For decades the surest and safest mortgage has been the quiet and dull fixed-rate loan. With fixed-rate loans the monthly payment for principal and interest never changes, the interest rate stays the same, the loan balance declines every month and the threat of payment shock is non-existent. The biggest choice faced by fixed-rate borrowers is 30 years or 15.
Given the mortgage calamities seen during the past year it might seem logical that lenders would be pushing fixed-rate mortgages, but the good things which make such loans safe and secure for borrowers are increasingly unattractive to mortgage investors, the people who actually buy loans. The result is that fixed-rate mortgages are about to become increasingly rare even for the best borrowers.
The Good Old Days
One of the first homes I bought was financed in a way that would make TV real estate wizards proud: I assumed a 6 percent mortgage and the seller took back a second loan at the same rate for much of the rest of the purchase price.
This was long, long ago and each month I went to the local bank and made my payment on the first mortgage. The teller would mark my passbook by hand and as corny as it seems I actually looked forward to my monthly trips to the bank and the gradual reduction of my debt.
The problem was that with every payment the lender lost money.
The lender, I have no doubt, hated me. Nothing personal, merely a reflection of the reality that while I was paying 6 percent the very same lender was making mortgage loans in the late 1970s and early 1980s at 12, 13 and 14 percent.
My lender was financing long-term mortgages such as mine with short-term borrowing. The interest rates paid by the lender were higher than my loan rate, so the lender was losing money with every payment I made.
“Today lenders have gotten smarter,” says James J. Saccacio, chief executive officer at RealtyTrac.com, the nation’s best known source of foreclosure data and listings. “Freely-assumable loans don’t exist and the companies we see as ‘lenders’ are most-often mortgage retailers, companies without a vault, deposits or cash of their own. For the past few years the game has been to originate loans, sell them as quickly as possible, and then use the cash from the sale of one loan to finance the next.
“While the system of selling loans has been good in the sense of adding liquidity to the marketplace,” said Sacaccio, “ultimately it’s unchanged from the days of passbook loans: In the end there’s an investor putting up the cash for a mortgage and that investor does not want to take a loss.”
The Shifting Market
For the past 18 months, there have been almost daily reports of investors fleeing from subprime and Alt-A loans — the mortgages with the most defaults and the greatest level of risk.
Investors have also begun to back away from prime loans and with some reason: Even they are not as sure or certain as expected. As Jaime Dimon, chairman and chief executive officer at JPMorgan Chase just told analysts, “prime looks terrible.”
At Dimon’s bank, for example, net charge offs for prime loans rose from .05 percent in the second quarter of 2007 to .91 percent a year later — an 18-fold increase for the best loans held by one of the nation’s best-regarded lenders.
From an investor’s point of view, the default rate for prime loans is not quite what it seems. Yes, bigger losses are a problem, but there are other concerns as well.
A large and growing portion of the American economy is financed by overseas dollars. If you’re an investor and live outside the U.S. then you have a number of ways to make money with American assets.
Imagine if you buy prime mortgage-backed securities worth $75 million that pay 5 percent interest. If you expect .5 percent of the loans to fail — loans worth $375,000 — you will still earn your 5 percent. But if fully 1 percent of the loans fail — mortgages worth $750,000 — you won’t earn 5 percent because you now have an additional $375,000 in losses.
That’s a problem, but perhaps not a terrible problem. Remember, the value of your investment is measured in dollars so in a sense your mortgage-backed security is a commodity of sorts. If you have a $75 million asset and the value of dollars increases by 10 percent against your currency then you’ve made $7.5 million because now your dollars buy more.
But what if dollar values fall? If the value of the dollar drops 10 percent your spending power has been reduced by $7,500,000. Add in $750,000 in foreclosed loans and you’re out $8,500,000. Ouch!
There is, however, still another way to protect your investment. Instead of fixed-rate mortgages, you could make sure that some or all of the loans in your package are adjustable. As inflation increases and the value of the dollar drops, interest rates would automatically rise as indexes go up. In effect, ARMs are a lender hedge against inflation and devaluation.
For example, if the overall interest rate on your loans went from 5 percent to 6 percent, you would gain an additional $750,000 each year.
Not only would your interest income go up, if loss rates remained at expected levels the value of your security would also increase. A $75 million security that pays 5 percent produces income worth $3,750,000 a year. A security that produces $4,500,000 is worth $90,000,000 for investors looking for a 5 percent return.
The Quadruple Whammy
International investors during the past few years have been hit with four central problems when it comes to U.S. mortgage-backed securities:
First, loss rates are higher than most analysts predicted. You can see this every day in the headlines and news reports.
Second, more foreclosures mean less interest income, thus devaluing securities.
Third, home values have declined during the past year, so there is less security to protect investors if mortgages fail. One government study says that between April 2007 and May 2008 home values nationwide dropped 4.6 percent.
Fourth, the dollar has taken a beating relative to most major currencies. This is one reason the price of oil has soared in the past year — it’s not that oil costs more to produce, it’s that dollars buy less and less on overseas markets.
In June 2005, one Euro was worth $1.22 according to the Federal Reserve Bank of St. Louis. By June of this year that same Euro cost $1.56 — a 28 percent drop in the buying power of the U.S. dollar. Seen another way, if you go to Italy now it will cost 28 percent more than three years ago, but when Italians come here their costs have fallen by that same 28 percent.
What does it all mean? It would not be unreasonable to see mortgage investors shift their preferences. Some investors will simply exit the mortgage marketplace, meaning that mortgage financing and refinancing will be more difficult to get in the U.S. and that rates will be higher. You can already see this with subprime and Alt-A loans because many lenders do not want to buy securities backed by such loans.
Another possibility is that investors will begin to shy away from fixed-rate prime loans. Not all prime loans, but fixed-rate mortgages to the best borrowers.
Adjustable-rate prime mortgages are an excellent hedge for lenders against both inflation and declining dollar values. If you’re an investor you want to finance prime ARM borrowers so that you have the fewest number of defaults plus you get the benefit of changing rates.
Alternatively, as an investor the borrower you don’t want is the person with great credit and a fixed-rate loan — somewhat like me and my passbook mortgage, borrowers who are good about making loan payments and therefore have loans which stay outstanding for a long time. That’s a problem to investors if inflation is growing, rates are rising, flexibility is needed and better returns can be obtained elsewhere.
Is inflation a real worry, something that should concern investors? You bet. As Federal Reserve Chairman Ben Bernanke just cautiously told Congress, the “upside risks to the inflation outlook have intensified lately, as the rising prices of energy and some other commodities have led to a sharp pickup in inflation.”
HUD, for it’s part, has already given in to international pressures. Instead of using Treasury securities for FHA adjustable loans, it began insuring ARMs last August with rates based on the LIBOR index — the London Interbank Offered Rate. The use of the LIBOR index is designed specifically to make mortgage securities backed with FHA loans easier to sell worldwide.
While there will surely be fixed-rate mortgages in the future there’s little doubt that such loans over time will be increasingly difficult to get. Borrowers who want fixed-rate loans will soon pay a significant premium for such financing, even borrowers with great credit and substantial equity. The growing investor preference for adjustable-rate mortgages does not mean there will be fewer mortgages, it does mean that the risk of inflation will increasingly rest with borrowers.
The bottom line: If you’re now in the market to finance or refinance it would be a particularly good time to consider fixed-rate loans — while you can.
Peter G. Miller is the author of the Common-Sense Mortgage and is syndicated in more than 100 newspapers.