This article analyzes the adverse economic effects of an improper increase in the popularity of adjustable rate mortgages (ARMs) during a recovering California real estate market.


A foreboding trend during recovery


The adjustable rate mortgage (ARM) is about to make a comeback, according to a recent study of lenders by the Federal Home Loan Mortgage Corporation (Freddie Mac). [To view complete survey results, see the Freddie Mac 27th annual ARM survey.]

The majority of 112 Freddie Mac lenders surveyed agreed ARMs are attracting homebuyers after a considerable dark period for the alternative (and generally deleterious) mortgage financing device. ARMs accounted for only 3% of all home loans in 2009 as homebuyers recoiled at their threat and jumbo loans were essentially unavailable. Yet, lenders and investors expect one out of every ten homebuyers seeking purchase-assist financing in 2011 will close using an ARM, the more volatile “black sheep” cousin of the fixed rate mortgage (FRM).

Considering ARMs are the only option for those purchasing homes financed with high-tier (read: jumbo loan amounts of $729,750 or higher) loans, one might infer that Freddie’s surveyed lenders are optimistic that the jumbo loan is returning. However, Freddie and the Federal National Home Mortgage Association (Fannie) do not fund or guarantee jumbo loans. While high-tier loans must be accounted for when discussing the prevalence of ARMs in the mortgage market, an increase in jumbo loans is a non-issue when determining the threats that ARMs pose to a recovering real estate market.

Jumbo loan ARMs are outside the ARMs-ratio problem for one reason: the (relatively) wealthy obtain ARMs to purchase high-tier housing. These buyers are typically well-educated and financially savvy. They are certainly not first-time homebuyers and, due to their generally higher skill level, they have sufficient accumulated wealth and income capacity to manage the vicissitudes that ARMs are famous for. In other words, the standard of living for those who qualify for jumbo loans will typically not be affected when ARMs once again go wild (read: the Fed raises short term rates). Thus, it is necessary to monitor ARM activity amongst the sectors of the home-buying public that are adversely affected by them: first-time, low- to mid-tier homebuyers and owners.

Given the fact the interest rate on 30-year FRMs is holding steady at around 5%, why would anyone financing a home for less than $729,750 rationally choose what became the riskiest mortgage on the market for long-term property ownership? As the more unstable version of ARMs that rose to ubiquity during the boom (namely the negatively amortizing option-ARMs) have effectively been regulated out of existence, public opinion of ARMs as inherently predatory, which they are, seems to be changing.

Why would anyone financing a home for less than $729,750 rationally choose what became the riskiest mortgage on the market?

The recovery of the ARMs’ once sullied reputation has to do with the now-popular and widely available 5-1 hybrid — the Canadian rollover of reset fame. The interest rate remains constant and not subject to change for the first five years of the loan, but may not be referred to as “fixed” for that period. Thereafter the interest rate (and thus monthly payments) adjusts annually. Interest rate volatility is ostensibly controlled by minimum floor and maximum ceiling limitations. [See first tuesday form 320-1]

It appears that as an increasing percentage of homebuyers is again overreaching to borrow greater amounts than the fundamentals of long-term homeownership suggests is prudent, the ARM is getting more attractive (read: low intro rates near 3%).

Risk for sale


As a matter of policy, first tuesday generally opposes the use of ARMs to finance ownership of a buyer’s residence, especially when the 30-year FRM interest rates remain at numerically historical lows. In the current mortgage market, little justification for ARMs exists except as a method for homebuyers to overreach when purchasing a home. Not including loans greater than $729,750 (jumbos), the only justification for borrowing on an ARM is to borrow more money than the far less financially risky (conventional) FRM will allow.

Buyers of single family residences (SFRs) are typically on fixed incomes and will not stay in the same home under the same financing for 30 years. However, on average they are likely to remain longer than five (as they are presently forced due to widespread illiquidity of real estate), and usually do not expect a dramatic increase in their income to cover the adjusted interest payments inevitable with an ARM.

Unfortunately, the standard sales technique of lenders (and untrained buyer’s agents) is to encourage homebuyers to borrow the maximum they qualify for at the time the loan is made. Few, if any, of the gatekeepers to California’s SFR real estate market actually inform their buyers about the level of risk which accompanies the benefits of borrowing more (or any) money by using an ARM. [For a detailed study of lenders’ interests versus owners, see the February 2011 first tuesday article, Lenders vs. owners and the real estate interest of each: 2000-2011 and beyond.]

When encouraging the use of an ARM, the limited focus for lenders and buyer’s agents alike is ensuring the loan payment is at 31% of an employed buyer’s monthly income, regardless of future rate indexing or changes in the payment. Notwithstanding new disclosure requirements for ARMs put in place by the Federal Reserve (the Fed), there still exists an asymmetry of information between homebuyers and lenders, especially regarding the risks of financing a home priced at less than $729,750. [For more information on the Fed’s regulation of ARM disclosures, see the February 2011 first tuesday article, The Fed flexes its ARM muscles.]

A bridge to nowhere

The ARM has its place in real estate transactions. That place is in the hands of seasoned real estate buyers — speculators, builders and other knowledgeable risk takers with capital to lose — who already have a detailed financial plan for maintaining ARM payments, selling the property before the adjustments become an issue or simply taking a loss and moving on.

