Assignment on Adjustable Rate Mortgage

BUS 4227: Financial Markets and Institutions

SUBMITTED TO

Prof. Dr. Nesar Ahmed

Professor, Dean & Department Head
Faculty of Business Administration
Fareast International University

SUBMITTED BY

Md. Tamim Hossain (ID# 18201006)

Faculty of Business Administration
Fareast International University

Fareast International University

December 20, 2019
December 20, 2019

Prof. Dr. Nesar Ahmed

Professor, Dean & Department Head
Faculty of Business Administration
Fareast International University
House # 50, Road # 11, Block – C, Banani, Dhaka-1213, Bangladesh

Subject: Submission of Assignment

Dear Sir,

This is to inform you that I am, Md. Tamim Hossain, submitting my assignment on “Adjustable
Rate Mortgages” to you which is aligned with the course ‘BUS 4227: Financial Markets and
Institutions’.

It is true that it could have been done in better way if there would not be the limitations.
I hope you will assess my report considering the limitations of the study. Hence, I am always
prepared to welcome any further clarification that may require. Your kind
advice will encourage me to do further research in future.

Sincerely Yours,

Md. Tamim Hossain

ID# 18201006
Department: F.B.A.
Program: B.B.A.
 I

Table of Contents.

Section Particulars Page

1.1 Introduction 1
1.2 Objective of the study 2
1.3 Rationale of the study 3

2.1 Adjustable Rate Mortgages and Lender Considerations 4

2.2 Interest Rate Risk of Constant Payment Mortgages 4
2.3 Price Level Adjusted Mortgage (PLAM) 4
2.4 Adjustable Rate Mortgages (ARM) 6
2.5 Adjustable Rate Mortgages (Yield and Rates) 8
2.6 ARM Effective Yield 14
3.0 References 14
 Financial Markets and Institutions Fall 2k19 1

1.1 Introduction

A variable-rate mortgage, adjustable-rate mortgage (ARM), or tracker

mortgage is a mortgage loan with the interest rate on the note periodically adjusted
based on an index which reflects the cost to the lender of borrowing on the credit
markets.[1] The loan may be offered at the lender's standard variable rate/base rate.
There may be a direct and legally defined link to the underlying index, but where the
lender offers no specific link to the underlying market or index the rate can be changed
at the lender's discretion. The term "variable-rate mortgage" is most common outside
the United States, whilst in the United States, "adjustable-rate mortgage" is most
common, and implies a mortgage regulated by the Federal government, [2] with caps on
charges. In many countries, adjustable rate mortgages are the norm, and in such places,
may simply be referred to as mortgages.

Among the most common indices are the rates on 1-year constant-maturity Treasury
(CMT) securities, the cost of funds index (COFI), and the London Interbank Offered
Rate (LIBOR). A few lenders use their own cost of funds as an index, rather than using
other indices. This is done to ensure a steady margin for the lender, whose own cost of
funding will usually be related to the index. Consequently, payments made by the
borrower may change over time with the changing interest rate (alternatively, the term
of the loan may change). This is distinct from the graduated payment mortgage, which
offers changing payment amounts but a fixed interest rate. Other forms of mortgage
loan include the interest-only mortgage, the fixed-rate mortgage, the negative
amortization mortgage, and the balloon payment mortgage.

Adjustable rates transfer part of the interest rate risk from the lender to the borrower.
They can be used where unpredictable interest rates make fixed rate loans difficult to
obtain. The borrower benefits if the interest rate falls but loses if the interest rate
increases. The borrower benefits from reduced margins to the underlying cost of
borrowing compared to fixed or capped rate mortgages.

______________________________
1. Wiedemer, John P, Real Estate Finance, 8th Edition, pp 99–105
2. https://homeguides.sfgate.com/definition-variable-rate-mortgage-8870.html
 Financial Markets and Institutions Fall 2k19 2

1.2 Objectives of the study

The objective of the study can be classified in to three main strata: Primary objective,
secondary objective and tertiary objective.

Primary Objective of the report is to complete this assignment which is aligned with
BUS 4227: Financial Markets and Institution and Internship as a special requirement of
assignment submission on a topic regarding Major areas, i.e., Finance, General, to Dean
and Departmental Head of Faculty of Business Administration.

Secondary Objective of the study is to have a detail insight on Price Level Adjustable
Mortgage, especially, when there is a scope of embezzlement of fund and fraud.

