The Wall Street Journal is excellent today to spotlight a sudden jump in ARM interest rates on New Year’s Eve and what it means about the way floating rates are calculated. This is arcane but important stuff.
The problem is with the Cofi index, which, like the more well-known Libor, is used to calculated the interest rate on ARMs. It’s calculated by the Federal Home Loan Bank of San Francisco and lenders typically set a mortgage’s interest rate at a fixed number of percentage points above the floating Cofi rate.
Cofi, first published in 1981, is calculated by tallying up the interest expense that some two-dozen western U.S. savings banks pay to borrow money by their total funds, including deposits and other borrowings. Cofi is then published at 3 p.m. on the last business day of the month following the month where the data are collected. Bigger banks can have a disproportionate impact on the index.
You know where this is going. One of those bigger banks, Wachovia, is no more after a run on the bank forced it into Wells Fargo’s arms in the fall of 2008. The FHLB finally took it out of the Cofi index at the end of December.
Wachovia was too big to fail and so it was able to borrow at cheaper rates than its smaller competitors:
People familiar with the change now believe that Wachovia, unlike other savings banks that largely borrow via deposits, was raising cheaper money via the wholesale market. Because it was so large relative to the other banks, its low borrowing rates had a big impact on the index, keeping the number down and effectively keeping mortgages tied to the number lower than they otherwise might have been.
Let’s turn it over to Reuters’s Felix Salmon for the context:
When Wachovia was taken over by Wells Fargo, it was no longer eligible to be a reporting member of COFI, and the COFI index went from being overwhelmingly based on Wachovia’s cost of funds to being much more reflective of what smaller banks are paying. And it turns out that smaller banks pay much more than Wachovia did for money.
This datapoint is telling, because Wachovia — largely because of the Golden West acquisition — was a very rocky bank indeed, and was sold as a highly-distressed asset to Wells Fargo. The fact that its cost of funds was so low clearly had nothing to do with its inherent safety, which means that we have to attribute it instead to the moral hazard trade. And indeed the government went to great lengths to rescue Wachovia’s bondholders by forcing a sale of the bank.
Salmon points out this is another good reason for Obama’s proposed big-banks tax, which would be 0.15 percent on certain assets, although it doesn’t come close to leveling the playing field for smaller competitors. The press really needs to zero in on this area more: How do the benefits of being too big to fail distort markets and hurt smaller competitors?
What does the Cofi rise mean for the economy? Nothing good. More money for banks. Less money for borrowers, many of whom, WSJ reports, will see their payments rise by 9 percent. That’s all they and we need right now.
Fine reporting by Carrick Mollenkamp and The Wall Street Journal.