BR

REDMortgage
MoreM
Moneyin
nYourPo
ocket

On
neoftheimpo
ortantlessonsslearnedinthegreatrece
essionisthat homeownersswouldbenefitfromtheaabilityto
buildequityinttheirhomefaster.Equityh
helpsaborrow
wertorefinannceduringan
neconomiccrrisis,tosaveffora
tradeuppurchaase,toaccesssabusinesslo
oan,andtosh
hapeonesreetirement.Furthermore,th
hemarketwill
exp
periencechan
ngesinthene
earfuturethaatsuggestan
needforimprrovedequityggrowth.Balan
ncingtheneeedfor
mo
oreequitywitthotherconsumerprioritieslikeaffordabilityiskey. Thispieceisintendedtorraiseadiscussion
abo
outloomingcchangesinthemarket,theeneedforfina
ancialinnovaationinproduuctsandinstittutions,ando
one
1
pottentialsolutio
on,butitisno
otanofficialN
NARpositionorendorsem
ment.

dandPotenttialChallenge
es
LesssonsLearned

Ah
homeownerd
derivesthreetypesofequiityfromtheirrhome:theddownpaymen
nt,priceappreeciation,andprinciple
payyments.Theh
homeownerh
hastotalconttroloverthedownpaymeent,butitdoeesnotgrowo
overtime.Pricce
app
preciationisllesscertain,b
butprinciplep
paymentsare
ebuiltintothhestructureo
ofthemortgageandtheyaarethe
foccusofthiscon
ncept.

Mo
ortgageratesare
exp
pectedtorise
eoverthe
2
nexxtdecade an
ndrising
mo
ortgageratescanmake
iteevenmorediffficultto
buildequityasttheycut
intoaffordabilitty,slowing
housingdemand
dand
pricegrowth.In
naddition,
asaffordabilitywanes
som
mebuyerswillmigrate
toadjustablerate
ortgage(ARM
M)
mo
pro
oductsthathavelower
introductoryfixedrates
and
dpaymentsin
norderto
purchaseahom
me.Thesebuyyersoftencho
oseARMswiththeintentttorefinancettheirmortgaggebeforetheerate
ressetsfollowinggthefixedratteperiod.

Withtheseconcceptsinmind
d,thehousinggmarketwou
uldbenefitfroominnovation
nsgearedtow
wardbuildinggequity,
eveeninarisingrateenvironm
ment.

APopularProduct
30yearFRM:A

Theedominantm
mortgageform
mintheUnite
edStatesisth
he30yearfixxedratemorttgage(FRM).Itspopularityyamong
con
nsumersiswe
ellmeritedassthelong30yearamortizationperiod stretchesouttthetotalpaymentsmaking
mo
onthlypayme
entsamongth
helowestofaallconvention
nalproducts. Inaddition,ttherelativelylowmonthlyy
payymentsarefixedfortheliffeoftheloan
nallowingthe
ehomeownerrtobudgetefffectively.Fin
nally,thesheeersizeof
theemarketandgovernmentsupportallow
wforliquidityyandpricing advantages.

AbroaderdiscussionoftheBR
RED,otheralte
ernativemortgageproductsfforarisingrateeenvironmentt,andrisksoftthis
uctureweresh
haredduringapresentationfforRealtorUniiversityonSepptember,9th20015
stru
2
Th
hisforecastisn
notofficial,butforillustratio
onandgenerattedbyaddingtthehistoricalspreadbetweenthe10yearTTreasury
and
dtheaverage3
30yearFRMto
otheCBOsforrecastforthe1
10yearTreasuury:https://ww
ww.cbo.gov/pu
ublication/45066


Theerearedrawbackstothe30yearFRM,though.Beccauseofthel ong30yearaamortization,,theowneraaccrues
equ
uityslowly.W
Withoutsufficcientequityaconsumerco
ouldfinditdiffficulttorefin
nanceahomee,tosellahome
witthoutincurrin
nganegativecreditevent,,ortofinance
ethepurchasseofatradeuphome.

other
LLikewise,theo
twopopular
cconventionalmortgage
p
products,the5/1ARM
aandthe15yeearFRM
h
havebenefitsand
d
drawbacks.Th
he15
yyearFRMbuildsequity
rapidlyandispaidoff
in
n15years,bu
utthe
m
monthlypaym
mentis
m
muchhighertthanthe
3
30yearFRM.
C
Conversely,th
he5/1
A
ARMhasthellowest
in
ntroductoryp
payment,
b
butafter5yeaars,the
p
paymentschaange
3
ann
nuallybasedontheprevailinginterestratewithapossibleincreaaseinpaymentof51% ovvertheinitial
payyment.

