years,” says Blackwell. “We thought that was far too risky for the customer. And we’ve put a 2 percent cap on first adjustment as well,” he adds. With this approach, the most the 3.5 percent mortgage can rise to in the sixth year would be 5.5 percent.


The current level of interest in ARMs is a bit of an about-face. Borrower interest in ARMs declined from 2009 through 2011, based on call-report data from bank and thrift portfolio lenders, according to Inside Mortgage Finance.


However, starting in 2012, bank and thrift holdings of ARMs began to rise. In the fourth quarter of 2013, banks and thrifts held $647.42 billion in ARMs on their books. This represented 37.1 percent of the total mortgage portfolio of $1.743 trillion for all banks and thrifts. By comparison, at year-end 2011 the share was lower at 31.9 percent.


The largest ARM producer in 2013 was Wells Fargo Home Loans, with $35.28 billion in production, according to Inside Mortgage Finance.


The next four largest ARM originators last year were Chase Home Finance, Edison, New Jersey ($27.06 billion); PHH Mortgage, Mount Laurel, New Jersey ($19.85 billion); Bank of America Home Loans, Calabasas, California ($13.30 billion); and Citi Mortgage, O’Fallon, Missouri ($10.53 billion).


Conventional, conforming ARMs


Frank Nothaft, chief economist at Freddie Mac, is forecasting that the ARM share of conforming originations in the conventional, conforming single-family market will rise to 12 percent this year, up from last year’s 9 percent.


“That may be low compared to where it was 15 to 20 years ago, but it is a pretty hefty increase in the share of the market compared to 2013,” Nothaft says.


The Federal Reserve Board’s Federal Open Market Committee (FOMC) appears to be in agreement on gradually tapering the Fed’s monthly purchases of Treasuries and agency mortgage-backed securities (MBS) steadily in the coming months and ending them entirely this fall. This tapering will, along the way, push up interest rates on 30-year fixed-rate mortgages by “as much as a half a percentage point over the course of 2014,” Nothaft says.


At the same time, the Fed has made it clear it intends to keep its short-term Federal Funds Rate between 0 percent and 0.25 percent for the rest of the year.


Federal Reserve Chair Janet Yellen, in her debut press conference in March, when pressed on when short-term rates might be raised after tapering concludes, indicated that she expected that could occur six months after that, which market observers suggest would put the rate rise in the spring of 2015. In a subsequent speech in Chicago she indicated that the subpar U.S. job market would require the Fed to keep rates low “for some time.” Based on that outlook, Nothaft is forecasting the market share for ARMs to rise further next year to 15 percent of all conventional, conforming originations.


A shift in mortgage originations from refinancings to purchases is another factor driving the increase in ARMs. More than 95 percent of borrowers who refinanced during the refi boom took a fixed-rate loan, according to Nothaft, but rising rates are dampening the refi market. Meanwhile, the home purchase market, which had also been dominated by fixed-rate mortgages, is moving more in the direction of adjustable-rate mortgages. Thus, as purchase mortgages become more important to the market, so do ARMs, Nothaft explains.


In the conventional, conforming market, the most appealing ARM product is the 5/1 hybrid, according to Nothaft--an appeal he thinks is likely to increase.


In the agency’s annual ARM survey of 106 ARM lenders in January, Freddie Mac found that 71 percent of the lenders offered the 5/1 hybrid--by far the most prevalent ARM product.


“There’s the most bang for the buck [for borrowers] in the current interest-rate spread in a 5/1 ARM,” says Guy Cecala, president of Inside Mortgage Finance. In mid-March, for example, borrowers could get a 5/1 ARM for 2.984 percent, which is almost 150 basis points lower than the rate for the 30-year fixed-rate mortgage. “That’s the main reason people are taking the 5/1 ARM,” says Cecala.


The regulatory thicket


For lenders and borrowers, rules affecting ARMs are brutally complex and there are different rules on qualifying borrowers within the ability-to-repay (ATR) and Qualified Mortgage (QM) rules. Plus, there are separate rules for IO ARMs.


The Consumer Financial Protection Bureau, despite requests, failed to provide someone at the agency to explain in an interview how these rules interact to affect how lenders should qualify borrowers for a range of ARM products. Market participants and observers, however, have been willing to explain their understanding of the complications and complexities of these rules authorized under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.


