A COFI break.

Author:Stahl, David
Position:Cost-of-Funds Index - Includes related article on California's economy recovery

The once-dominant ARM product based on the cost of funds of West Coast thrifts has suffered a decline of late. The so-called COFI ARM is getting creamed by other ARM products that consumers find easier to swallow. Whether this break with past popularity will continue is uncertain.

Several major california lenders used to routinely serve COFI - that is, 11th District Cost-of-Funds Index (COFI) mortgages. Higher interest rates in California used to automatically mean high demand for COFI loans. Today, COFI loans face tough competition from a variety of forces, including other ARMs, a consolidating lender market in the COFI stronghold of California and an uncertain interest rate outlook.

This kind of ARM may yet prove one of the lingering staples in the fickle world of mortgage products. Or, instead of being good to the last drop, COFI could be getting a little stale.

The index is based on what the 11th Federal Home Loan Bank District members paid for their cost of funds. The Cost-of-Funds Index was a semiannual index throughout the 1970s. It became a monthly weighted index in July 1981, according to Amy Stewart of the Federal Home Loan Bank of San Francisco.

The index reflects the actual interest expense of the 78 savings institutions in the 11th FHLB District, Stewart explains. Commercial bank members, which outnumber thrifts in the district, are not included in determining the COFI. The FHLBank does not plan to include commercial banks or thrift-and-loan companies (a separate category of small lenders) in the COFI, although consolidation has thinned the ranks of institutions that determine the index.

COFI break

COFI loans are the dominant ARM product in California, accounting for nearly half the adjustable-rate loans and more than one-third of total originations as of late August, according to lenders. The rates are more attractive than fixed-rate loans and many California lenders are willing to promote them to their customers, says Keith Gumbinger, vice president of HSH Associates in Butler, New Jersey. The only significant non-California COFI business is done by Great Western Bank, A Federal Savings Bank of Chatsworth, California; Home Savings of America FSB of Los Angeles and other H. F. Ahmanson subsidiaries that have branches outside of the Golden State.

ARM lenders must sell the features of the loan beyond its low introductory offer, says Sam Lyons, senior vice president of mortgage banking at Great Western. With an ARM, borrowers can qualify for more house, he points out. In August, a COFI ARM, for example, had an introductory rate of 3.95 percent. After three months, the rate rises to 7.26 percent, or 245 basis points more than the Cost-of-Funds Index. Although borrowers see a 331-basis-point rise in their interest rate, the contract rate remains about a full percentage below the interest rate on a fixed-rate loan.

Rising interest rates usually perk up the demand for ARMs. Lenders argue that ARMs are right for homeowners who plan to stay in a house a short while or who expect rates to drop. Borrowers reap the benefits of lower interests costs and no compelling need to refinance because the loan automatically adjusts downward when rates move lower.

Interest rates based on the index of the 11th District cost of funds lag movements in the one-year Treasury index. That [TABULAR DATA FOR FIGURE 1 OMITTED] means that when the Treasury index starts moving up, COFI loans remain attractive, particularly for borrowers stretching to qualify for a mortgage.

"COFI borrowers get a rate break at the front end," says William Mortensen, chairman and CEO, First Federal Bank of California, FSB, Santa Monica, California. For the first-time homebuyer, the major COFI customers, this rate advantage could determine whether they can purchase a house.

"COFI ARMs popularity has not moved east," says Jeffrey Tuchman, president of The Mortgage Shopper, a mortgage research firm based in Pleasantville, New York. He counseled a few customers to refinance out of COFI loans, but no one has ever asked for one. He does not originate any loans, but counsels customers on what loans are right for them and tells them which institution offers the best rates.

"COFI interest rates start as low as 3 percent in some areas of California," Gumbinger said at the time he was interviewed for this article. COFI rates rise to the full contract rate after three months, and then fluctuate...

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