Adjustable-rate mortgages enabled banks to hedge against inflation while offering borrowers low initial interest rates.
Adjustable-rate mortgages (ARMs) are loans for which the mortgage rate fluctuates along with the market interest rate. This type of mortgage instrument is an alternative to the traditional fixed-rate mortgage (FRM). The interest rate on an ARM usually is tied to a reference interest rate. ARM contracts include several other stipulations, including the frequency of interest rate changes, the maximum permissible change in monthly payments, and the low initial rate. ARMs are also referred to as variable-rate mortgages.
ARMs were introduced in California as early as 1975. Four years later, the Federal Home Loan Bank Board
One way to simplify discussion of ARMs is to think of them as series of short-term mortgages, each with a maturity equal to the length of the adjustment period. The interest rate at a given time is the sum of two elements: an index of market interest rates and a fixed margin. A borrower’s monthly payments therefore would change as a result of fluctuations in the interest rate index. The two most popular market indexes are the interest rate on one-year Treasury bills and the Eleventh District Cost of Funds. The latter is a weighted average of interest rates on deposits for S&Ls located in California, Arizona, and Nevada. Despite being specific to only one region, over time this index has mirrored the national average of interest rates on deposits. Each ARM is matched with an index of corresponding maturity. For example, a six-month ARM (one with interest rate adjustments every six months) is pegged to the interest rate on Treasury bills with a maturity of six months, a one-year ARM to the rate on Treasury bills maturing in one year, and so on.
The most popular is the one-year ARM. The shorter the adjustment period, the more frequent the fluctuations in monthly payments, with ARMs having longer adjustment periods resembling fixed-rate mortgages. An adjustment takes place following a change in the ARM interest rate index. The most common way to adjust the monthly payments is by an amount proportional to the change in the index.
In order to limit the increase in monthly payments, ARMs are subject to periodic caps and lifetime caps. Periodic caps limit the amount that the interest rate can increase or decrease at each adjustment. The periodic caps vary with the frequency of the adjustment periods. A typical periodic cap on a one-year ARM is 2 percent.
Lifetime caps and floors limit the range of change in the interest rate over the entire course of the loan. The lifetime cap is expressed as a change from the mortgage’s initial rate. A typical lifetime cap or floor is 5 percent. For example, if a one-year ARM has an initial rate of 8 percent, a periodic cap of 2 percent, and a lifetime cap of 5 percent, then the interest rate will be between 6 and 10 percent in the second year and will never fall below 3 percent or rise above 13 percent.
To make ARMs more appealing than fixed-rate mortgages, lenders often offer initial rates that are lower than the prevailing market mortgage rate. These are called teaser rates and are temporary. At the first adjustment, the teaser rate is replaced by the market interest rate index plus the margin. There is no general rule for how attractive teaser rates should be. Generally, teasers vary inversely with the loan origination fees, commonly called points. Lenders vary in the points charged to borrowers. The higher the points, the more attractive the teaser rate is likely to be. Borrowers have to look for the best combination of interest rates and fees.
Although ARMs provide several benefits to borrowers, including low initial rates and the ability to benefit from falling interest rates without refinancing, their features are complex and can hide surprises. For example, a mere 2 percent increase in interest rates could raise monthly payments by 25 percent under reasonably likely conditions. This can occur because the first few payments on a loan are almost entirely interest payments, with little payment of principal. A rise of 2 percent in the interest rate with an initial rate of 8 percent thus would cause payments to rise by about 25 percent. The borrower’s ability to pay may not increase by the same proportion. For example, interest rates may rise in response to expected inflation that has not yet caused higher wages.
Another disadvantage with ARMs is that although their initial rate is tempting, borrowers have a difficult time comparing them with their FRM counterparts. Because the value of an ARM changes frequently with market interest rates, a borrower is forced to guess the future trend in mortgage rates before making a choice between an ARM and an FRM. As a result, borrowers often select an FRM because they know that the monthly payment will never change.
The core business of savings and loan associations is the issuance of home mortgages. S&Ls raise funds by offering their customers checkable and time deposits. Traditionally, most of their assets consisted of fixed-rate thirty-year mortgages, whereas their liabilities were typically short-term certificates of deposit with a maximum maturity of five years.
Because of the nature of their business, raising funds short-term and lending long-term, S&Ls are particularly vulnerable to interest rate risk. For example, if market interest rates rise, S&Ls would be forced to raise deposits on the open market by paying high deposit rates while earnings from fixed-rate mortgages remained stagnant. Falling interest rates benefited S&Ls, but borrowers had the option of paying back their mortgages and refinancing at lower rates.
Interest rate risk posed only small problems as long as rates were relatively stable. The period from 1976 through 1982, however, was marked by the most volatile interest rates in modern U.S. economic history. FRM rates rose sharply from 9 percent in 1976 to 16 percent in 1982, driving many S&Ls out of business. This increase was a result in part of tight monetary policy pursued by the Federal Reserve system in a long effort to fight inflation. The crucial role of ARMs during that period was their fundamental feature of shifting interest rate risk to borrowers. On the traditional fixed-rate mortgages, the lender bore the entire risk from interest rate increases.
