Adjustable rate mortgages cause volatility in California house prices

Housing bubbles are catastrophes. Like the Hindenburg or the Titanic, house prices had an aura of invincibility that came crashing down and sunk to an (under)watery grave.caddyshack_toxic_mortgage

If a mortgage product were to inflate a housing bubble, the pump and hose that primes the first stages are adjustable rate mortgages. These risky products give the market ability to weather interest rate shocks, but they also provide the air that inflates prices 10% to 15% above stable prices set by using fixed-rate mortgages.

Californians pay too much for their houses because many get trapped into adjustable-rate mortgages to borrow as much as possible. It becomes a rite-of-passage that your first purchase requires you to take on a risky loan and stretch to the max so your bank can extract as much money as possible from your working life.

Some wise up to the adjustable-rate mortgage trap, and they either refinance or move to a different home when their financial situation changes. They take with them the equity built up from the frightened masses that came after and inflated neighborhood values.

Adjustable rate mortgages are not a product I like because it forces borrowers to assume interest rate risk. Many people who use adjustable rate mortgages claim they understand interest rate risk, but in the last 30 years, interest rates have done nothing but go down. There has been no consumer risk in holding adjustable-rate paper.

That changes when interest rates hit the bottom of the cycle and begin to rise.

Each adjustment in rate going forward represents a larger cost to the borrower. Everyone stretching today to get into real estate using an adjustable rate mortgage will face an increasing payment without obtaining any appreciation to compensate. It’s a lose – lose. Those using fixed rate mortgages with affordable payments can weather any storm.

Adjustable rate mortgages will burn most who use them over the next decade. Those with assumable fixed rate mortgages will fare the best.

Also, for those awaiting the return of HELOC riches, how much of that equity are you going to borrow at 7% when your primary mortgage is 4.5%?

The article that follows is a bit wonkish, but it provides a detailed explanation of how adjustable rate mortgages impact the California real estate market.

The iron grip of ARMs on California real estate

By Bradley Markano • Dec 28th, 2010

This article discusses how the ratio of adjustable rate mortgages (ARMs) to all loans originated in California can be used to determine the health and direction of California’s near-term real estate market.

Data Courtesy of MDA Dataquick, the US Federal Reserve, and Standard and Poor’s

The above charts present two real estate market perspectives on adjustable rate mortgage loan (ARM) volume in California. Both charts track ARM loans as a percentage of all mortgages recorded in California (the blue line), called the arms-to-loans (ATL) ratio. The first chart juxtaposes California’s ATL ratio with the fixed rate mortgage (FRM) rate for the Western Census Region (the green line), while the second chart joins the ATL ratio with the combined monthly tri-city average of low-tier home pricing in San Diego, Los Angeles and San Francisco (the red line).

The ATL ratio is a crucial measure of the relationship between ARMs and FRMs, and can be used to determine probable sales volume and price movements for 12 and 24 months forward (respectively). [For a more detailed look at home pricing in California, see the first tuesday Market Chart, California Tiered Home Pricing.]

In the top chart, notice the collapse of ARM lending after 2006. ARMs went from nearly 80% of the market down to 2%.

ARMs depend on FRM Rates

The availability of purchase-assist money is the single most powerful engine driving price movement in California real estate transactions, as shown by the boom in sales volume and pricing caused by excess funding in the mid-2000s; a phenomenon called the financial accelerator effect. Purchase-assist money is delivered almost exclusively by either ARMs or FRMs (except for the very few buyers who pay cash).  [For more information about the financial accelerator, see the May 2010 first tuesday article, Cleaning up after the ruptured housing bubble.]

Because mortgage financing is so dominant in sales transactions, the friction in the movement between the 30-year FRM Rate and the ATL ratio is essential to the understanding of brokers who wish to hazard a prediction of what lies ahead for their real estate market.

