BRED Mortgage: More Money in Your Pocket

8/20/2019 BRED Mortgage: More Money in Your Pocket

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double6 the equity accrued after 5 years compared to a 30‐year FRM. Furthermore, as depicted below the

payment would fall by nearly $800 after 15 years compared to a 30‐year FRM. This structure might appeal to a

homeowner facing future college tuition payments or a partial retirement.

There are other important features of this mortgage worth pointing out. Since equity accrues faster in this

structure, a mortgage with private mortgage insurance (PMI) would reach the 78% requirement detachment point

faster than a 30‐year FRM, reducing the borrower’s total payment. Because PMI plays an important role in this

structure, we

include

it

as

part

of

the

user

costs

in

all

estimates.

BRED and the Secondary Market

The BRED is an odd duck when juxtaposed with the current market, a hybrid whose bones look familiar. Currently,

the to‐be‐announced (TBA) market does not account for a mortgage of this structure. The TBA is a futures market

for mortgage backed securities (MBS) that allows originators and securitizers to manage the production process

with more certainty and reduces mortgage rates as a result. While there is an execution for hybrid mortgages, the

most commonly traded products on the TBA market are vanilla 30‐year FRMs, but all TBA eligible products are de‐

risked, pass‐throughs with no tranches7. The BRED structure would share these characteristics. The TBA has

developed over time and the BRED mortgage with its first lien and three pass‐through components might

eventually see

its

way

into

TBA

pools.

But what investor would want to buy these pools with mixed payment structures and terms? In today’s market

CMOs and REMICs 8 are used to cut pools of mortgages into different products based on their cash flows.

Repackaging the tranches of BREDs as their fundamental pass‐through products (e.g. 5/1 ARM, 30‐year FRM, and

15‐year FRM) could facilitate this specialization. To provide volume, multiple pools could be aggregated in a Megas

security before repackaging. This path may limit watering down of the benefit of market volume with a

completely new product.

Alternatively, a large enough lender could retain the mid‐tier BREDs (those with the ARM component) in portfolio.

The relatively low 40% share of FRMs in the mid‐tier product would mitigate some of the rate risk. However, the

lender could issue a covered bond or securitization for the fixed rate portion of the pool while retaining the ARM

portion in

portfolio.

This

structure

would

allow

the

lender

to

off

load

the

interest

rate

risk,

while

using

the

ARM

to

retain a portion of the credit risk and to satisfy regulatory requirements.

Finally, the Federal Home Loan Banks could expand on this execution by acting as a conduit for smaller lenders to

pool BREDs and funnel them to a selected special purpose vehicle for securitization. The lenders could retain some

of the credit risk via the ARMs, while diversifying the interest rate risk through the securitization.

Regulation and a Rising Rate Environment

Depository lenders naturally gravitate to investments with terms that best match the terms of their liabilities. For

lenders, shorter term mortgages or mortgages that adjust to market rates allow them to better match the interest

rate payments

they

must

make

on

their

deposits

with

the

income

(interest)

received

on

mortgages

they

own.

If

rates paid on deposits outpace the interest earned on assets, the mismatch can drain a bank of profits. This

problem caused a surge in bank defaults during the savings and loan crisis of the 1980s.9

6 $20,000 more equity after five years 7 While the BRED is segmented into three pass‐through structures, it is not tranched to redistribute the timing of payments or

to create credit enhancement. Per SIFMA U

8 The resulting securities would not be TBA eligible, though as they are a share of 1

st lien mortgage unless TBA rules were

altered. 9 https://www.fdic.gov/bank/historical/history/167_188.pdf



Rate mismatch was a relatively benign issue while mortgage rates fell for the last two decades, but rates are likely

to climb in the future. Increased availability of more stable ARM products could provide lenders with a valuable

asset and help to satisfy demand for tier‐1 capital.10

Not Without Its Issues

The mortgage structure proposed here is not without its limitations. As with any potential mortgage product many

unknowns must

be

overcome.

Like

alternative

structures

for

introducing

private

capital

into

the

market,

introducing this or any new mortgage would entail a slow and gradual process of introduction and price discovery.

In addition to issues discussed earlier, investors, insurers, and originators will have to derive new techniques for

modeling and pricing the structure. This structure will change consumers’ incentives and as a result pre‐payment

and default propensities. Furthermore, the refinance and default propensities of different types of BREDs may

vary. The same is true for a pass through security that is created by disaggregating a BRED compared to the same

vanilla pass‐through security. These differences may limit the ability to aggregate them and in turn raise rates.

For insurers the BRED structures should mute default risk and severity. This benefit will be offset in part by

consumers reaching the 78% detachment point for insurance faster, though this may be ameliorated by slower

priced growth

in

a rising

mortgage

rate

environment.

In

addition,

the

private

mortgage

insurance

industry

is

going

through changes such as new capital and practice requirements from the new Private Mortgage Insurance

Eligibility Requirements (PMIERs) which could change pricing and incentives. Finally, consumers may prefer the

lender‐paid option to the borrower‐paid MI payments that are incorporated into these estimates and the FHA’s

permanent MI policy reduces the benefit of these structures.

How will investors respond to the BRED? By co‐opting the refinance alternatives, the BRED should reduce

refinance risk for investors. But, the secondary market structure proposed here would have multiple callers on the

same collateral (the property). While a strong legal agreement and counterparty like a GSE might help to

ameliorate this risk to the investor, concerns will remain. Furthermore, as alluded to earlier, TBA eligibility is

critical and could prove a hurdle for broad acceptance.

Finally, the

BRED

is

a significant

departure

from

mortgages

in

the

current

market.

It

is

more

complex

for

the

secondary market, the originator, and for the consumer. Costs may rise for originators and servicers while

consumers may require a leap in financial literacy. Ongoing improvements in financial literacy courses may help as

will clearer closing documents under TRID and on‐line tools developed by the CFPB, but the complexity to the

consumer in particular will create headwinds.

BRED and the 30‐year FRM

The BRED is not a silver bullet to solve all problems and it does not replace the 30‐year FRM. In fact, the 30‐year

FRM makes up a significant portion of the BRED’s structure and is thus the backbone of the BRED. Furthermore,

questions remain about the scalability of BREDs in the secondary market and the impact of changing incentives.

What the

BRED

could

do

is

provide

home

owners

with

more

options,

while

putting

more

equity

in

their

pockets.

If

nothing else, the BRED may spark a discussion about homeownership, equity, and sustainability in a rising rate

environment.

10 Assuming the products were backed by the GSEs or FHA/GNMA

BRED Mortgage: More Money in Your Pocket

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