Tertiary Objectives of the study are:

 To know the process of Adjustable Rate Mortgages.

 To increase adaptability of Adjustable Rate Mortgages in organizations like
investment, mortgage and Banking Industry etc.
 Financial Markets and Institutions Fall 2k19 3

1.3 Rationale of study

ARMs generally permit borrowers to lower their initial payments if they are willing to
assume the risk of interest rate changes. There is evidence that consumers tend to prefer
contracts with the lowest initial rates such as in the UK, where consumers tend to focus
on immediate monthly mortgage costs.[4] Decisions of consumers may also be affected
by the advice that they get, and much of the advice is provided by lenders who may
prefer ARMs because of financial market structures. [4]

In many countries, banks or similar financial institutions are the primary originators of
mortgages. For banks that are funded from customer deposits, the customer deposits
typically have much shorter terms than residential mortgages. If a bank offered large
volumes of mortgages at fixed rates but derived most of its funding from deposits (or
other short-term sources of funds), it would have an asset–liability mismatch because
of interest rate risk.[4] It would then be running the risk that the interest income from its
mortgage portfolio would be less than it needed to pay its depositors. In the United
States, some argue that the savings and loan crisis was in part caused by the problem:
the savings and loans companies had short-term deposits and long-term, fixed-rate
mortgages and so were caught when Paul Volcker raised interest rates in the early
1980s. Therefore, banks and other financial institutions offer adjustable rate mortgages
because it reduces risk and matches their sources of funding.

Banking regulators pay close attention to asset-liability mismatches to avoid such

problems, and they place tight restrictions on the amount of long-term fixed-rate
mortgages that banks may hold in relation to their other assets. To reduce the risk, many
mortgage originators sell many of their mortgages, particularly the mortgages with
fixed rates.

For the borrower, adjustable rate mortgages may be less expensive but at the price of
bearing higher risk. Many ARMs have "teaser periods", which are relatively short initial
fixed-rate periods (typically, one month to one year) when the ARM bears an interest
rate that is substantially below the "fully indexed" rate. The teaser period may induce
some borrowers to view an ARM as more of a bargain than it really represents. A low
teaser rate predisposes an ARM to sustain above-average payment increases.

__________________________
4. International Monetary Fund (2004). World Economic Outlook: September 2004:
The Global Demographic Transition. pp. 81–83. ISBN 978-1-58906-406-5.
 Financial Markets and Institutions Fall 2k19 4

2.1 Adjustable Rate Mortgages and Lender Considerations

 The need for adjustable rate mortgage instruments

 The interest rate risk of constant payment mortgages is tested in 1970s when
inflation accelerated
 Thrifts (Savings and Loan Associations) borrow funds short-term at low rates
then invest in long-term fixed rate mortgages (Maturity mismatch)
 As long as short-term rates are low, this works fine
 What happens if short-term rates rise (inflationary expectations)
 Maturity mismatch will cause severe problems
 First, market value of constant payment mortgage portfolio will be less
 Second, prepayment rate will slow reducing revenues from prepayments and
penalties
 Tilt effect: Inflation fuels future inflationary expectations leading to high rates
and payments on constant payment mortgages – Affordability problem

2.2 Interest Rate Risk of Constant Payment Mortgages

 An constant payment mortgage is just like a corporate bond: it’s value will
change depending on the current market interest rates
 Suppose that we own a mortgage loan with the following original term:
$100,000, 30-year, 10%, monthly payments
 The monthly payment on this loan is 877.57
 After 5 years, the market interest rate is 12%
 The remaining (outstanding) balance of the loan is 96,574
 What is the market value of the mortgage?

N I/Y P/Y PV PMT FV

300 12 12 -83,322.24 877.57 0

2.3 Price Level Adjusted Mortgage (PLAM)

 With the PLAM the lender receives the real rate of return as the contract rate on
the loan
 The lender then receives the premium for inflation through an upward adjustment
on the remaining balance of the loan
 The upward adjustment is equal to the rate of inflation over the previous year
 Loan payment pattern depends on the inflation
 Financial Markets and Institutions Fall 2k19 5

(A Math)

