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Whose Cost of What Funds?
All adjustable rate mortgages are tied to an index, and changes in the index determine periodic changes in the interest rate charged on the mortgage.
Different from all other indexes in use today is the "11th District Cost of Funds Index," also known simply as "Cost of Funds," or by its initials, "COFI" (pronounced "coffee" in financial whizbang slang).
There are dozens of different indexes available. The one most often used is the four-week moving average yield on one-year Treasury bills. Other indexes from the common to the peculiar include three-, five-, seven-, and ten-year Treasury notes, as well as yields on certificates of deposit, and LIBOR. (LIBOR is the London Interbank Offered Rate. If you don't already know what LIBOR is, don't ask, and don't ever use it in your mortgage.)
All of the above indexes are money market instruments. Their behavior is reasonably well-understood under all sorts of conditions: tight Fed, easy Fed, recession, depression, overconfidence, panic, or boom. They have also been around for a long time. Adjustable rate mortgages have been available only since 1980, but the Treasury has been selling bills and notes for two hundred years.
COFI is completely different. COFI is the weighted average interest rate paid to depositors each month by financial institutions in the 11th Federal Home Loan Bank District.
Let's back up, one step at a time. The "Federal Home Loan Bank" system used to be part of the S&L industry (hence, the initials FHLB are pronounced "flub" by insiders). The 11th FHLB District consists of California, Nevada, and Arizona, and the "financial institutions" mentioned here are mostly S&Ls which survived the Great Foolishness. The "weighted average" is computed by dividing all the deposits at 11th District institutions into the interest they paid to their depositors (hence, "cost of funds") each month, and then annualizing the monthly figure.
COFI has some unique advantages over all other indexes, and also some unique pitfalls.
Advantages:
--COFI is relatively slow-moving. The deposits in the 11th (and everywhere else) are a mix of demand deposits and longer term CDs and borrowings. When money market interest rates rise, rates on demand deposits rise immediately. However, the COFI index as a whole can't move far until the first of the old, low-rate, six-month CDs begin to roll over (then the one-year, three-year, and so on.)
--In another aspect of this slow motion rollover, COFI normally lags market rate increases by one to two years.
--COFI is not only slow to move, it moves gracefully, with little volatility. In the last thirteen years, the maximum annual COFI movement was 1.6%. In five of the 13 years, the index moved less than one percent.
Pits and Falls:
--The rollover slow motion is double-edged: COFI takes a year or two to fall after market rates fall. Some data indicate that COFI rises more quickly than it falls, but the history is so short that we can't yet be sure. (See below.)
--COFI has been computed for only 13 years, and has no history prior to July 1981. Very old people may remember that it was only in 1979 that checking accounts began to pay interest, and before that time, deposit rates were set by the Federal government: 5.25% maximum at a bank, and 5.50% at S&Ls.
--Most charts comparing COFI to the T-bill Alps contain no disclaimer that COFI was understated until 1986 by the presence of old, regulated rate CD's. Old timers, do you remember the 8%, eight-year CD, the best deal a saver could get until 1979?.
--The 11th District consists of 177 S&Ls (a "Federal Savings Bank" or "FSB" is still an S&L) and a few banks. This is a very small cross-section of the nation's 15,000 financial institutions.
The sum of the negatives is not a sign of serious danger. However, a short history and a small sample mean that we have no idea how long COFI's advantages may last, or how distorted the index may become under special industry or regional influence. If you are going to use COFI, stay alert to surprises.
There is an excellent, if temporary reason to choose a COFI-indexed loan above all others this year: deposits are cheap, and the depositor's loss is the borrower's gain. This market condition also illustrates the potential for aberration in COFI versus the rest of the financial world.
I wrote an article two months ago poking fun at banker friends, and pointed out that banks were paying rates for CDs that were way under Treasury yields. Bank rates are still low: it's very hard to find a six-month CD paying over 3.00%, while the Treasury pays 5.20% for six months.
The same phenomenon prevails in the 11th. The most recent COFI value (for June, released July 29) is 3.804%. The one-year Treasury bill, COFIs most common competitor, now pays 5.70%. No matter what the teaser rate camouflage may be, why take a T-bill ARM, and start out almost two percent in the index hole?
Deposit costs will someday increase, and COFI will catch up to or exceed Treasury yields. But until banks get hungry for deposits, and have to pay higher interest rates to attract funds, COFI is the best adjustable deal in town.
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