Combined in analysis, these two factors – the FRM rate and the ATL ratio – have the power to predict California’s future home sales volume and price movement. Local market conditions, on the other hand, seem to have little influence on sales volume and pricing, since both are controlled by financing trends, which are moved only by the bond market and federal monetary policies. [For a more global review and critique of ARMs, see the March 2010 first tuesday article, The Danger of an ARMs Buildup.]

ARMs Ratio1   

The FRM-ATL Connection

30-year FRMs are the most basic and essential form of financing for homebuyers in the real estate market. If FRMs are available at comparatively low rates, and the homebuyer is well-informed (and somewhat rational), the homebuyer will almost always choose the FRM over the much riskier ARM loan.

When ARMs became 80% of the market in 2006, nearly everyone forgot the common sense idea that fixed-rate debt is better. Now that ARMs are nearly extinct, some are lemanting their demise. Good bye and good riddance.

In a normally functioning purchase-assist and refinancing mortgage market, the percentage of ARMs – the ATL ratio – rises and falls only in direct response to changes in FRM rates, in sympathy until friction develops and leads to a deviation in movement between the ATL ratio and FRM rates. Such a deviation is a clear warning of an impending distortion in real estate sales volume and pricing.

As the top chart vividly indicates, observed rises in FRM rates tend to lead to increases in ARM volume, the normal situation. The reasons are intuitive, since ARMs allow borrowers to obtain more funding when the FRM rate increases (sellers refuse to lower their prices in response to FRM rates, so buyers are forced to either lower their standard of living or obtain a higher amount of funding).

Note that this normal dynamic is not present in a market laden with distressed properties. If affordability declines in a normal market, buyers often foolishly adjust by taking out ARM loans since sellers rarely come down on price. However, since so much of our current inventory is distressed, for this inventory to clear, prices must come down to whatever price level borrowers can obtain. In other words, it is different this time.

For instance, the number of ARMs jumped dramatically when FRM rates were raised in 1988, 1994 and 1999.  Prices never moved down, as the ARM supported sellers’ demands by delivering more money than the buyers would otherwise be qualified to borrow.

It is useful to think of ARMs as bridge loans, spanning gaps in the availability of purchase money when FRM rates rise. Any rise in FRM rates immediately reduces the buyer’s purchasing power, since lenders do not permit buyers to make loan payments higher than 31% of their income. Higher interest rates always mean lower principal amounts are available to borrow. [For more on the influence of rates upon the buyer’s ability to get financing, see the first tuesday Market Chart, Buyer Purchasing Power.]

This is the point I have been making for months now. Lower borrowing amounts when coupled with excessive must-sell inventor leads to lower prices.

When FRM rates rise, ARMs tend to keep prices from falling. Unfortunately, ARMs originated in excess will quickly cause prices to rise during periods of flat or declining FRM rates. ARM financing permits sellers to raise prices beyond what buyers would otherwise be able to pay. Increased availability of funds from ARMs help stabilize the market in a time of temporarily high FRM rates, but they can just as quickly lead to a home pricing bubble and a potential market crash when the ATL ratio is running contrary to the FRM rate movement as occurred in 1993 and 2002.

ARMs are the cause of volatility in California’s housing market. The Option ARM was the culprit that inflated the Great Housing Bubble because it allowed huge principal values with tiny payments. The same payment can finance two or more times the loan amount with an Option ARM as compared to a FRM.

In the past, ARMs in healthy markets have generally made up approximately 20% to 40% of the home loan market, while the remainder is made up of FRM loans. If the ATL ratio exceeds 40%, which normally happens when FRM rates rise too high, it is a sign of instability in the financing market, and forebodes potential problems for homeowners and homebuyers in the near future – weaker sales volume and home prices.

Forecasting the future

With FRM rate movements in mind, it is possible to forecast the future of sales volume and sales price trends by comparing FRM rates with movement in the ATL ratio. To do so, take a close look at the correlation from year to year between FRM rates and the ATL ratio on the first chart above.

