May 23, 1990
TO: SEC RULES COMMITTEE NO. 30-90
INVESTMENT ADVISERS COMMITTEE NO. 17-90
RE: GINNIE MAE TO PROHIBIT "LIVE FREE" MORTGAGES
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According to the attached Wall Street Journal article, the
Government National Mortgage Association has decided to issue a
letter to mortgage industry participants prohibiting so-called
"live free" mortgages.
"Live free" mortgages are originated at an above-market
coupon rate and allow borrowers to avoid making monthly mortgage
payments for an agreed-upon period (for example, six months). At
the end of such period, the lender refinances the mortgage by
selling it into a mortgage pool at a slightly lower but still
premium rate. This process is then repeated several times until
a market interest rate is reached. At that point, the borrower
takes over the monthly payments on the mortgage. In the interim
the sale of the high-rate mortgage at a premium price enables the
lender to cover service fees, make pass-through payments on
mortgage securities and still retain a profit.
For investors in mortgage-backed securities such as mutual
funds, however, "live free" mortgages, because they are quickly
prepaid, create the potential for significant losses. If a
mortgage pool contains "live free" mortgages, the substantial
prepayment risk more than outweighs the benefit to the investor
of a premium coupon rate. Unfortunately, investors may not be
able to assess their prepayment exposure accurately because the
mortgage pool may appear to be seasoned.
We will keep you informed of developments.
Frances M. Stadler
Assistant General Counsel
Attachment