Yield Spread Premiums Revealed as Interest Rates Rise

Editor’s Note: This article might help you understand the workings of a yield spread premium. For every 1% difference in interest rate the “cost” of the loan to you goes up 19%. Now if you look at it from the point of view of the “lender” that means the “value” goes up by 19%. That means, on a $100,000 loan an increase of $19,000.

So if you have a $100,000 loan and you qualified for a 5% loan, then a smooth-talking mortgage broker or mortgage originator might get you confused enough to get into a loan that looks better but ends being worse.

The result might be that you pay a 10% rate when the loan re-sets. This increases the “cost” of the loan (oversimplifying here for the purpose of education) to the borrower and the “value” of the loan to the “lender.” How much? 19% for every 1% increase, so in our example here, to keep it simple, the cost to you on a $100,000 loan is increased by 19%x5=95%. So you will pay $95,000 more for that increase. And the lender will get $95,000 more for their “investment.”

The mortgage broker gets a “share” of that increase as a reward for having talked you into a worse loan product even if it means that the viability of the loan (the likelihood that you will pay it off) has been diminished. This “share” is called a premium and it is caused by the spread between the original 5% that you could have had and the 10% loan they you bought. Hence yield spread premium, and I call that “tier 1.”

Tier 2 occurs because the source of funds is not the bank, it is an investor who is kept in the dark much as you are. They think they are getting 5% on a $200,000 loan. But what Wall Street did was they actually funded your $100,000 loan, valued it at 10%, and then kept the balance of the $200,000 investment for themselves. To the investor the numbers look the same — they expected 5% on their $200,000 purchase of mortgage backed securities which is $10,000 per year. Wall Street gave them what looked like an investment that yielded $10,000 per year simply by creating toxic loans and used it against the borrowers who would have otherwise paid on the loans because they could.

It is the same yield spread between 5% and 10%, but used in reverse against the investor.
In my opinion this gives rise to recovery of the undisclosed tier 2 yield spread premium payable to the borrower. It might also give rise to a cause of action for securities fraud that the investor could claim. At the moment, few people are pursuing this. Eventually as the mystery unravels, there will be competing claims for this money, and the first one to the finish line is probably going to be the winner.
April 10, 2010

Interest Rates Have Nowhere to Go but Up

By NELSON D. SCHWARTZ

Even as prospects for the American economy brighten, consumers are about to face a new financial burden: a sustained period of rising interest rates.

That, economists say, is the inevitable outcome of the nation’s ballooning debt and the renewed prospect of inflation as the economy recovers from the depths of the recent recession.

The shift is sure to come as a shock to consumers whose spending habits were shaped by a historic 30-year decline in the cost of borrowing.

“Americans have assumed the roller coaster goes one way,” said Bill Gross, whose investment firm, Pimco, has taken part in a broad sell-off of government debt, which has pushed up interest rates. “It’s been a great thrill as rates descended, but now we face an extended climb.”

The impact of higher rates is likely to be felt first in the housing market, which has only recently begun to rebound from a deep slump. The rate for a 30-year fixed rate mortgage has risen half a point since December, hitting 5.31 last week, the highest level since last summer.

Along with the sell-off in bonds, the Federal Reserve has halted its emergency $1.25 trillion program to buy mortgage debt, placing even more upward pressure on rates.

“Mortgage rates are unlikely to go lower than they are now, and if they go higher, we’re likely to see a reversal of the gains in the housing market,” said Christopher J. Mayer, a professor of finance and economics at Columbia Business School. “It’s a really big risk.”

Each increase of 1 percentage point in rates adds as much as 19 percent to the total cost of a home, according to Mr. Mayer.

The Mortgage Bankers Association expects the rise to continue, with the 30-year mortgage rate going to 5.5 percent by late summer and as high as 6 percent by the end of the year.

Another area in which higher rates are likely to affect consumers is credit card use. And last week, the Federal Reserve reported that the average interest rate on credit cards reached 14.26 percent in February, the highest since 2001. That is up from 12.03 percent when rates bottomed in the fourth quarter of 2008 — a jump that amounts to about $200 a year in additional interest payments for the typical American household.

With losses from credit card defaults rising and with capital to back credit cards harder to come by, issuers are likely to increase rates to 16 or 17 percent by the fall, according to Dennis Moroney, a research director at the TowerGroup, a financial research company.