Eacchofthesem
mortgageprod
ductscanbeffinancedthro
oughthegoveernmentspon
nsoredenterp
prises(GSEs),the
Fed
deralHousinggAdministrattion(FHA),aswellasthep
privatesectorandhavecon
nsiderablepo
oolingandpriicing
ben
nefitsasaressult.Thelimittednumbero
ofconvention
nalproductsccreatesefficieenciesandpriicingbenefitssfrom
larggevolumeso
ofhomogeneo
ousmortgage
eproduct.

Theechallenge,tthen,istocre
eateaproducctthatretainssthebenefitssofthe30yearFRM,lowaandstablemonthly
payyments,while
ebuildingequ
uity,thathasbroadaccesssforconsumeersovertheh
housingcyclee,andthatlevverages
currrentefficiencciesintherobustsecondaarymortgagemarket.

BR
RED:HowitW
Works

Theemethodpro
oposedhereiistoblendseveralcommo
onmortgagesstructuresinttoone,takinggtheadvantagesof
eacch,whileminimizingthedownsideofe
each.Thismixxedratemorttgageorblend
dedrateequiitydriver(BRED)
com
mbinesthem
mostdominan
ntandliquidm
mortgagestru
ucturesintoaasinglefirstliienmortgagee:the30yearrFRM,
thee15yearFRM
M,andthe5/1ARM.4Themixturecanb
betailoredtoothebuyer,b
butineachcaaseequitygro
owsfaster
thrroughprinciplepayments.

Forrafirsttimebuyerwhocaanaffordaslightlyhigherp
payment,aB
BREDwouldin
ncorporate80
0%30yearFR
RMand
20%
%15FRM.Th
hepaymento
ona$200,000
0homewith3
3%downpayymentis$85m
moreamonththana30yyearFRM
and
dimpliesthatttheconsumerwouldnee
edaslightlyhigherincomee.However,ttheconsumerendsupwitth40%5
mo
oreequityafterfiveyearsaidingatrade
euppurchase
e.Rentshaveegrowndram
maticallyintod
daysmarketanda

Heretheuserco
ostisdefinedaastheprinciple
e,interest,and
dmortgageins urance
Th
heseratioscou
uldbechanged
dtomeetdifferentdesiredoutcomes;loweerpayment,lesssvolatility,ettc.
5
Th
heequityaccru
uedismorethansimplysavin
ngthedifferen
nceinpaymentt.
4

com
mmoncomplaintisthatco
onsumerscan
naffordamortgagepaymeentbutnotth
hedownpaym
ment.Thisprroduct
cou
uldbeanaturalfitinhighcostmarketssandhelpthe
ebuyertobuuildequityrap
pidlyforanevventualtradeeup.

buyerchoosin
ngbetweenthelowpaymeentofanARM
Mandthatoffa30yearFR
RM,the
Altternativelyforatradeupb
BREDcouldbe
structuredwith
60%
%5/1ARM,3
30%
30yearFRM,an
nd
10%
%15yearFRM.
Theepayment
wo
ouldbeaboutt
$20
0lesspermo
onth
forraborrowerw
with
a1
10%down
payymentona
$20
00,000home
e.As
dep
pictedbelowat
theeendoffive
yeaars,theowne
er
hassroughly30%
%
mo
oreequityor
mo
orethan$5,000.
Ho
owever,from
yeaarsixthrough
h15
theepaymentsfloat.
Inaaworstcase,after10yearrsthemonthllypaymentw
wouldrise23%
%abovetheinitialpaymen
ntandremain
natthat
pointthroughyear15.After15yearsthough,the15yyearmortgageeisfullypaidandthepaym
mentfallsclo
oserto
uldnotriseaffteryear5andcould
thaatofthe30yearfixed.Underabestcasesituationthemonthlyppaymentwou
falllbelowthato
ofa30yearFFRMforthelifeoftheloan
n.