Loan Amount $60,000.00

Interest Rate 4.00%
Loan Term 30
Payment per Year 12
Number of Payments 360

Beginning Ending
Monthly
Month Loan Interest Amortization Loan Inflation
Payment
Balance Balance
0
1 $60,000.00 $286.45 $200.00 $86.45 $59,913.55
11 $59,122.42 $286.45 $197.07 $89.37 $59,033.05
12 $59,033.05 $286.45 $196.78 $89.67 $62,479.98 6.00%
13 $62,479.98 $303.64 $208.27 $95.37 $62,384.61
23 $61,511.85 $303.64 $205.04 $98.60 $61,413.26
24 $61,413.26 $303.64 $204.71 $98.93 $64,993.19 6.00%
25 $64,993.19 $321.85 $216.64 $105.21 $64,887.98
35 $63,925.16 $321.85 $213.08 $108.77 $63,816.39
36 $63,816.39 $321.85 $212.72 $109.13 $67,529.70 6.00%
37 $67,529.70 $341.17 $225.10 $116.07 $67,413.63

(PLAM Payments)
 Financial Markets and Institutions Fall 2k19 6

Major shortcomings of the PLAM include:

 A relatively complicated loan instrument for the average borrower

 Negative amortization that may occur if an individual property price fails to rise
with the level of general inflation upon which the annual adjustments to the
balance are made
 PLAMs may not completely solve the maturity mismatch problem unless
financial intermediaries are able to issue price-level-adjusted deposits

2.4 Adjustable Rate Mortgages (ARM)

 ARM allows the interest rate on the loan to move with the market interest rate
 Ability of adjusting the interest rate shifts the interest rate risk to the borrower
 The lender’s interest rate risk is not completely eliminated because interest rate
adjustments occur in periodic intervals
 The longer the interval the greater the interest rate risk
 Borrowers would not assume all of the interest rate risk. For that reason there
will be caps on the interest rate

A new loan payment is computed at each reset date

 Composite Rate = index + margin

 Index
o Interest rate that the lender does not control
o Treasury securities
o Cost Of Funds Index (COFI)
o London Interbank Offered Rate (LIBOR)

 Margin
o Premium added to the index

 Expected Start Rate

o Index plus margin on loan closing date. This rate is lower than Fixed
Rate Mortgage (FRM) rate since interest rate risk is lower for lender

 Actual Start Rate

o Market driven and likely to be lower than expected start rate
o Teaser Rate – low rate to attract borrowers

 Reset Date
o When mortgage payment is readjusted

 Negative Amortization
o Payment does not cover the interest due and inflates the amount owed.
The negative amortization may be allowed in the loan agreement
 Financial Markets and Institutions Fall 2k19 7

 Limits or Caps
o Maximum increases allowed in payments, interest rates, maturity, and
negative amortization

 Floors
o Maximum reductions allowed in payments or rates

 Assumability
 Points
 Prepayment

 Conversion
o Right of a borrower to convert ARM into FRM

(A Math)

 3/1, 5/1, and 7/1 Hybrid ARMs

o Longer initial reset period
o The extension of initial reset period will reduce the spread between ARM
and FRM rates

 Example: $100,000 with 6% initial rate for the first 3 years, monthly payments,
and 30 years
o Payment per month for the first 3 years:

N I/Y P/Y PV PMT FV

360 6 12 -100,000 599.55 0

o Balance of the loan after 3 years is 96,084

o Payment for the following year assuming a new rate of 6.5%

N I/Y P/Y PV PMT FV

324 6.5 12 -96,084 629.88 0

 Financial Markets and Institutions Fall 2k19 8

 Interest Only Hybrid ARM

 I.O. for initial reset period

 I.O. Option ARM

 Borrower choice
o Pay interest only
o Pay interest & some principal
o Sometimes negative amortization occurs
o Fully amortizing payments required in future

 Teaser Rate
o Initial rate below market composite rate (index + margin)
o Market Competition
o Accrual Rate – The loan payments are based on teaser rate, however,
balance of the loan increases by difference between market interest rate
and teaser rate
o Negative Amortization – The existence of accrual rate will cause negative
amortization
o Payment Shock – Significant increase in payment when there is a reset of
interest rate

2.5 Adjustable Rate Mortgages (Yields and Rates)

 Yields are a function of:

o Initial interest rate
o Index & margin
o Any points charged
o Frequency of reset date
o Any rate or payment limits
 Financial Markets and Institutions Fall 2k19 9

Adjustable Rate Mortgage Risks

 Default Risk
o Can borrower afford new payments?
o Impact of negative amortization