“The banks don’t have a lot of pricing options,” Mr. Moroney said. “They’re targeting people who carry a balance from month to month.”

Similarly, many car loans have already become significantly more expensive, with rates at auto finance companies rising to 4.72 percent in February from 3.26 percent in December, according to the Federal Reserve.

Washington, too, is expecting to have to pay more to borrow the money it needs for programs. The Office of Management and Budget expects the rate on the benchmark 10-year United States Treasury note to remain close to 3.9 percent for the rest of the year, but then rise to 4.5 percent in 2011 and 5 percent in 2012.

The run-up in rates is quickening as investors steer more of their money away from bonds and as Washington unplugs the economic life support programs that kept rates low through the financial crisis. Mortgage rates and car loans are linked to the yield on long-term bonds.

Besides the inflation fears set off by the strengthening economy, Mr. Gross said he was also wary of Treasury bonds because he feared the burgeoning supply of new debt issued to finance the government’s huge budget deficits would overwhelm demand, driving interest rates higher.

Nine months ago, United States government debt accounted for half of the assets in Mr. Gross’s flagship fund, Pimco Total Return. That has shrunk to 30 percent now — the lowest ever in the fund’s 23-year history — as Mr. Gross has sold American bonds in favor of debt from Europe, particularly Germany, as well as from developing countries like Brazil.

Last week, the yield on the benchmark 10-year Treasury note briefly crossed the psychologically important threshold of 4 percent, as the Treasury auctioned off $82 billion in new debt. That is nearly twice as much as the government paid in the fall of 2008, when investors sought out ultrasafe assets like Treasury securities after the collapse of Lehman Brothers and the beginning of the credit crisis.

Though still very low by historical standards, the rise of bond yields since then is reversing a decline that began in 1981, when 10-year note yields reached nearly 16 percent.

From that peak, steadily dropping interest rates have fed a three-decade lending boom, during which American consumers borrowed more and more but managed to hold down the portion of their income devoted to paying off loans.

Indeed, total household debt is now nine times what it was in 1981 — rising twice as fast as disposable income over the same period — yet the portion of disposable income that goes toward covering that debt has budged only slightly, increasing to 12.6 percent from 10.7 percent.

Household debt has been dropping for the last two years as recession-battered consumers cut back on borrowing, but at $13.5 trillion, it still exceeds disposable income by $2.5 trillion.

The long decline in rates also helped prop up the stock market; lower rates for investments like bonds make stocks more attractive.

That tailwind, which prevented even worse economic pain during the recession, has ceased, according to interviews with economists, analysts and money managers.

“We’ve had almost a 30-year rally,” said David Wyss, chief economist for Standard & Poor’s. “That’s come to an end.”

Just as significant as the bottom-line impact will be the psychological fallout from not being able to buy more while paying less — an unusual state of affairs that made consumer spending the most important measure of economic health.

“We’ve gotten spoiled by the idea that interest rates will stay in the low single-digits forever,” said Jim Caron, an interest rate strategist with Morgan Stanley. “We’ve also had a generation of consumers and investors get used to low rates.”

For young home buyers today considering 30-year mortgages with a rate of just over 5 percent, it might be hard to conceive of a time like October 1981, when mortgage rates peaked at 18.2 percent. That meant monthly payments of $1,523 then compared with $556 now for a $100,000 loan.

No one expects rates to return to anything resembling 1981 levels. Still, for much of Wall Street, the question is not whether rates will go up, but rather by how much.

Some firms, like Morgan Stanley, are predicting that rates could rise by a percentage point and a half by the end of the year. Others, like JPMorgan Chase are forecasting a more modest half-point jump.

But the consensus is clear, according to Terrence M. Belton, global head of fixed-income strategy for J. P. Morgan Securities. “Everyone knows that rates will eventually go higher,” he said.

16 Responses

  1. […] can read his post here, but it basically boils down that the bank sold it to the investor at, say 5% interest on a […]

  2. Patrick,

    Neil is correct. If a mortgagee assigns a bond and mortgage and receives money for that assignment – those monies mustbe credited to the debt.