At first, the 5/1 ARM appears to be a problem for borrowers who could use the lower monthly payments to make home purchases more affordable.


So, how does one navigate the different rules under ATR and QM?


“You use ATR as the first litmus test,” says PNC’s Boomer. “Typically, what you’re looking at to meet the ability-to-repay [rule] is the highest of either the initial note rate or the fully indexed rate in the first five years.” Then you can proceed to QM, if the ATR rule does not end a borrower’s quest for a mortgage. “Under QM, the question is what is the highest possible rate the customer could pay in month 61,” says Boomer. That’s the first month after the first five years.


For IO ARMs, under QM a lender must qualify a borrower to be able to afford a payment based on a 20-year amortization schedule instead of on the initial interest-only cap, regardless of the length of the amortization schedule of the mortgage or when it begins after the initial IO period. Plus, under ATR, the lender also has to qualify an IO borrower on either the initial loan rate or the highest possible fully indexed rate in the first five years, Boomer explains.


Despite the hurdles, borrowers are finding IO ARMs attractive and PNC is finding more than 5 percent of borrowers choose this product in the jumbo market.


“It’s really more a factor when you look at financial management,” explains Boomer. For example, some people earn a great share of their annual pay as a single bonus once a year and the IO payment allows them to manage their cash flow and then use the bonus to pay down the principal each year, according to Boomer.


Farmers, for example, see nearly all their income when they sell their harvest. “An IO needs to be the right product for the right customer for the right reason,” Boomer says. It probably is not the right product for borrowers who intend never to make principal payments and need the IO to buy a home they could not otherwise afford.


Lender interest-rate risk


For lenders, the move toward more borrower-friendly ARMs comes with a higher risk. “A lot of banks and depository institutions are putting ARMs on their books, feeling that that’s mitigating the interest-rate risk, when, in effect, if you look closer, most of those loans are closer to a fixed-rate loan than to a pure ARM,” Cecala says. “For instance, if you’re loading up your books with five-year ARMs and interest rates jump 100 basis points next year, you get no protection whatsoever.”


Portfolio lenders might prefer the 5/1 ARM over the 7/1 ARM and the 10/1 ARM, because the interest-rate risk is less, according to Cecala. However, most of them “are doing whatever they can sell,” he says, which means borrowers are driving the types of ARMs being originated.


For portfolio lenders, the cost of funding the loan is 0.2 percent. “You put a loan on your books at 3 percent. That’s almost a 300-basis-point margin. Even if that was cut in half, you’d still have a positive margin while you wait for the loan to adjust,” says Cecala.


If interest rates only rise by 1 percent or 100 basis points over the next year, “as a lender you’re not going to be able to capture that,” Cecala says. “I guess the comfort they take is that their spreads are so wide now over their cost of funds, which is deposits, they could eat up a lot before they were really underwater on the loan.”


Interest-only mortgages


With the final ATR and QM rules in place, it has made it more difficult for borrowers to qualify for loans; however, the degree of increased difficulty is fairly modest when compared with the tighter underwriting practices that banks have followed since 2009, according to Karen Mayfield, senior vice president, national sales manager at Bank of the West, San Francisco.


“One of the first things we changed in 2009 was to say, ‘You know what? The qualifying payment is going to be based on the higher principal and interest to make sure you can afford this,’” Mayfield says.


At Bank of the West, a borrower pre-Dodd Frank who applied for a 7/1 IO ARM began to in the eighth year for an additional 30 years would have to qualify for the amortized payment in the eighth year, according to Mayfield.


Since the finalization of ATR and QM, however, lenders like Bank of the West have accelerated the pace of the amortization for such loans to comply with new rules by reducing the number of years the mortgage amortizes to 23 instead of 30. Thus, the full life of the loan is 30 years instead of 37 years.


The shorter amortizing term, in turn, increases the amortized payment in the eighth year even more than before the final ATR and QM, and requires borrowers to have a higher income to get the loan, she explains.


Self-employed borrowers, whose incomes can vary from year to year, face a more difficult time qualifying for mortgages since 2009 and now even more so in the post-Dodd-Frank world. For these borrowers, an ARM loan is looking increasingly attractive, “because the 30-year fixed rate has gone up while the adjustable-rate mortgages have not moved that much,” says Mayfield. She agrees that it is not easy for the self–employed to get a mortgage today, but notes it has been that way since 2009 and most of the adjustment came before Dodd-Frank made it more difficult.