Wh
hilea23%inccreaseinpaym
mentundertheworstcase
eissignifican t,itisfarlesssthanthe51%
%ofa5/1AR
RM.
Furrthermore,th
headditional30%equityaafterfiveyearrsincreasesthheprobabilityythatthecon
nsumercanreefinance
whentherateonth
heir
mortgaageresets.Th
hus,the
consum
mercanbevieewedas
payingslightlymoreefor
insuran
nceagainstapotential
paymentshockifrattesrise
significantly,butstilll
receivin
ngalowerpaayment
thana30yearfixed
d.

Foraco
onsumerwho
owould
liketoccompleteherr
paymentsin15yearrs,but
cantafffordthehigh
h
introdu
uctorypaymeentofa
15yearFRM,theBR
REDcould
bestructuredtoinclude60%
15yearFRMand40
0%30
yeaarFRM.Thism
mixwouldyie
eldapaymentnearly$160
0lowerperm
monththana15yearFRMandmorethan

double6theequityaccruedafter5yearscomparedtoa30yearFRM.Furthermore,asdepictedbelowthe
paymentwouldfallbynearly$800after15yearscomparedtoa30yearFRM.Thisstructuremightappealtoa
homeownerfacingfuturecollegetuitionpaymentsorapartialretirement.

Thereareotherimportantfeaturesofthismortgageworthpointingout.Sinceequityaccruesfasterinthis
structure,amortgagewithprivatemortgageinsurance(PMI)wouldreachthe78%requirementdetachmentpoint
fasterthana30yearFRM,reducingtheborrowerstotalpayment.BecausePMIplaysanimportantroleinthis
structure,weincludeitaspartoftheusercostsinallestimates.

BREDandtheSecondaryMarket

TheBREDisanoddduckwhenjuxtaposedwiththecurrentmarket,ahybridwhoseboneslookfamiliar.Currently,
thetobeannounced(TBA)marketdoesnotaccountforamortgageofthisstructure.TheTBAisafuturesmarket
formortgagebackedsecurities(MBS)thatallowsoriginatorsandsecuritizerstomanagetheproductionprocess
withmorecertaintyandreducesmortgageratesasaresult.Whilethereisanexecutionforhybridmortgages,the
mostcommonlytradedproductsontheTBAmarketarevanilla30yearFRMs,butallTBAeligibleproductsarede
risked,passthroughswithnotranches7.TheBREDstructurewouldsharethesecharacteristics.TheTBAhas
developedovertimeandtheBREDmortgagewithitsfirstlienandthreepassthroughcomponentsmight
eventuallyseeitswayintoTBApools.

Butwhatinvestorwouldwanttobuythesepoolswithmixedpaymentstructuresandterms?Intodaysmarket
CMOsandREMICs8areusedtocutpoolsofmortgagesintodifferentproductsbasedontheircashflows.
RepackagingthetranchesofBREDsastheirfundamentalpassthroughproducts(e.g.5/1ARM,30yearFRM,and
15yearFRM)couldfacilitatethisspecialization.Toprovidevolume,multiplepoolscouldbeaggregatedinaMegas
securitybeforerepackaging.Thispathmaylimitwateringdownofthebenefitofmarketvolumewitha
completelynewproduct.

Alternatively,alargeenoughlendercouldretainthemidtierBREDs(thosewiththeARMcomponent)inportfolio.
Therelativelylow40%shareofFRMsinthemidtierproductwouldmitigatesomeoftheraterisk.However,the
lendercouldissueacoveredbondorsecuritizationforthefixedrateportionofthepoolwhileretainingtheARM
portioninportfolio.Thisstructurewouldallowthelendertooffloadtheinterestraterisk,whileusingtheARMto
retainaportionofthecreditriskandtosatisfyregulatoryrequirements.

Finally,theFederalHomeLoanBankscouldexpandonthisexecutionbyactingasaconduitforsmallerlendersto
poolBREDsandfunnelthemtoaselectedspecialpurposevehicleforsecuritization.Thelenderscouldretainsome
ofthecreditriskviatheARMs,whilediversifyingtheinterestrateriskthroughthesecuritization.