Ordinarily, the ATL ratio rises and falls in tandem with FRM rates, roughly following it in a stable and nearly parallel relationship. However, this stable relationship can and does sometimes fail when external factors cause the ATL to move contrary the FRM rate. Such external factors may include:

  • increases in jumbo loan demand;
  • rapid shifts in demographic demands to buy or sell;
  • too much or too little construction activity; or
  • changes in government regulations on homeownership or mortgage financing.

You can develop an understanding of what will be the real estate sales volume for the next 12 months, and sales price movement for a full 24 months by following any failure in ATL/FRM relationship.

In the real estate market, home sales volume tends to rise and fall in a cyclical fashion corresponding to economic recessions (represented above by gray vertical bars on the charts) and booms. Home prices change primarily due to prior changes in sales volume, although the pricing inertia generated by rising sales volume tends to continue for 8 to 12 months after home sales volume reaches its apex (this delayed change in pricing, which is particular to SFR property, is referred to as the sticky pricing phenomenon). [For a more thorough analysis of sticky pricing, see the first tuesday December 2009 article, The Flat Line Recovery: A Side-Effect of Sticky Housing Prices.]


To make an accurate and well-informed prediction of home sales volume and pricing in California, the only figures you need are the ATL ratio and the FRM rate for the past 12 months. When these two figures fail to move in tandem during the prior 12 months, the friction between them is predictive of the extent of the change in sales volume and pricing trends in future months. Which direction the trend will take depends upon whether the two rates become more closely aligned or more distant.

It is unnecessary to look to any information other than the correlation between the ATL ratio and the FRM rate for forecasting the next 12 months of sales volume and 24 months of pricing.  All other factors either reflect the ATL and FRM rates, or are directly caused by the fluctuations in those rates. For instance, while the volume of notices of default (NODs) and trustee’s deeds (TDs) may appear to have an influence on price movement at the moment of analysis, in fact NOD/TD volume is merely a manifestation of prior price movements which are dictated by FRM and ATL frictions. [For more information on NODs in the current market, see the first tuesday Market Chart, NODs and Trustee’s Deeds.]

When the ATL ratio parallels the movement of FRM rates, both sales volume and prices will remain fairly constant in the future. This is the definition of a normal market: looking forward, readers can safely predict that neither a measurable boom in pricing nor a recession will take place in the two years following such conditions.

Instead, sales volume will continue much the same as at present for at least 12 months, and prices will remain reasonably steady, adjusting upward at approximately the rate of inflation in the consumer price index (CPI) for a longer period, another 6 to 12 months. [For the most current CPI figures, see the first tuesday Rates Page.]

However, any sustained period (12 months or more) in which the two factors are at odds with one another, as demonstrated by a widening or narrowing of the space between the two lines on the ATL/FRM chart, discloses a hazardous abnormality in the home financing market. Any such abnormality establishes a divergent trend going forward in real estate sales and pricing. Examples of such divergences are elucidated below.

I have used the loosly defined term “normal” market on many occassions. The definition above is a good one, if a bit technical.

Historical trends

To get a clear idea of the power of FRM rates and the ATL ratio to predict action in the real estate market, take a look at these illustrative instances:

1.      Between 1996 and 2002, the ATL ratio moved in approximate synchronicity with FRM rates, in an example of the ideal lending conditions on the market. Thanks to stable and sane loan demands by homebuyers and homeowners, real estate prices rose at a slow and sustainable rate for the duration of this period.

2.      Beginning in 2002, FRM rates dropped continuously for two years. In the meantime, the ATL ratio began to rise, thanks to deregulation of lenders and Wall Street Bankers which allowed them to push for increased use of ARM loans and the concurrent rise in asset prices. The unnatural rise in ARMs led to excessive home price increases, which continued to rise for one to two years even after a return to standard ATL/FRM synchronicity (the ATL ratio peaked in early 2005, but home pricing did not reach its apex until one year later).

