The adjustable rate mortgage (ARM) is a mortgage with periodic changes in interest rate over the life of the note based on various money indices, such as London Interbank Offered Rate (LIBOR) or the 12-month Treasury Average Index.
Banks Reallocation of Mortgage Risks to Borrowers
Mortgage lenders developed the ARM product to pass onto the borrower the risks of volatile market interest rates during the life of a mortgage note. By bearing this risk, the ARM borrower also assumes the potential for financial rewards if the market plays in his favor.
The mortgage lender in fixed-rate mortgages, however, is locked in at the initial interest rate on the loan. Accordingly, the lender is made to suffer the lost in profits if inflation rises or the market forces interest rates upward. A fixed-rate vs. adjustable rate interplay would suggest that a drop in the fixed mortgage interest rate (reduction in the cost of borrowing) would result in an increase in adjustable rate mortgages by lenders.
History of Adjustable Rate Mortgages
In 1969, Barney R. Beeksma, then a savings and loan banker with InterWest Savings Bank, popularized the use of the variable rate mortgage product in U.S. residential mortgage lending. In 1981, ninety percent of InterWest Savings Bank’s loans were ARMs. This allowed it to survive the interest rate spike and inflation that devastated the thrift industry during the S&L crisis of the 1980s.
According to L. William Seidman, former FDIC Chairman, “[t]he banking problems of the ‘80s and ‘90s came primarily, but not exclusively, from unsound real estate lending.” A review of the current mortgage crisis suggests that history is repeating itself.
Subprime Mortgage Crisis: Teaser Rates Led to Payment Shock
In 2006, about three-quarters of subprime ARMs had a low rate for the first two or three years followed by a higher floating rate on the remainder of the life of the note. The introductory rate offered on adjustable rate mortgages—often termed the “teaser rate”—is usually set very low as a borrower’s incentive to assume the risks of a variable rate loan.
In February 2007, Senator Chris Dodd (D-CT), Chairman of the Banking, Housing, and Urban Affairs Committee reported that approximately 80% of U.S. subprime mortgages were adjustable-rate mortgages. In December 2007, the number of subprime ARMs were reporting at 2.9 million by the Mortgage Bankers Association. ARMS were resetting to higher interest rates and led to a payment shock that jolted subprime market borrowers—those with poor or no credit history and disproportionately representing minority, elderly, and immigrant populations.
In mid-2007, financial markets deeply vested in the derivatives market of mortgage-backed securities began to feel the effect of risky subprime lending held by borrowers who were no longer able to bear the variable adjustments. RealtyTrac reported that there were about a quarter of a million foreclosure filings in the month of June 2008 alone – a three percent drop from the previous month.
Consumer Protection in Home Mortgage Finance Markets
The ARM often has a built-in consumer protection component against rapid escalation in borrowing costs. In the mortgage industry, these are called “caps” on interest rate increases in any single year. For instance, an adjustable rate mortgage with an introductory rate of 7 ½ percent, an annual increase cap of 2%, and a lifetime cap of 5%, cannot rise higher than twelve point five (12.5) percent.
Even with these safety components in place, by mid-2007 the Federal Reserve, Comptroller of the Currency, FDIC, Office of Thrift Supervision, and the National Credit Union Administration announced a need for stronger guidelines to address the subprime mortgage loan crisis. The number of mortgages impacted by the crisis was no longer just within the subprime lending market.
Increased Federal Regulations as a Response to Unhealthy Market Risks
Federal regulations were beefed up and required mortgage lenders to increase the amount of information collected from a borrower. Borrowers needed to demonstrate an ability to pay an adjustable rate mortgage to mitigate the risk of foreclosure. Consumer protection groups proposed that borrowers be required to qualify for the ARM loan product at the highest rate allowed under the annual cap on interest rate -- a proposal rejected by regulators as too limiting.
Teaser rates on adjustable rate mortgages create a huge incentive to home buyers. The recent harsh impact of interest rate resets on ARMs has went beyond the subprime lending market and illustrates the risks of these mortgage products. Considering that the purchase of a home is the biggest ticket item of most Americans, it is important to thoroughly understand how it works and that it is not for the risk adverse.
References:
- U.S. Federal Reserve Consumer Handbook on Adjustable Rate Mortgages
- “The S&L Debacle: Public Policy Lessons for Bank and Thrift Regulations,” by Lawrence J. White, Oxford University Press (1991)
- “Regulators Tighten Subprime-Lending Rules,” by Damian Paletta, Wall Street Journal at B1 (June 30, 2007)
General Disclaimer: This article is for informational purposes only and should not be used as a substitute for tax or legal advice.
Vanessa Cross - Vanessa Cross is a freelance writer who writes about international trade, business law and small business development issues.
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