Inadvertently, tight underwriting standards for the self-employed may benefit the tax coffers of the federal government because lenders are telling borrowers they will need to amend their past federal tax returns to show more income if they want to qualify for a mortgage they are seeking.


“We’ve certainly worked with a lot of people where getting the loan made more sense than the savings in taxes,” says Mayfield.


So in those cases, the borrowers filed amended tax returns for the prior two years to show a higher income, then paid the taxes and got the mortgage to purchase the home they wanted, she explains.


Bank of the West, like many other lenders, is qualifying borrowers at the first adjusted payment on five-year jumbo ARMs. For borrowers who are finding this makes it more difficult to qualify for a loan, they might want to look at the 7/1 ARM or the 10/1 ARM.


“Their interest rate may be a little higher than with the 5/1 ARM, but it may be the difference between getting a loan and not getting a loan,” Mayfield says. “Because the seven-year and 10-year rates are more stable, a lot of lenders are not increasing the initial rate to qualify,” she adds.


Sometimes, however, a borrower who might prefer a 3/1 ARM may not qualify because lenders have to add as much as 6 percentage points to the interest rate for the first adjustment when qualifying for the loan. That borrower could, however, qualify for a 30-year fixed rate or a 7/1 or 10/1 ARM.


“In the first couple of months since [the final QM and ability-to-repay rules], lenders are fine-tuning their practices, and it wouldn’t surprise me if we saw lenders change some of their practices three to six months from now, after they’ve gotten a better feel and they’ve seen the impact to their business for the good or for the worse,” says Mayfield. Lenders may become more stringent later or decide their initial response was “too fearful” and start offering non-qualified mortgages, she adds.


The ability of portfolio lenders to fill the gap in providing mortgage finance appears to be somewhat limited, both by regulation and by the inclination of lenders to maintain fairly tight underwriting.


The ARM share for portfolio lending, while rising in recent years, was just under 20 percent for 2013, according to Inside Mortgage Finance’s Cecala. While that represents some advance from the 7 percent share in 2009, “Any serious mortgage banker is doing much more for agency business than portfolio lending,” Cecala says, “and most of the portfolio lending in the last three or four years has been jumbo lending.”


Non-traditional loans, if offered, would necessarily be portfolio products, and so far there has been little evidence portfolio lenders are venturing into or expanding non-traditional lending. For starters, a return of a reduced-documentation or alternative-A lending seems highly unlikely beyond some offerings on a very limited scale, according to Cecala.


“One of the requirements of the ability-to-repay rule, regardless of whether it’s QM or not, is that every lender has to collect or look at a certain amount of information, including the credit score, and assets that normally you would not have to do in the past,” he explains.


Johnson-Crapo legislative proposal


The question of how to provide adequate mortgage credit could change if and when Congress moves forward with mortgage reform. In March, Senate Committee on Banking, Housing and Urban Affairs Chairman Tim Johnson (D-South Dakota) and ranking member Sen. Mike Crapo (R-Idaho) announced they had reached a bipartisan agreement on the legislative provisions for a mortgage reform bill that would, among other things, wind down Fannie Mae and Freddie Mac within five years.


Under Johnson-Crapo, the role now played by government-sponsored enterprises (GSEs) Fannie and Freddie in the current market would be taken over by a newly created entity know asthe Federal Mortgage Insurance Corporation (FMIC). This new agency would oversee a Mortgage Insurance Fund similar in concept to the Deposit Insurance Fund overseen by the FDIC.


The new agency would provide an explicit government guarantee for mortgage-backed securities instead of the implicit one originally provided for Fannie and Freddie. The proposal keeps current conforming loan limits at $417,000 for most markets, but up to $625,500 for high-priced markets.


The agreement also includes a 10 percent capital base from private investors for FMIC “to protect taxpayers against future bailouts,” according to a release from the Senate Banking Committee. There would also be a member-owned securitization platform to issue each single, standardized FMIC-wrapped security. This would permit institutions to issue private label securities in a manner that encourages standardization and which would improve market liquidity. There would also be a mutual cooperative jointly owned by small lenders. The cooperative would be created to make sure that community banks and credit unions do not work at a disadvantage with big financial institutions on the securitization platform.


