Cost of funds indexed mortgage contracts with government-backed catastrophic insurance (COFI-Cats): A realistic alternative to the 30-year fixed-rate mortgage?

Abstract

We analyze the feasibility an adjustable-rate mortgage product tied to a nationwide bank cost of funds index (COFI) that is equal to the total interest expense divided by the total liabilities for all domestic commercial banks. This mortgage product also includes actuarial-based government-backed tail-risk insurance provided either to bankers directly or to investors who purchase pools of these mortgages. We refer to a COFI mortgage with this form of catastrophic insurance as a “COFI-Cat” contract. The costs and benefits associated with these contracts are considered from the perspective of households, bankers, investors and policymakers using estimates of COFI-Cat rates constructed from historical data over 2000–2014, inclusive.For households, monthly mortgage payment cost savings for COFI-Cat mortgages compared to 30-year fixed-rate mortgages are substantial, estimated to average more than $100 per month at issuance over the period considered and to accumulate to more than $11,000 over a typical six-year period, the average tenure a household spends in a home. Thus, cost savings could be substantial for homeowners who expect rates to fall or who have a higher moving probability.For bankers, hedging costs for COFI-Cat mortgages are lower than for either 30-year fixed-rate mortgages or adjustable-rate mortgages based on short-term market-based rates. Because banking organizations have cost of funds that generally move in sync with each other, mortgage-backed securities (MBS) based on pools of COFI-Cat mortgages potentially provide much needed geographic diversification, particularly for smaller U.S. banks, while still being relatively easy to hedge compared to fixed-rate and other adjustable-rate mortgages.For investors, such as asset managers, banks, thrift institutions, pension funds and central banks, COFI-Cat MBS could provide lucrative opportunities for stable returns. Historically, we demonstrate LIBOR funded investors could have hedged such MBS and maintained positive returns even when LIBOR rates blew out in 2008. Moreover, credit risk transfer transactions structured in a manner that the government backs only catastrophic risks are shown to result in guarantee fees that are lower than those actually charged by the GSEs during 2012–2014.For policymakers, replacing fixed-rate mortgages with adjustable rate mortgages, such as COFI-Cat mortgages, could improve monetary policy pass-through when market rates are lowered; households would not need to refinance when interest rates drop, thereby benefiting a broad range of households, including those with little or no home equity and/or low credit scores. As a result, the need for special federal programs such as the Home Affordable Refinance Program or FHASecure is potentially reduced. In a rising interest rate environment, depository institution COFIs tend to adjust at a slower pace than other indexes typically tied to adjustable-rate mortgages. Consequently, the distributional consequences associated with tighter monetary policy are less with COFI-based mortgage contracts than with other adjustable-rate mortgage contracts.