    “The debt, therefore, is the principal thing; and it is obvious that if an action was brought on the bond in the name of the mortgagee, as it must be, the mortgagor shall pay no more than what is really due upon the bond; if an action of covenant was brought by the covenantee, the account must be settled in that action.” Carpenter v. Longan, 83 U.S. 271 (1872)

    These mortgages were sold at full price and then some. Additionally, as has been recently revealed (which was written about here) there was insurance on these certificates. When the mortgages defaulted, the insurance paid out. Those monies should be credited to the accounts. Again, this is black letter law. Doesn’t matter if the homeowner had no contract with the trusts in question.

  3. http://www.creditslips.org/creditslips/2009/01/bullshitprofessionally-speaking.html

    Bullshit–Professionally Speaking
    posted by Elizabeth Warren

    I don’t get to post very often right now, but sometimes I can put on my academic robes and talk about a new piece of scholarship. And what better thing to talk about when wearing academic robes than bullshit?

    Curtis Bridgeman and Karen Sandrik have written a new piece called Bullshit Promises. The piece focuses on contract language that is designed to make someone believe that something has been promised (e.g., a promise of a fixed interest rate highlighted in the contract) while buried somewhere else is another provision that takes away that right (e.g., reservation to change terms at any time). The result is a “bullshit promise,” something that will mislead–all within the bounds of current contract and tort law.

    The work plays off Harry Frankfurt’s best seller, “On Bullshit,” distinguishing lying (emphasis on false belief) and bullshit (lack of concern with truth). The philosophical difference is abstract (and only arguable) for me, but Bridgeman and Sandrik bring it alive as a critical legal distinction. We contracts teachers are still teaching the old illusory promise cases in which the promisor who gives with one hand and takes away with the other made no binding promise. The cases skirt actionable fraud, and the person who is misled is treated as a chump instead of a victim. Many of today’s consumer contracts–credit cards, cell phones, mortgages, etc–have perfected the art of drawing attention to certain benefits of the contract while burying the tricks and traps elsewhere.

    Treat yourself to reading Bullshit Promises. It is well-written and engaging, and it makes an important point about the shortcomings of consumer contract law.

  4. Are you up against Florida Default Law Group? If so, the Florida state Attorney General wants to hear all about the fraudulent documents, false statements, incompetent affidavits, etc!

    Call Deanna Pierce at the Florida Attorney General’s Office and request an affidavit form to submit a complaint. 954-712-4625

  5. Neidermeyer,

    Until you have the exact purchase cost of each bond by the investor, you have nothing but speculation.

    Bond purchases are at discounted prices, to reflect guaranteed interest rates. To make up for interest rate changes and defaults, the Trust must be “overcollateralized” to make up for shortfalls in payments. That is where the difference in rates comes into play.

    By the way, if rates increase and that is a YSP owed you, then why don’t you own the bank when rates decrease on your loan?

  6. Neidermier- sounds like you’ve done your homework. Please keep us all posted as to the outcome of your case. Best wishes.

  7. Today on CNBC…

    WaMu engaged in Loan Fraud and Faked Documents…

    http://www.cnbc.com/id/36431859

  8. I’ll give my personal example …

    I was desperate for a refi in Jan 2007 as I was in bankruptcy (medical related in 2003) and I was about to get behind on court ordered payments (creditors and house etc.) due to a broken ankle that kept me from walking for 4 months. Quite simply I didn’t qualify for SQUAT but me and the wife both had high 600’s FICO scores.

    I saw the bubble forming for years and only asked for 70% leaving 30% as equity/down … 240K on a 370K appraisal.. The BK courts intervened on my behalf when asked by me and they negotiated my rate down to 6.5% on a 30 year fixed loan from the 8.5% offered.

    I can guarantee you that the BK was never disclosed to the lender (“real lender” used Deutsche Bank to table money to Option One) and I can also guarantee you that my income was “normalized” to eliminate the 4 months lost to injury. My wifes income was also “adjusted” by the mortgage broker to make the 30% payment to income numbers.

    INITIAL NUMBERS
    Appraisal 367,900
    offered loan of 320,000 at 8.5% fixed
    Tier 2 YSP = 2% or $121,600 PLUS $47,900 (total the true lender would be told they were funding)
    GRAND TOTAL $169,500

    HOW IT ENDED UP
    Appraisal 367,900
    took loan of 240,000 at 6.5%
    Assuming Tier2 YSP of 0% at the 6.5%
    true lender funds $367,900 ,,, Option One/Deutsche/GS withholds $127,900 for themselves and as payoff to the broker as compensation for them “making the numbers work” … Also my existing mortgage company was paid off about $10k over the actual payoff amount for bogus legal fees and such related to servicing the loan while in bankruptcy.