What’s currently unknown, however, is whether there will be a robust private-label MBS market for jumbo mortgages after mortgage finance reform is enacted.


To be sure, players in that private-label market, however, are lining up behind most of the provisions in Johnson-Crapo. “We definitely support the essence of the bill,” says Mike McMahon, managing director of Redwood Trust Inc., Mill Valley, California, a leading player in efforts to rebuild the jumbo securitization market.


The firm has done 22 securitizations totaling $8.8 billion since 2010, 12 of those last year amounting to $5.6 billion. Importantly, “FMIC should guarantee that there will be enough credit available” for the mortgage market, says McMahon.


Redwood identifies several features in Johnson-Crapo that it likes. “It is a creative solution that puts the government and taxpayer in the secondary risk position,” McMahon says.


“The 10 percent subordinate level is a very high firewall, probably twice as much or more than is needed.” The government guarantee will keep funding costs low and competitive, while ensuring there will be sufficient liquidity for the to-be-announced (TBA) market, according to McMahon.


The impact on mortgage rates may, however, be muted. “Because private capital will take the first 10 percent in loss, the rate on underlying mortgage will more closely reflect market rates,” McMahon says. “I’d expect [FMIC-backed securities] to trade tighter to Treasuries than RMBS [residential mortgage-backed securities].”


Current state of the private securitization market


Redwood would have preferred to see lower loan limits to give the private RMBS market room to make a bigger comeback. So far, however, “private-label hasn’t really taken off. It’s still taking baby steps,” says McMahon.


Total new issuance since 2010, when the market first returned, is $17.7 billion through the end of 2013, with $13.05 billion of that done in 2013 alone, according to Inside Mortgage Finance. (Redwood’s $8.8 billion since 2010 is half of all the new volume.)


Meanwhile, the commercial mortgage-backed securities [CMBS] market saw $85 billion in issuance last year and is likely to see $85 billion to $95 billion this year, according to McMahon.


Investors would return in greater numbers to the RMBS market, as they have to other forms of securitization, if there were more RMBS issues available in which to invest, according to McMahon.


“There’s no real meaningful supply” available to investors right now, he says. “There’s no reason for New York-based BlackRock Inc. and Newport Beach, California-based Pacific Investment Management Co. LLD to hire teams of people to allocate funds to RMBS when there are no securities to buy,” he says. “If PIMCO bought all the RMBS issued since 2010, it wouldn’t matter to their returns. It’s just too small.”


Sufficient supply to attract investors would happen if banks returned to their historic pattern of keeping half the jumbo mortgages in portfolio and securitizing the rest, according to McMahon. Instead, banks are keeping nearly 100 percent of their jumbo originations, he says.


Because jumbo loans are so profitable in the current interest-rate environment, “there’s no economic incentive to securitize,” says McMahon. Meanwhile, banks are holding nearly $1.1 trillion in 30-year fixed-rate jumbos on their books--loans that carry a lot of interest-rate risk for the banks.


A number of trade groups and organizations have expressed support for the Johnson Crapo proposal. The Bipartisan Policy Center, for example, said the legislation mirrors priorities it set in its own report last year, including a bigger role for private capital and a federal government insurance backstop. The Securities Industry and Financial Markets Association called it a positive development.


Mortgage Bankers Association President David Stevens commended the Senators’ effort and pledged to work with them and the committee to move legislation forward. The Independent Community Bankers of America expressed qualified support for the proposed legislation. “Because community banks must continue to be able to sell individual loans for cash and to retain servicing on those loans, ICBA is encouraged by provisions of the Johnson-Crapo plan that support continued access for community banks,” the organization stated in a prepared release.


Not everyone thinks the Johnson-Crapo discussion draft legislation will work as advertised.


“It would encourage too much of the wrong kind of debt for our economy--debt that bids up existing housing assets and the land they sit on,” says Edward Pinto, resident fellow at the American Enterprise Institute (AEI), Washington, D.C. He argues that, in turn, would create “a temporary wealth effect and a crowding out of capital investment needed for a productive growing economy and jobs growth.” The explicit federal guarantee for FMIC-backed securities will inevitably lead to an oversupply of mortgage credit that will fuel “another artificial housing boom and consequent bust,” he predicts.