After 1982, a combination of volatile interest rates, a deregulatory political environment, and widespread mismanagement compounded the problems of S&Ls. By 1989, the S&L industry required a $150 billion rescue plan. The 1989 bailout legislation, known as the Financial Institutions Rescue, Recovery, and Enforcement Act
Perhaps the major shortcoming of FIRREA is that it failed to address the gap in maturity between S&L assets (mortgages) and liabilities (deposits). That gap was at the root of the interest-rate risk that resulted in disaster. The problems of the S&Ls could have been alleviated by avoiding FRMs and issuing primarily ARMs. S&Ls, however, use their fixed-rate mortgages to speculate on the future course of interest rates. If interest rates are expected to fall, S&Ls will issue fixed-rate rather than variable-rate mortgages, hoping to lock in the currently high rates. S&Ls did not want to give up an instrument that enabled them to bet on the trend of future rates, with enormous rewards for correct predictions. It is the riskiness of long-term mortgages that makes them unsuitable for thrift institutions, which ideally should be averse to risk. Although the odds of an interest rate increase or decline are equal on average, their impact on thrifts is asymmetric because borrowers have the option to refinance their mortgages when rates fall.
A fundamental difficulty in evaluating mortgages lies in the prepayment option that a borrower can exercise and how it is affected by changes in interest rates. When interest rates go down, borrowers rush to refinance their existing mortgages at lower rates in order to reduce their monthly payments. This poses a problem for the S&L lender, because it causes an early redemption of principal that will have to be reinvested at a lower market interest rate. Conversely, when rates increase, borrowers delay prepayment. This often takes the form of continuing to live in a current home rather than selling, prepaying the mortgage, and getting a new mortgage on a new home. For example, a borrower would take into consideration the cost of giving up a below-market mortgage at 8 percent on a current home and getting a new one at 12 percent on a new house. At the same time, a rise in interest rates reduces S&L profits because existing assets are earning a below-market rate of return.
Mortgage refinancing on ARMs is less significant than on fixed-rate counterparts primarily because an ARM’s interest rate mimics the movement in the market interest rate. That is not to say that ARMs are immune from prepayment. Borrowers often prepay on existing ARMs in order to substitute others at lower initial rates.
Soon after they were introduced, ARMs accounted for 40 percent of all mortgage originations. In 1984, more than 65 percent of all new residential mortgages issued by S&Ls were ARMs. By mid-1987, however, as interest rates started to decline, many S&Ls returned to FRM lending, and the share of ARMs fell. The mortgage expansion during that period triggered by a strong housing sector led to a large increase in the dollar amount of ARMs in lenders’ portfolios. By 1992, the share of ARMs had stabilized at about 25 percent. As both the level and volatility of mortgage interest rates declined, FRMs regained their lost appeal. However, during the early twenty-first century, when a housing boom corresponded with historically low interest rates, ARMs still proved popular ways for home buyers to buy more expensive houses.
It is unclear how the real estate market would be affected if S&Ls stopped issuing FRMs altogether. Most economists argue that the impact on housing demand would be minimal, primarily because ARMs are subject to restrictions on how much their monthly payments can adjust in a given year. An analysis of the period preceding the introduction of ARMs shows that housing starts were significantly inversely related to mortgage rates: The higher the mortgage rates, the smaller the volume of housing starts. After 1982, this relationship became weaker as a result of the ARMs’ low initial interest rates. Despite high mortgage rates during that period, housing starts were brisk as home buyers switched to the cheaper ARMs. After 1986, the relationship between housing starts and FRM interest rates was much weaker, since borrowers could choose low initial rates through ARMs. When rates began to drop after 1989, home buyers switched back to FRMs to lock in low rates.
It thus appears that ARMs ease the impact of high mortgage rates on the housing sector and complement the role of FRMs in mortgage lending. Equally important is the growth in housing caused by the introduction of ARMs. Because of the low initial rates of ARMs, home owners unable to qualify under the guidelines of FRMs may very well be able to qualify for ARMs with lower initial monthly payments. This important feature made housing affordable to a larger share of the population, as evidenced by the explosive growth in housing sales from 1982 to 1984. Housing starts grew by almost 85 percent during that period. The introduction of ARMs made the housing sector more resilient to economic slowdowns and less sensitive to changes in interest rates.
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Jaffee, Dwight M. Money, Banking, and Credit. New York: Worth, 1989. An intermediate text in money and banking. Well written by a distinguished professor of economics. Using simple examples, the author discusses how ARMs can reduce interest-rate risk. -
Kamerschen, David R. Money and Banking. 10th ed. Cincinnati: South-Western, 1992. A standard textbook in money and banking. Accessible to the beginning reader. -
Mayer, Thomas, James S. Duesenberry, and Robert Z. Aliber. Money, Banking, and the Economy. 6th ed. New York: W. W. Norton, 1996. Includes material on the relationship between ARMs and the S&L crisis. Easy to read. -
Mishkin, Frederic S. The Economics of Money, Banking, and Financial Markets. 7th ed. Boston: Pearson Education, 2004. Economics explained for the layperson. An excellent introductory text. -
Smith, Gary. Money, Banking, and Financial Intermediation. Lexington, Mass.: D.C. Heath, 1991. Primer provides helpful examples showing how changes in interest rates affect a home owner’s monthly payments. Also presents a simple discussion of loan eligibility criteria. -
White, Lawrence J. The S&L Debacle: Public Policy Lessons for Bank and Thrift Regulation. New York: Oxford University Press, 1991. Written for a nonacademic audience. Traces the origins of the S&L crisis to the fixed-rate mortgage instrument. Detailed discussion of events preceding and following introduction of ARMs.
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