RegulationandaRisingRateEnvironment

Depositorylendersnaturallygravitatetoinvestmentswithtermsthatbestmatchthetermsoftheirliabilities.For
lenders,shortertermmortgagesormortgagesthatadjusttomarketratesallowthemtobettermatchtheinterest
ratepaymentstheymustmakeontheirdepositswiththeincome(interest)receivedonmortgagestheyown.If
ratespaidondepositsoutpacetheinterestearnedonassets,themismatchcandrainabankofprofits.This
problemcausedasurgeinbankdefaultsduringthesavingsandloancrisisofthe1980s.9

$20,000moreequityafterfiveyears
WhiletheBREDissegmentedintothreepassthroughstructures,itisnottranchedtoredistributethetimingofpaymentsor
tocreatecreditenhancement.PerSIFMAU
8
TheresultingsecuritieswouldnotbeTBAeligible,thoughastheyareashareof1stlienmortgageunlessTBAruleswere
altered.
9
https://www.fdic.gov/bank/historical/history/167_188.pdf
7

Ratemismatchwasarelativelybenignissuewhilemortgageratesfellforthelasttwodecades,butratesarelikely
toclimbinthefuture.IncreasedavailabilityofmorestableARMproductscouldprovidelenderswithavaluable
assetandhelptosatisfydemandfortier1capital.10

NotWithoutItsIssues

Themortgagestructureproposedhereisnotwithoutitslimitations.Aswithanypotentialmortgageproductmany
unknownsmustbeovercome.Likealternativestructuresforintroducingprivatecapitalintothemarket,
introducingthisoranynewmortgagewouldentailaslowandgradualprocessofintroductionandpricediscovery.

Inadditiontoissuesdiscussedearlier,investors,insurers,andoriginatorswillhavetoderivenewtechniquesfor
modelingandpricingthestructure.Thisstructurewillchangeconsumersincentivesandasaresultprepayment
anddefaultpropensities.Furthermore,therefinanceanddefaultpropensitiesofdifferenttypesofBREDsmay
vary.ThesameistrueforapassthroughsecuritythatiscreatedbydisaggregatingaBREDcomparedtothesame
vanillapassthroughsecurity.Thesedifferencesmaylimittheabilitytoaggregatethemandinturnraiserates.

ForinsurerstheBREDstructuresshouldmutedefaultriskandseverity.Thisbenefitwillbeoffsetinpartby
consumersreachingthe78%detachmentpointforinsurancefaster,thoughthismaybeamelioratedbyslower
pricedgrowthinarisingmortgagerateenvironment.Inaddition,theprivatemortgageinsuranceindustryisgoing
throughchangessuchasnewcapitalandpracticerequirementsfromthenewPrivateMortgageInsurance
EligibilityRequirements(PMIERs)whichcouldchangepricingandincentives.Finally,consumersmaypreferthe
lenderpaidoptiontotheborrowerpaidMIpaymentsthatareincorporatedintotheseestimatesandtheFHAs
permanentMIpolicyreducesthebenefitofthesestructures.

HowwillinvestorsrespondtotheBRED?Bycooptingtherefinancealternatives,theBREDshouldreduce
refinanceriskforinvestors.But,thesecondarymarketstructureproposedherewouldhavemultiplecallersonthe
samecollateral(theproperty).WhileastronglegalagreementandcounterpartylikeaGSEmighthelpto
amelioratethisrisktotheinvestor,concernswillremain.Furthermore,asalludedtoearlier,TBAeligibilityis
criticalandcouldproveahurdleforbroadacceptance.

Finally,theBREDisasignificantdeparturefrommortgagesinthecurrentmarket.Itismorecomplexforthe
secondarymarket,theoriginator,andfortheconsumer.Costsmayrisefororiginatorsandservicerswhile
consumersmayrequirealeapinfinancialliteracy.Ongoingimprovementsinfinancialliteracycoursesmayhelpas
willclearerclosingdocumentsunderTRIDandonlinetoolsdevelopedbytheCFPB,butthecomplexitytothe
consumerinparticularwillcreateheadwinds.

BREDandthe30yearFRM

TheBREDisnotasilverbullettosolveallproblemsanditdoesnotreplacethe30yearFRM.Infact,the30year
FRMmakesupasignificantportionoftheBREDsstructureandisthusthebackboneoftheBRED.Furthermore,
questionsremainaboutthescalabilityofBREDsinthesecondarymarketandtheimpactofchangingincentives.
WhattheBREDcoulddoisprovidehomeownerswithmoreoptions,whileputtingmoreequityintheirpockets.If
nothingelse,theBREDmaysparkadiscussionabouthomeownership,equity,andsustainabilityinarisingrate
environment.

10

AssumingtheproductswerebackedbytheGSEsorFHA/GNMA