Jul152009

Should Adjustable-Rate Mortgages be Curtailed?

In 2004, Alan Greenspan, then the head of the Federal Reserve, had this to say, “Indeed, recent research within the Federal Reserve suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade.” Many people took this as a tacit endorsement of these loans by the head of the Federal Reserve.fool

The ignorance of Greenspan’s statement reveals a pathological mindset among policy makers in Washington; the people in charge genuinely believed the general population capable of managing their own financial risks — risks they often are not aware of and obviously do not understand. For evidence of this ignorance one has to look no further than the nationwide epidemic of foreclosures. Regulators took this same attitude toward major financial institutions. The resulting flaunting of risk is the direct cause of the severe economic recession we are now enduring.

When an entire population is encouraged to take tremendous risk, the resulting losses can be so large that neither the individuals nor the institutions that encouraged them can absorb the losses. The Government must step in as the counter-party who absorbs the losses others cannot; hence, you and I and everyone else is paying for the excesses of The Great Housing Bubble.

The government is going to tackle the issue of how much risk can financial institutions take on in upcoming policy and regulation debates. Today, I want to focus on whether or not people should be allowed to risk foreclosure with an adjustable-rate mortgage.

I am no longer the Reagan Era free-market capitalist I used to be. I am not alone in making this philosophical change. Privatizing profits is great, but the need to nationalize the losses reveals that free-market capitalism never really existed, and perhaps needs to be further regulated in order to protect the public interest.

Much of the risk sold into the mortgage market during the bubble has already blown up in the form of subprime loans. The worst loan program was commonly known as the two-twenty-eight (2/28), and it was given to subprime borrowers. It has a low fixed payment for the first two years, then the interest rate and payment would reset to a much higher value and recast to a fully amortized schedule for the remaining 28 years. Anecdotal evidence is that most of these borrowers were only qualified based on their ability to make the initial minimum payment (Credit Suisse, 2007). The demise of this loan has flattened the low end of the housing market.

All adjustable rate mortgages (ARMs) are risky because the payments can go higher thus increasing the likelihood of borrowers losing their homes. Interest-only ARMs are bad because they generally have a fixed payment for a short period followed by a rate and payment adjustment. This adjustment is almost always higher; sometimes, it is much higher. At the time of reset (or recast), if the borrower is unable to make the new payment (salary does not increase), or if the borrower is unable refinance the loan (home declines in value below the loan amount), the borrower will lose the home.   It is that simple. These risks are real, as many homeowners have already discovered.

Given the problems with ARMs, why do people use them? What is their incentive? When compared to fixed rate mortgages, people who use ARMs can finance greater sums and thereby outbid more conservative borrowers. This enables the reckless to outbid the responsible to obtain real estate. This is a powerful inducement to take on the risk of ARM loans; however, since borrowers have proven unwilling to accept the consequences of their risky behavior (foreclosure), it is legitimate to ask if this behavior should be permitted at all (Obviously, I don’t think it should be).

The problems with ARMs are many and obvious, but the overriding problems was the failure to qualify people based on the largest payment possible under the loan program. Let me explain.

Buried in the terms of your loan contact is the maximum interest rate you could be charged on the loan. Many people who signed up for 4% ARMs this year have a clause buried in their contract whereby the interest rate could increase by several percentage points during the life of the loan. Most people are qualified based on their ability to make the payment based on the initial rate period; if interest rates go up, or if there is an amortization recast, the loan blows up and the borrower loses the home.

Lenders are willing to loan people money on these terms because they believe (1) interest rates will not go up that much, or (2) people will either refinance into another ARM or (3) sell the home. As the Great Housing Bubble proved, those assumptions are erroneous.

All ARMs rely on the fact that lenders believe they have transferred the risk to some other party — either a borrower or an insurer. However, when too much risk has been concentrated on borrowers or insurers, they become unable to absorb the losses and the whole system becomes unstable.

The only way ARMs can be a stable lending vehicle is if the borrower is qualified based on the payment required with the largest combination of loan balance and interest rates allowable under the terms of the note. Anything less than that leaves a dead zone where borrwers can fall into the foreclosure abyss.

Dead Zone of ARM Interest Rates

ARM rates

 

If people were qualified based on the payment required at the contractual limit, ARMs would no longer be dangerous — and they would no longer be useful as an “affordablity” product. Lenders might be able to construct ARMs with low contractual limits to permit ARMs under certain circumstances, but they would no longer function as an affordability product, and borrwers would not have to choose between risking foreclosure or missing out on buying a property to the competition.

The beauty of fixed-rate mortgages is that borrowers can truly manage their payment risk. Since the payment is fixed, they know they can make the payment barring a job loss (which we have seen plenty of). An ARM provides no mechanism for the borrower to control their payment risk. If the terms of the note allow the interest rate charged to skyrocket, the borrower will surely default.

The scary part of this story is that we are still writing ARMs with unstable terms. We are still building this foreclosure tsunami of the future, and nobody seems to care because we are solving our immediate problems with excess foreclosures. Putting people into unstable loans just pushes the problem out a few years, but it does not solve it.

If we are lucky, this third wave of foreclosures will coincide with the upcoming wave caused by Option ARMs and interest-only ARMs given to Alt-A and Prime borrowers. If interest rates go up dramatically while that wave is cresting, we may flush all these bad loans out of the system once and for all… Perhaps I am too much of an optimist. Until we stop writing ARMs with unstable terms, the housing market will continue to be volatile and prone to bouts of numerous foreclosures.