    This assumes the true lender was told they were to receive 6.5% although it could have been much lower.

    All the upfront profit explains one helluva lot… they pocketed the equivalent of 6 full years of payments.

    I have representation that “gets it” and I’m in a judicial state.

  9. Rose,

    I have been involved in this since Sep 07. My “focus” is much greater than you could ever guess.

    The arguments he makes about disclosure is not realistic. How can you at closing predict that rates will go up or down, by how much, and make such disclosures? You can’t.

    Neil wrote

    ” Tier 2 occurs because the source of funds is not the bank, it is an investor who is kept in the dark much as you are. They think they are getting 5% on a $200,000 loan. But what Wall Street did was they actually funded your $100,000 loan, valued it at 10%, and then kept the balance of the $200,000 investment for themselves. To the investor the numbers look the same — they expected 5% on their $200,000 purchase of mortgage backed securities which is $10,000 per year. Wall Street gave them what looked like an investment that yielded $10,000 per year simply by creating toxic loans and used it against the borrowers who would have otherwise paid on the loans because they could. It is the same yield spread between 5% and 10%, but used in reverse against the investor.
    In my opinion this gives rise to recovery of the undisclosed tier 2 yield spread premium payable to the borrower. It might also give rise to a cause of action for securities fraud that the investor could claim. At the moment, few people are pursuing this. Eventually as the mystery unravels, there will be competing claims for this money, and the first one to the finish line is probably going to be the winner. ”

    Right there he is saying that the increase in rates results in a Yield Spread Premium paid to the lender. This is absolutely false. That money is retained for the over collateralization needed for the Trust, to ensure the payment stream as well as cover losses for defaulting loans.

    Read a Pooling and Servicing Agreement. It tells you everything in it about over-collateralization. It is not an easy read, but if you do it carefully, you will begin to understand more.

  10. Patrick, your focus is too narrow, and misplaced. I have heard Niel speak in depth of this and I believe he is speaking of the YSP gained during the “wild” period of 2001 through late 2007/ early 2008. This model is not (and has not been ) applicable since the meltdown of our housing industry. Take a step back and take a look at the larger picture.

    He is not arguing that you should get money back if the rates go up. He IS saying that homeowners should have been INFORMED of this YSP and since they were NOT, they are due any undisclosed profits back.

    That’s a pretty simple argument that has NOTHING to do with the day to day cost of money… otherwise known as “interest”.

  11. Neil
    Very goood article! ICould you ever write an article that follows a hypothetical loan from incision to the end. Including what is insured against default? What part does PMI insurance paid by the borrower play. How does fractional reserve banking fit in? We in Wis hjave small banks that keeps their loans in house. They do not use diravatives but “loan swaps”.
    Thank you
    Stanley Putra
    Racine Wi.

  12. The rates will go up, but it is NOT a Yield Spread Premium. The money is used for over-collateralization.

    With his thinking, if rates go down, you should pay the lender more money. That would only be fair, since he argues that you would be entitled to money back for rates going up.

    Muddy thinking.

  13. Patrick,

    “What Garfield does not say is that each Index has gone down since the Housing Crisis started”

    But the Index will go up as mortgages rates go up as well.

  14. Mr. Gross made a lot of money packaging the bad loans and turning them into bonds. BTW I think Allan Greenspan works as a Consultant for PIMCO now. Mr. Gross is one of the people that help Wall Street.

    William H. Gross

    Jamie Rector for The New York Times
    Updated June 22, 2009

    Bill Gross is a hugely successful bond fund manager and the co-chief investment officer of Pimco. He personally manages the company’s flagship, the Total Return fund, which has $158 billion in assets.

    Mr. Gross has long been celebrated for his eccentricities. He learned some of his lucrative investing strategies by gambling in Las Vegas and he drapes his Hermès ties around his neck like scarves so he can labor with his collar open.

    Treasury secretaries call him for advice. Warren E. Buffett, the Berkshire Hathaway chairman, and Alan Greenspan, the former Federal Reserve chairman, sing his praises.

