Tools for rising interest rate environments
- what a weighted average coupon (WAC) ARM pool is
- how to calculate the cost of a 2-1 buydown
- what contribution limits are
- how to hedge against rising pipeline exposure from normal lock flows
- how to use float down locks, long term locks and forward builder commitments.
Mortgage bankers may be required to use all of these tools and some not mentioned here if we experience a rising interest rate environment.
Forward builder commitment
A forward builder commitment is a put option sold to a builder for a fee, wherein the mortgage lender agrees to fund loans at a specified rate and price for a given set of loan programs over a longer-than-normal period of time.
For example, a builder may want to protect $10 million worth of home sales in a housing development they are constructing currently that should begin closing in 6 months and finish closing in 12 months.
- If today’s rates are 3.875% at -1 point for a 30-day lock on FNMA 30-year fixed rate: under a standard builder commitment, the mortgage banker would offer a 12-month agreement to fund loans for clients of the builder at 4.5% and -1 point or lower for up to a year for an upfront fee of 1 point.
- If during the period rates are lower and loans are ready to fund, the builder commitment-capped loans would be locked as normal to the daily rate sheet.
- If rates were higher (for example, 6% and -1 point during the period), then the clients’ loans would be locked and close at 4.5% and -1 point.
A forward builder commitment allows the builder to guarantee that they will have affordable financing available to their buyers in the event the market turns for the worse in a rising rate environment. Builders who purchase these puts will have a competitive advantage in their market by offering this type of financing to their buyers.
Long term locks for 180 days on purchase transactions can be used effectively to allow borrowers to lock their loan for 180 days at a price that reflects the current 180-day market for a given product. The cost to do so usually requires an upfront fee that is refundable towards closing costs if the loan funds. The upfront fee is usually retained by the mortgage banker in the event the borrower cancels the transaction to guard against fallout during the period and roll costs.
Float down lock
A float down lock structure is like a one-off builder commitment sold to a buyer directly, wherein the mortgage banker agrees to fund the loan at a maximum rate and price over a longer period usually limited to 180 days (the construction period.) The pricing is registered and hedged as an optional exposure sold to the buyer, and the borrower has the right during the period to lock at the current pricing available or the maximum set in the commitment, whichever is lower.
Contribution limits are set by the agencies to limit the amount a seller can contribute toward the closing costs in a transaction. Builders and sellers in the past have used this tool to incentivize buyers to purchase their houses without lowering the price of the home. For example, FNMA sets its contribution limit for an 80% LTV loan on a purchase transaction for a 30-year fixed rate mortgage at 6 points.
Buydowns and contribution limits are tied together because buydowns are usually paid for by the seller and have various limits according to the type of transaction and LTV level.
For example, FHA allows a 2-1 buydown on the interest rate under a GNMA II 30-year fixed rate program, and the cost of the buydown is simply the interest reduction cost of the buydown. If the principal and interest payment for a $200,000 loan at 3.75% with a 30 year term is $926.23, then the buydown cost is sum of the difference in payments for the first year at 1.75% ($926.23 – $714.49 = $211.74 x 12 = $2,540.88). The cost for the second year at 2.75% would be $926.23 – $816.48 = $109.75 x 12 = $1,317 (or $3,857.88 and 1.93 points, which is usually rounded up to a 2 point cost to the seller.) These rates, however, do not set the qualification rate level. Borrowers must still qualify for the mortgage at the rate of in the example of 3.75%. This total cost of the buydown is significantly lower than what it used to be when rates where in the 8% range. Do the math and check it out!
Adjustable Rate Mortgages (ARMs) and WAC pools
Historically, ARM loans have been used to combat a rising interest rate environment. Typically, short-term rates do not rise as fast as long-term rates and carry a lower rate in any given market. However, this is not always the case as in the past short term rates have risen faster than long term rates with short term rates reflecting a higher yield than long term rates. The products still offered in today’s market the 3-1, 5-1, 7-1, and 10/1 ARMs provide borrowers with lower initial period rates than what is currently offered on a 15- or 30-year fixed rate programs and must be pooled seperately. These lower rates are used for qualifying purposes however, not on the 3/1 ARM as either 2% above the initial rate or the fully indexed rate is used. A WAC pool refers to the weighted average coupon contained in the pool of loans delivered to the market as an ARM mortgage-backed security (basically the weighted average gross start rate less servicing fee), and the WAC (weighted average coupon) is used amongst other statistics by investors to price the pool.
Speculative Put Option Purchases
Another tool used by mortgage bankers in the past to secure lower-than-market financing availability to borrowers was the purchase of put option contracts on mortgage-backed security TBA products with expiration dates in the future. Prior to a market move, a firm would speculate that the market was about to deteriorate and execute purchases of put option contracts on MBS securities in the deliverable range to alleviate the impact. In the event the market sold off significantly, bankers priced loans according to securitizing the loans into the MBA security price with the option strike that was in the money. The reason they don’t simply pair off the in the money put options in such a market after a successful speculation is that the loans are worth more than the pair off would be by generating servicing, miscellaneous fee, and interest income. While this method was costly then, it has become increasingly costly today as option pricing from actual volatility levels has increased, and the availability of options to purchase from dealers has decreased significantly.
There are many more tools available to combat a rising interest rate environment, although not that many in the market today remember that the tools are available. It’s time to arm your company with these tools before the market changes and rising rates have a significant impact to your origination volume and profitability.
Copyright 2013 MCM