3.      Between 2005 and 2009, FRM rates remained flat, but the ATL ratio reversed course and dropped significantly. The declining ATL ratio, coupled with a flat FRM, presaged an inevitable decline in housing prices, and a similar drop in the amount of money available for homebuyers and homeowners to borrow. In short, the dropping ATL ratio (without a drop in FRM rates) was both a symptom and a cause of the catastrophic Great Recession. Lenders dropped FRM rates further, in early 2009, but the ATL ratio responded by dropping to almost zero, a condition that exists at the end of 2010.

The authors contention is backed up by the data. Although this indicator and explanation are hard to follow, it makes sense that sudden changes in financing behavior, particularly the use of risky ARM loans, will lead to market volatility and instability.

The current market

As of October 2010, adjustable rate mortgages (ARMs) made up only 5% of mortgage market originations statewide, compared to 77% at the height of the Millennium Boom (for comparison, the peak national rate was only 36% ARMs). This 5% ATL is very low, yet it is higher than the bottom of 2% in May 2009, and continues a downward trend from an ATL ratio of 6.5% in May 2010.

Both the ATL ratio and the FRM rates are bouncing around at about the same level, with the ATL ratio literally bumping along on the bottom (as it cannot go lower than zero). Yes, the FRM is artificially low and will move around depending on the effectiveness of Fed and congressional stimulus at end of 2010 which will take effect throughout 2011, but that is not the issue.

The ATL/FRM relationship has remained relatively normal for the past year, after a logical bounce at the end of 2009.  Sales volume is thus likely to remain constant or drop over the next 12 months, and the same is true of prices for the next 18 to 24 months from now. Buyers need not expect any changes in market conditions until mid- to late 2012. Government programs to encourage ownership, or to create pre-foreclosure workout sessions, will not significantly alter this situation. It will change only if buyers return to the streets intent on scarfing up real estate.

History also helps us to predict how ARMs will behave at the end of a real estate recession. Historically, recessions have led to a restabilization of the ATL ratio between 20 to 40% levels, typically following the FRM rate closely for three to five years following the recession’s end. This rule is not absolute, however; most recently, the period of 2001 to 2004 violated this condition (due to government efforts to artificially bolster the homeownership rate in the US from 64% to 70%, at the expense of homebuyers who were financially unprepared for homeownership).

As the gatekeepers to real estate, brokers and their agents need to know the shift in mortgage preferences among homebuyers from fixed rate mortgage (FRM) to ARM financing in the absence of increased FRM rates means the real estate market is destabilizing.

ARMs are not a stable loan product, and although 20% to 40% may typically be present, that only means 20% to 40% of the buyers are taking foolish risks and remaining market participants must deal with it. The presence of ARMs is not helpful, but the product doesn’t totally destabilize the market while ratios are in that range and prices are rising.

With insight to apply this information, they will be able to provide better advice to both sellers and homebuyers.

The author is assuming agents care enough to convey truthful information even when they have it. My observation is that agents don’t care about the truth unless it is helpful in generating a commission.

ARMs and the dysfunctional real estate market

While an ATL of up to 40% indicates a healthy home sales market, we wish to clarify that ARMs are almost never beneficial to the individual homebuyer, and are in fact largely (if not totally) responsible for the Great Recession in the real estate market.

The weaknesses of the real estate market revealed by the recent Millennium Boom (and the associated GreatRecession)are tied inextricably to the prevalence of ARM originations during that period. Without ARMs, introduced in 1982 by authority of the US Treasury, the world of real estate would not be in its present dire condition.  Financing the purchase of any type of real estate with ARMs points to several key instabilities in a momentum environment of increasing sales volume:

  1. Homebuyers are over-anxious. Over-anxious homebuyers who cannot finance the purchase of homes with stable long-term FRM loans will make the myopic decision to resort to ARMs in order to get into the home immediately, even though this choice entails greatly over-extending their future finances. They are not being told, nor do they themselves properly consider, the true cost of ARM loans when short-term rates increase — as they invariably and often dramatically do in normal business cycles of recession and recovery. This overheating of the real estate market — its weakness — creates a breeding ground for speculators and ever more ARM borrowing.
  2. Speculators have a large presence in the market. ARMs provide a free lunch for flippers:  rates are cheap with minimum cash flow requirements in the short term, providing speculators with enough time to get in, wait for prices to go up — the rush delivered by a momentum-based market — and then sell, hoping all the time to take a profit. ARMs also lower origination costs: a great incentive for speculators.
  3. Home prices are unnaturally inflated. As more speculators enter the market to suck out their share of rising equities, they bid up property without any need to consider the fundamentals of real estate valuation, and over-inflation of housing prices ensues.

All of these conditions point to a most financially pernicious condition: the asset bubble. Thus, whenever ARM loans — sometimes referred to as zero-ability-to-pay (ZAP) loans — inconsistently rise in popularity compared to movement in the FRM rate (as indicated by an aberrant increase in the ATL ratio and a flat or dropping FRM rate),

This is a brilliant insight. ARMs equal instability. The more ARMs dominate the market, the more unstable that market is and the deeper the potential correction.

it should raise a massive red flag in the face of industry professionals. Such a rise in ARMs means that the Federal Reserve (the Fed) will soon need to slam on the brakes of the speeding real estate market before the new bubble implodes.

If only real estate professionals cared enough to send a warning. Few in the industry would argue against a bubble when so many are making so much from its inflation. Besides, as I can attest, any such warnings will be largely ignored anyway. People are going to do what they are going to do, often irrespective of the information made available to them.

The Fed accomplishes this primarily by raising short-term rates, which determine ARM origination costs and rates, and by raising reserve requirements for private banks to discourage lending in the overheating real estate market. The Fed’s measures, in turn, result in upward payment adjustments on ARMs that discourage new purchases and put current homeowners at risk of loss by sale or by foreclosure.

The advice below is some of the best I have come across. Do you think anyone in the real estate industry is actually telling thier customers stuff like this:

Knowledge brokers can use

The old joke in lending is that when a borrower opts for an ARM loan, lenders not only get an ARM off the borrower, but eventually his leg, as well. The industry has long been aware of what borrowers cannot seem to take to heart: ARMs are great only for the lenders who gladly take the fees and for speculators who don’t care about long-term ownership or market stability.

Agents need to counsel their buyers not to succumb to the toxic ARM. Brokers and agents who keep a close eye on the ATL will have the knowledge(and as fiduciaries, the duty) to provide the warning bells to their clients by supplying up-to-date information and their opinions about the potential direction of ARM rates and the prices of real estate.

As ARMs become more popular during this recovery, as they will, potential buyers will become more confident. Faced with these conditions, prospective homebuyers will find it increasingly difficult to compete with their ARM-using peers, and will opt to use ARMs once more in spite of the untenable risk they present.

This is my greatest concern with the way properties are being released. Everyone will end up in an ARM. If every new buyer is forced to stretch to the max in order to make up for the bad debts at the banks, everyone still ends up paying a huge loan ownership tax to the banks. I don’t feel like putting the maximum allowable DTI toward a house less comfortable than my rental for the privilege of paying huge interest payments in hopes of future appreciation. Forget it.

These buyers must be told that there is no wisdom in mortgaging their future financial solvency for what will amount to a short-term tenancy when they can no longer make mortgage payments on their ARM. The mistake of an ARM purchase will only be compounded by the fact the new owner has most likely paid too high a price, since ARMs are only useful when homes become unavailable at FRM rates.

The high purchase price, unfortunately, makes it impossible for the buyer to resell and recover any equity when things turn sour at the end of the virtuous cycle. Able, informed buyers drive speculators away, giving sellers a fair price for their properties and brokers and agents a stable income.