It appears that for now, lenders are in a transitional period in terms of exploring what loan products they can and cannot offer, either to comply with complex rules or to adhere to their own underwriting criteria.


Lenders, however, seem prepared to test the waters with a growing array of variations in ARM products. Among the available products, borrowers seem to be in the driver’s seat on what will and will not fly. Even so, many borrowers would probably prefer to see more choices than the generally plain-vanilla market that now exists in mortgages.  MB



Robert Stowe England is a freelance writer based in Milton, Delaware, and author of Black Box Casino: How Wall Street’s Risky Shadow Banking Crashed Global Finance, published by Praeger and available at He can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..





Rep. Maxine Waters Introduces GSE Reform Bill



Rep. Maxine Waters (D-California), ranking member of the House Financial Services Committee, introduced a mortgage finance reform proposal in March that represents a more liberal-leaning option among the several offerings now on the table in Congress.


Titled the Housing Opportunities Move the Economy (HOME) Forward Act of 2014, it includes a provision once vigorously opposed by nearly all Democrats in Congress--the complete winding down of Fannie Mae and Freddie Mac.


The Waters bill takes a different approach to the architecture of a new mortgage finance system than all competing proposals. Instead of having financial institutions individually and separately issue mortgage-backed securities (MBS), the HOME Forward Act would create “one big issuer”--a mortgage securities cooperative made up of lenders, explains Mark Calabria, director of financial regulation studies at the Cato Institute, Washington, D.C.


The proposed legislation creates a new regulator, the National Mortgage Finance Administration, which replaces and takes over the duties of the Federal Housing Finance Agency, including overseeing the Federal Home Loan Bank system. The NMFA would adopt rules governing the placement and retention of first loss credit risk pieces by either the issuer of the mortgage-backed securities or the originator of the loans sold into the mortgage pool.


The bill provides for a federal guarantee of securities issued by the cooperative from a newly created mortgage insurance fund. “You would have an FDIC-style [Federal Deposit Insurance Corporation-style] entity that sells credit wraps around different issues,” Calabria explains. The mortgage insurance fund would have seven years to build up a reserve of 1.5 percent of the outstanding principal balance of guaranteed securities and 12 years to reach 2.25 percent.


The concept of a cooperative is probably a better approach than providing a federal catastrophic backstop, as others in Congress have proposed, according to Calabria.


What’s missing, however, is that the members of the cooperative “do not have any skin in the game,” says Calabria--meaning they do not have to contribute equity into the cooperative. He contends that a cooperative would work better if it were to be patterned along the lines of the Federal Home Loan Bank System, where member institutions have to put in capital to cover their advances from regional federal home loan banks.


“The bill takes the idea of a cooperative and gets rid of the parts of a cooperative that are valuable and that align the incentives appropriately between the owners and the purpose of the cooperative,” Calabria argues. The cooperative has one vote per member, which gives a greater role for smaller financial institutions.


The HOME Forward Act would require a 5 percent private capital buffer in each securities issue ahead of the government insurance. This is less than the 10 percent capital buffer spelled out in competing bipartisan proposals in the Senate, including the one from Senators Tim Johnson (D-South Dakota), chairman of the Senate Banking Committee, and Mike Crapo (R-Idaho), the committee’s ranking member.


The two senators in March reached agreement on a legislative discussion draft that is offered as a substitute for the Housing Finance Reform and Taxpayer Protection Act (S. 1217), the legislation introduced in June 2013 by Senators Bob Corker (R-Tennessee) and Mark Warner (D-Virginia).


The Waters proposal also brings the government-sponsored enterprise (GSE) debt onto the federal government balance sheet and returns the principal lent to the GSEs as senior preferred stock issued by the Treasury Like Johnson-Crapo, the Waters bill eliminates the GSE affordable-housing goals but replaces them with a broad duty to serve the entire market, including underserved urban and rural areas.


To advance this goal, the HOME Forward Act provides for guarantees for mortgages with up to 97 percent loan to value (LTV), as long as they are Qualified Mortgages (QMs).


Copyright © 2014 Mortgage Banking Magazine

Reprinted With Permission




Robert Stowe England is an author and financial journalist who has specialized in writing about financial institutions, financial markets, retirement income issues, and the financial impact of population aging.

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