The bigger picture of ARMs is their supporting role during an economic cycle in the real estate market — home sales volume and prices — as a “bridge loan.” In a marketplace with steadily increasing FRM interest rates and home prices, the ARM provides a means for buyers to finance a home they can no longer qualify to purchase if financed by a FRM at their increased current rates.

This temporary shift from FRM to ARM financing brings about an overall stabilization of home sales volume and pricing, satisfying the extant demand for housing via the ARM rather than through a reduction in prices by sellers in order to maintain sales volume. If an ARM is limited in its role to bridge this gap in loan amounts, then when interest rates for FRMs decline the ARM’s ratio of all mortgages will decline in turn. Ideally, those homebuyers who bridged the gap of homeownership in a bull market of momentum pricing and increasing FRM rates by using an ARM will refinance their home with an FRM when more favorable interest rates and lower monthly payments return. [For more information on current California home sales volume and prices, see the February 2011 first tuesday article, Buyer Purchasing Power.]

Thus, one sign of overall health in the real estate market, and thus the appropriate use of ARMs, is when the ratio of ARMs to all mortgages originated runs in tandem with the 30-year FRM interest rate. In other words, an increase in the ARMs ratio is economically sustainable when FRM interest rates and prices rise, thus necessitating a marketplace bridge to maintain home sales volume. [For more information on the ARMs ratio and its effect on the California real estate market, see the January 2011 first tuesday article, The iron grip of ARMs on California real estate.]

However, today in the early 2011 economic landscape of the California real estate market, prices are actually declining. Consequently, an increased demand for ARMs in a market environment such as the one we are presently experiencing signals the possible beginnings of the unsustainable excesses that occurred during the Millennium Boom — unless, of course, they are mostly jumbo loans.

Given that prices are slipping and FRM rates are nominally low, there is no need for the ARMs-bridge to homeownership of homes priced less than $729,750. When ARMs are used excessively, as seems to be the trend, home sales volume is artificially spurred, which will have a negative effect on prices in the long run if the Fed allows the trend to persist.

As more homebuyers use ARMs to finance homes they are not otherwise qualified to buy with FRMs, the housing supply will diminish, thus driving up prices. In the short view, this creates the illusion of a thriving real estate market, as occurred with the subsidies of 2010: sales volume goes up, prices increase. More importantly, ARMs allow lenders and real estate agents to increase their earnings during what should properly be a slump to clear out excessive pricing of the past — the magic worked by a recession.

Unfortunately, just as occurred with ARMs during the Millennium Boom, homebuyers using ARMs with today’s stable property prices and interest rates are buying a bridge to nowhere, and thus a crash — at least personally. Given the fact interest rates are slowly rising, and will continue to rise as the recovery grows legs, the ARM is providing entry for under-qualified homebuyers — tenants unprepared for ownership — in a market environment that will not allow them to refinance that ARM when rates rise.

Homebuyers using ARMs with today’s stable property prices and interest rates are buying a bridge to nowhere.

In five years, when all the hybrid ARMs made today inevitably adjust to match what will most certainly be short-term interest rates and thus unreachable monthly payments for too many, there will not likely be an FRM waiting around the corner with an interest rate lower than it is today.

Thus, as all have found to be axiomatic based on the experience of the recent past in the California real estate market, the number of ARMs originated today will increase the number of defaults we will see six years hence. [For a concise picture of Notices of Default (NODs) and Notices of Trustee’s Sale (NOTS) in the California real estate market, see the first tuesday article, NODs and trustee’s deeds: grim signs of real estate’s present condition.]

Why ARMs, why now?

Memory spans are short in the real estate market. As moviegoers watching a fantastical scene play out before their eyes, real estate professionals often employ a willful suspension of disbelief when it comes to issues they would rather ignore. Hopefully the better-educated, mindful and conscientious real estate agents and brokers operating among us in the new real estate paradigm will apply the benefit of their experience. Those that do will advise and thus remind their buyers and sellers of the ARM’s calamitous role in the not-so-distant past decade, and that the ARM’s inherent defects have not been eliminated but merely delayed by hybridizing.

Since FRM interest rates are low and slowly rising, thus signaling an urgency to obtain an FRM before long-term interest rates continue to increase further, the recent increase in ARM originations can only mean one thing: lenders, along with the complicit help of real estate agents and brokers, are resorting to the same flawed modus operandi that precipitated the mess we are now trying to clean up.

In the interest of increasing sales volume now, real estate professionals placing buyers in ARMs are taking the serious risk of losing sustainable sales volume increases in the future, an effect no different than the rise and fall in sales volume and prices following the 12 months of homebuyer subsidies that ended in April 2010. Since lenders will not modify their efforts and act in the best interest of buyers (they are not licensed to do so), and given the federal government is doing everything it can by way of increased disclosure regulations to openly present buyers with the hazards of ARMs and impose an outright ban on the most toxic ARMs, real estate agents and brokers have the duty to explain this ARMs phenomenon to their buyers and help to protect them — a duty they are licensed for.

The hard truth is this: in the current market, if a prospective homebuyer can only purchase a home by obtaining an ARM, they are likely unqualified to purchase the home — the jumbo crowd excluded. Once again, it seems we are qualifying the unqualified to make the real estate market appear move vigorous than it is. This overreaching leads to a dip in sales volume and then in prices, and a longer period of stagnation before the organic recovery truly begins.

Moving forward with the hard-won experience and vivid knowledge gained from the recent past, real estate agents and brokers must present a clear picture of the reality of ARMs for their buyers, lest we repeat the history we now so deeply bemoan.