What Do Bi-Weekly Payments Mean For The Secondary Market?

Secondary market executives should cast their eyes on this small but growing payment option.

By Mitch Lichterman

The bi-weekly payment option has been around for more than half a century and has become considerably more popular in the past 20 years.

However, as far as the secondary market is concerned, it has not really risen to prominence. Since the early 1980s, lenders have seen an increased interest from customers in the bi-weekly payment process and have found that offering such programs can provide a boost in their volume.

The number of borrowers who apply a bi-weekly payment plan to a new or existing loan is slowly rising, and secondary market executives should now be interested in this relatively small and specific aspect of loan finance.

In order to truly understand the impact of bi-weekly payment programs on the secondary market, one must first consider the implications this payment process has for bi-weekly borrowers’ loans.

Who exactly is the bi-weekly borrower?

As stated, the number of borrowers who apply the bi-weekly payment plan to their loan is growing, but critical mass has not yet been achieved. It is estimated that there are approximately two million borrowers using bi-weekly payment programs, but this is only 2% of the estimated 100 million that make up the mortgage population in the U.S.

With so few bi-weekly borrowers and little research targeted toward them, there is very little data from which to draw. There is, however, a consistent behavior among borrowers who apply the bi-weekly payment program and from this collective behavior, a consistent borrower profile is created. This profile supports the hypothesis that “bi-weekly loans” are most likely to be prime paper and, therefore, appealing credit risks for lenders.

The data indicates that the borrower who investigates all available options and decides to enlist in the bi-weekly payment process is generally a person conscientious of their personal financial records.

This is not to say that borrowers who use other payment methods are not. Rather, considering the nature of the bi-weekly payment process, borrowers that choose this option are necessarily interested in reaping the maximum savings and benefits from the mortgage loan payment process.

In several cases, they have a more sophisticated knowledge of the mortgage process and secure a program that will rapidly build home equity and significantly reduce interest incurred. These types of borrowers are usually also risk-averse, subscribing to a plan that pays off their loan as quickly as possible.

Benefits for the secondary market

If the bi-weekly borrowers’ profiles reveal anything, it is that bi-weekly loans, whether 15-year-fixed, 30-year-fixed, or even ARMs, are less likely to default and offer a faster principal pay-off than other payment methods.

Lenders may argue that bi-weekly plans offer little profit opportunity because the interest payments are so drastically reduced, but for the secondary market, these loans can actually provide substantial and immediate income. Because of this, lenders may place lesser value on bi-weekly loans and offer them to the secondary market at lower prices.

If secondary market investors are presented with opportunities to buy these loans at a discount, they can receive the principal on these loans more quickly and can see an immediate yield gain.

For example, if an institution pays 97 cents on the dollar for a pool of bi-weekly loans, and those loans are paid $1 on the dollar, the investor gains a relatively quick profit. Of course, should the investor purchase bi-weekly loans at premium, the situation would change, leaving the investor with fewer gains, and even possible losses.

For many investors, the risk is simply not worth the investment when there are more secure and established methods to guarantee gain. Additionally, the lender community places less value on bi-weekly loans because they generate far less interest for the lender. It is clear how the borrower benefits from bi-weekly payment programs, but it is sometimes unclear how the secondary market can benefit.

As Greg Crosby of Associated Software Consultants, an expert on secondary market risk management, explains, “In today’s market, there isn’t a great demand pushing the bi-weekly loan, nor is there a large supply. Because of this, bi-weekly loans tend to trade at a higher rate or lower price than their counterparts.”

Crosby’s statements are directed toward the existing current market. Just as the market changes, so can the impact and impression of bi-weekly loans.

Reducing risk for investors

Consider the low-risk factor: the riskier the loan, the steeper its price. If applying the bi-weekly characteristic to a loan reduces the risk for the lender, should it not also affect the investor?

Yes, but its effect varies between loan pools wrapped in credit enhancers and those without credit enhancers.

For the investor who purchases loans without credit enhancements, the bi-weekly characteristic adds not only low-risk assurance, but also consistency to the loan pool. For banks and portfolios, this is particularly beneficial. However, when any institution purchases an investment that is not wrapped with credit enhancements, the risk capital requirements are slightly increased.

Depending on the collective characteristics of each loan, the bi-weekly aspect may neutralize the increase because it lowers the risk factor of the loan. According to Crosby, this risk capital increase is a kind of surcharge for investors who buy pools without a credit wrapping. Investors may see the added risk as an unnecessary cost, especially if the loan pool in consideration is otherwise in low-risk standing.

And what about the loans wrapped in credit enhancements? The reliability that the bi-weekly characteristic promises is inconsequential once the risk of unpaid principal is removed.

For some investors, this is the only perceived benefit the bi-weekly characteristic adds to a loan. “As an investor,” explains Crosby, “I don’t really care if they default or not, because my money, the principal, is already secured.”

While it is true that the principal is secured, the bi-weekly loan is actually added assurance that the secured principal will be there and, more importantly, will be repaid in full more quickly than other payment methods.

This is where it is crucial to understand how the atmosphere of the market determines the level of impact the bi-weekly loan can carry. Current secondary market conditions see the highest volumes in A and B paper, and the bi-weekly characteristic is notable, but has little to no influence on investment behavior.

Additionally, most loans are wrapped in credit enhancements and already insured with what the bi-weekly loan is offering.

Improving subprime credit

However, what happens when powerful economic changes do take place? If the economic climate moves into a deep recession, there will certainly evolve a substantial number of people with tainted credit, resulting in high subprime volume. As subprime borrowers need homes, too, the bi-weekly payment program will make a substantial impact.

In as much as applying a bi-weekly payment program to a loan shows that a borrower is interested in maximizing all of the benefits from the mortgage process, the same program may also demonstrate who is most determined to improve their tainted credit. Once a bi-weekly payment program is applied to a subprime loan, creditors see the subprime loan in a new light.

When these loans are wrapped with credit enhancements, creditors take into consideration the bi-weekly characteristic and are likely to wrap the loan for 20 to 50 basis points below normal. Then the benefits to the secondary market become obvious.

The bi-weekly payment program would make a considerable difference in the larger percentage of loans from which to pool, directly affecting the investor’s cost. The major shift in importance of the bi-weekly aspect (as far as the secondary market is concerned) would simply follow from a change in the economic climate.

The argument can be made that borrowers who apply a bi-weekly payment program to their loans are financially responsible and a better credit risk to lenders and the secondary market alike.

There are currently factors that tend to keep the secondary market from giving the necessary attention to the bi-weekly characteristic of a loan, but these factors are subject to change. Adding the bi-weekly characteristic to an A paper loan may seem redundant in terms of credit risk, but the subprime market will always exist, and C paper loans change face when the bi-weekly payment program is applied.

If the economy continues moving into a recession, the time will be right for secondary marketing executives to start looking at the bi-weekly loan more closely.

Mitch Lichterman is president of Mortgage Saver, a Los Angeles-based company providing automated bi-weekly payment processing programs.

This article was previously published in the May 2001 Issue of Secondary Marketing Executive