Financial Characteristics of Cost of Funds Indexed Loans

Abstract

Two recent articles by Hancock and Passmore (2016) and Passmore and von Hafften (2017) make several suggestions for improving the home mortgage contract to make homeownership more achievable for creditworthy borrowers. Though the proposals in the two papers differ in some aspects, one common feature is an adjustable rate indexed to a cost of funds (COF) measure. Such indices are based on the interest expense as a fraction of liability balance for one or a group of depository institutions. One of these, the 11th District Cost of Funds (COF) Index, was in wide use in the 1980s and '90s, but use has fallen off since then. COF indices have the advantage that they are less volatile than market-based indices such as the 1-year U.S. Treasury rate, so that borrowers are not exposed to rapid increases in payments in a rising rate environment. We analyze COF-indexed ARMs from the point of view of the lender. First we develop a methodology for constructing a liability portfolio that closely tracks the specific COF index proposed by Hancock and Passmore (2016) and Passmore and von Hafften (2017). We then explore the financial characteristics of this liability portfolio. We show that the liability portfolio, and by implication, the mortgages it would fund, s are a characteristic of fixed-rate mortgages: Values can vary significantly from par if rates change. This creates two problems for lenders: Pricing of COF-indexed ARMs is difficult because it depends not only on current interest rates but also on interest rates when principal is r paid, either through amortization or prepayment. Second, deviations from par make mortgage prepayment options valuable, so that lenders offering the product must manage option risk as well as interest rate risk. We conclude that while mortgages using a COF index have clear benefits for borrowers, they also are more difficult for lenders to price accurately. Further, once they are in lenders' portfolios, they increase the complexity of interest rate risk management. While these issues do not imply that COF indices cannot be part of innovative new mortgage designs, understanding their financial characteristics may contribute to the search for a better mortgage.

Keywords: Mortgages, cost of funds, interest rate risk, funds transfer pricing

JEL Classification: G12, G28