    And with the collapse of Wall Street, Mr. Gross has emerged as one of the nation’s most influential financiers. His frequent appearances on CNBC draw buzz, as do his wickedly humorous monthly investing columns on the Pimco Web site.

    Mr. Gross and his firm are trying to shape the government’s response to the economic crisis. He is one of the most fervent supporters of the Obama administration’s plan to enlist private investors to help bail out the nation’s ailing banks and try to revive the economy.

    Mr. Gross is a lanky yoga practitioner who sometimes speaks so softly that colleagues lean toward him. He nearly died in a 1966 car crash when he was a student at Duke University and spent much of his senior year recovering in the hospital. He also became obsessed with blackjack after reading “Beat the Dealer: A Winning Strategy for the Game of Twenty-One,” by Edward O. Thorp.

    After he got his diploma, Mr. Gross hopped a freight train to Las Vegas with $200 sewed into his pant leg. He played blackjack for 16 hours a day and, in four months, he turned $200 into $10,000. He used his winnings to pay for his studies toward an M.B.A. at the University of California, Los Angeles.

    He then took a job in the bond department at the Pacific Investment Management Company, a subsidiary of Pacific Mutual Life.

    Mr. Gross also dived into the first mortgage-backed securities and began studiously monitoring interest rates so he could place bets on his own macroeconomic predictions. This was highly unusual for a bond fund manager.

    In 1983, he became a regular on “Wall Street Week” on PBS, which gave Pimco a big boost.

    In 1999, Mr. Gross warned in his monthly investment column that the dot-com bubble would soon burst. The next year, it did. Despite the market downdraft, Mr. Gross’s fund ended 2000 up 12 percent, and that same year he and his partners sold Pimco to Allianz for $3.3 billion.

    In an October 2005 letter to investors, Mr. Gross made one of the most prescient calls of the last decade, warning of the looming subprime mortgage crisis. Almost everybody ignored him. But when the housing bubble burst and the financial markets fell apart, Mr. Gross’s clients were spared.

    Today, Mr. Gross is eager to buy the same subprime loans he once refused to touch, as part of the Treasury’s distressed-asset initiative.

    That effort, known as the Public-Private Investment Program, or P.P.I.P., has gained little traction so far. But Mr. Gross has energetically defended its architect, Treasury Secretary Timothy F. Geithner, against critics.

    Mr. Gross is hardly a disinterested observer. Pimco, owned by the German insurer Allianz, is jockeying to be picked by Mr. Geithner to relieve the likes of Bank of America, Citigroup and other banks of an estimated $1 trillion in soured mortgage debt so they can start lending freely again. Mr. Gross calls the plan a “win-win-win” for the banks, taxpayers and Pimco investors.

    But Pimco’s involvement in so many aspects of the bailout has made many other financiers and analysts uncomfortable. They say its proximity to the Treasury Department and the Fed may allow it to reap billions of easy dollars through federal contracts and preferential investment opportunities.

  15. This YSP argument is bunk. Here is why.

    The Option ARM had a 1% start rate for only one month. Then the rate went to the Fully Amortized Rate. This rate consisted of the Margin and the Index. The Margin could be from 2.2% generally, up to 4%, though some lenders had different Margin values.

    The Index was usually tied to the the MTA, COFI or CODI Index, with the MTA being the most common. The Indexes over the past few years have seen values from .35 up to over 5%.
    CAPS on the loans were from 8.95% up to 12.5%, of which most were 9.95%.

    What Garfield is arguing is that If the Index goes up, then the increase in the Interest Rate and the Monthly Payment is a second Yield Spread that should be owed to the borrower.

    What Garfield does not say is that each Index has gone down since the Housing Crisis started. Therefore, if you carry this thinking to the logical conclusion, you should OWE the money from the drop in payments to the lender. But he does not suggest that.

    What else you need to know is that since most Option ARMS were securitized, the “extra income” went into what was called “Over-Collateralization”. This meant the money would be held so that if interest rates dropped, and payments decreased, the income stream to the Trust would be kept the same.

    I don’t understand how you can try to make such an argument, if you have read and understand the Pooling and Servicing Agreements. Making this type of argument in a court filing will end up in the allegation being dismissed.

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