 Pricing Risk
o Allocation of interest rate risk
o Impact on default risk of specific borrowers
 Financial Markets and Institutions Fall 2k19 10

 Basic Relationships:
o ARM yield is lower than FRM yield at origination otherwise no one
would be willing to take interest rate risk
o Short-term vs. long-term indices – short-term rate are more volatile than
long-term rates. Less risk averse borrowers will prefer ARM based on a
short-term index
o Shorter reset periods vs. Longer reset periods – frequent rate adjustments
reduce lender’s interest rate risk
o Impact of caps & floors – they will reduce the borrower’s interest rate
risk by limiting the adjustments
o Negative amortization

(ARM Examples)
 Financial Markets and Institutions Fall 2k19 11

(ARM I – Payments / Balances)

 Financial Markets and Institutions Fall 2k19 12

(ARM III– Payments / Balances)

ARM III:
Loan Amount $60,000.00
Initial Rate 11.00%
Loan Term 30
Payment per Year 12
Number of Payments 360

Year 1 Payment:
N I/Y P/Y PV PMT FV
360 11.00% 12 -60,000 571.39 0

Balance After 1 Year:

N I/Y P/Y PV PMT FV
348 11.00% 12 59,730 571.39 0

Year 2 Payment:
N I/Y P/Y PV PMT FV
348 12.00% 12 -59,730 616.63 0
= MIN (Index + Margin, Previous Rate + Annual Cap, Initial Rate + Lifetime Cap)
 Financial Markets and Institutions Fall 2k19 13

Balance After 2 Years:

N I/Y P/Y PV PMT FV
336 12.00% 12 59,485 616.63 0

Year 3 Payment:
N I/Y P/Y PV PMT FV
336 14.00% 12 -59,485 708.37 0
= MIN (Index + Margin, Previous Rate + Annual Cap, Initial Rate + Lifetime Cap)
Balance After 3 Years:
N I/Y P/Y PV PMT FV
324 14.00% 12 59,301 708.37 0

Year 4 Payment:
N I/Y P/Y PV PMT FV
324 16.00% 12 -59,301 801.65 0
= MIN (Index + Margin, Previous Rate + Annual Cap, Initial Rate + Lifetime Cap)

Balance After 4 Years:

N I/Y P/Y PV PMT FV
312 16.00% 12 59,159 801.65 0

Year 5 Payment:
N I/Y P/Y PV PMT FV
312 12.00% 12 -59,159 619.37 0
= MIN (Index + Margin, Previous Rate + Annual Cap, Initial Rate + Lifetime Cap)
Balance After 5 Years:
N I/Y P/Y PV PMT FV
300 12.00% 12 58,807 619.37 0

ARM III
Index Year Month Month Interest Payment Balance
1 1 12 11.00% $571.39 $59,730
10.00% 2 13 24 12.00% $616.63 $59,485
13.00% 3 25 36 14.00% $708.37 $59,301
15.00% 4 37 48 16.00% $801.65 $59,159
10.00% 5 49 60 12.00% $619.37 $58,807
 Financial Markets and Institutions Fall 2k19 14

2.6 ARM Effective Yield

ARM I
CF0 = -58,800.00
C01 = 440.26 F01 = 12
C02 = 614.24 F02 = 12
C03 = 752.26 F03 = 12
C04 = 846.20 F04 = 12
C05 = 617.60 F05 = 11
C06 = 59,256.86 F06 = 1
CPT IRR 1.0851 %
Annual 13.02 %

ARM III
CF0 = -58,800.00
C01 = 571.39 F01 = 12
C02 = 616.63 F02 = 12
C03 = 708.37 F03 = 12
C04 = 801.65 F04 = 12
C05 = 619.37 F05 = 11
C06 = 59,426.10 F06 = 1
CPT IRR 1.1231 %
Annual 13.48 %

3.0 Reference:

https://www.bostonfed.org/-/media/Documents/neer/neer191d.pdf
https://finance.zacks.com/definition-price-leveladjusted-mortgage 10902.html
https://pdfs.semanticscholar.org/ff31/2fa272c1beecb5b47b0baf16439029fc280e
.pdf
https://investinganswers.com/dictionary/p/price-level-adjusted-mortgage-plam
https://www.investopedia.com/terms/p/price-level-adjusted-mortgage.asp
https://en.wikipedia.org/wiki/Adjustable-rate_mortgage