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“The Ratchet Mortgage™ and Its Many Benefits”

(Patent Pending)
Summary of Remarks by
Bert Ely
President, Ely & Company, Inc.
January 4, 2007

Mr Ely, of Ely & Company, Inc., proposed a new kind of mortgage instrument that may save home buyers many of the extra costs attendant to financing and refinancing a home mortgage.  His loose leaf printed summary and slides supported his informal delivery to the audience.  At the end of the luncheon meeting many people in the room agreed with Mr Ely that they would indeed like to have a Ratchet Mortgage™ on their homes.

figure 1In great brushstrokes, Mr Ely sketched the expensive and time-consuming rite of refinancing a fixed-rate mortgage.  He showed that neither the mortgage interest rate stated in the mortgage nor the APR quoted to prospective buyers is the true interest rate.  The true rate is the all-inclusive sum of the mortgage contractual interest rate plus the amortization of the mortgage upfront transaction costs over the actual life of the mortgage.  The length of the actual life can be known only after the mortgage is paid off.  It is safe to say, however, that the interest rate add-ons to recover origination costs decline as mortgage life is extended, as shown in figure 1.

Homeowners have traditionally refinanced their mortgages for two reasons:  (1) to obtain a lower mortgage interest rate, usually in a declining rate environment; and (2) to borrow some of the equity increase in the home.  Refinancing, however, is costly inasmuch as amortized transaction costs boost the all-inclusive mortgage rate.  Replacing the mortgage documents is very costly in itself.

The alternative Ratchet Mortgage™ or the RM is a much better deal.  The RM is analogous to a one-way ARM (adjustable rate mortgage).  Its rate will decline when interest rates fall, in accordance with a published rate index.  Differing from the ARM, the RM rate will not rise when the rate index rises—it will stay the same.  The initial RM interest rate should not exceed the rate on a fixed-rate mortgage offered to the same borrower on the same property.  The indexes to which RMs will be indexed most likely will be the 10-CMT, the 10-year swap rate, or be something comparable.  The RM rate will decline for all borrowers if the rate index drops by, for example, 25 or 50 basis points.  The RM rate declines will be costless for all concerned.  The RM has all of the advantages of a fixed-rate mortgage in a rising rate environment, and all advantages of an ARM in a declining rate environment.

The secret to RM economics is that the longer the RM stays in place, the lower the amount of monthly amortization of its origination costs.  And RMs should have a much longer average life than current fixed-rate mortgages.  The automatic rate reduction feature eliminates the incentive to refinance to get a lower mortgage rate.  And the same homeowners should be able to borrow additional amounts under an RM, without having to go through the refinancing process.  The visible advantages of the RM of course invite skeptical questions about why it is not offered already.  One reason is that the refinancing industry has mortgage brokers, title insurers, appraisers, and settlement attorneys who stand opposed because they would lose much livelihood.  Several earlier attempts to offer automatic-rate-cut mortgages did not succeed because they were hard to fund.

Figure 2The RM is different because it would be funded using Ratchet Pass-ThrusJ (RPTs) or Ratchet BondsJ (RBs).  RPTs are comparable to mortgage backed securities (MBSs).  The payments of mortgage principal and interest (less the lender’s spread) flow through to RPT investors.  When the RM rate indexes down, the RPT yield automatically drops by the same number of basis points.  Ratchet Bonds could have a variety of principal repayment schedules, but the RB rate would click down as the RM rate ratchets down.  See figure 2. 

RBs have a precedent in the ratchet bonds issued by the Tennessee Valley Authority.  The authority has an outstanding $1.1 billion of 30-year Putable Automatic Rate Reset Securities (PARRS).  These securities are surrogate callable bonds with an automatic no-cost repricing feature.

Table 1RMs funded by RPTs incur two unique costs that must be offset by transaction cost savings.  For one, RT Investors need additional initial yield, relative to MBS to compensate for the more efficient repricing of the RM as compared with the refinancing of fixed-rate mortgages.  The additional yield should not exceed 20 basis points.  And, two, mortgage brokers most likely will need a higher commission payment to originate RMs to compensate for future lost refinancing opportunities.  These two costs can be offset by the lower monthly amortization of the RM origination costs arising from the much longer expected life of the RM.  Table 1 shows the additional mortgage life that an RM must achieve to reach the RM breakeven point.

In sum, Mr Ely reviewed how RMs will benefit homeowners, mortgage lenders, and the wider economy.  Homeowners will find that:

  • The Initial RM interest rate comparable to the rate on a fixed-rate mortgage.
  • There is no need to refinance when interest rates decline.  This advantage saves homeowners search time and keeps them from being dependent on their current credit status.
  • There is no need to replace home equity lines of credit (HELOCs) and other junior mortgages to get a lower mortgage rate, as is the case when refinancing a fixed-rate mortgage today.
  • Cash is saved from any rate decline inasmuch as there are no refinancing costs and the regular mortgage payment automatically drops.
  • Homeowners can borrow more money under the RM without incurring the refinancing expenses and origination fee of a new mortgage.

Lenders will find that RMs generates:

  • Loyal customers who will not refinance away from their historic lender and who will provide cross-selling opportunities for housing-related and other banking products
  • Longer and more predictable profit streams
  • Fewer foreclosures among credit-impaired borrowers who are least able to refinance
  • Higher escrow income
  • Lower origination volatility
  • Lower HELOC turnover

The wider economy will see such benefits as:

  • Substantial reduction in mortgage transaction costs, perhaps $10-$20 billion annually.
  • A more efficient mortgage industry with less origination volatility.
  • Declines of interest rates, especially those of homeowners currently unable to refinance their homes.
  • Lower mortgage interest rates, once all fixed-rate mortgages have a ratcheting feature.
  • Extension of the RM concept to other types of debt.

To learn more about the Ratchet MortgageTM, please contact: 
Ely & Company, Inc., 703.836.4101, bert@ely-co.com; or
Andrew Kalotay Associates, Inc., 212.482.0900, andy@kalotay.com.
Monitor the progress of the Ratchet MortgageTM at www.ratchet-mortgage.com.
View the Ratchet MortgageTM patent application at www.uspto.gov, Publication  No. 20060184450.

Rapporteur:  Harold Brown

 


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