Maybe Adjustable-Rate Mortgages Aren't So Bad After All?

Misconception debunked: these seemingly risky loans did not cause the foreclosure crisis

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Of the robust cast of often-cited villains in the financial crisis, few have become as hated as the adjustable-rate mortgage. One of the chief rallying cries of housing finance reform opponents has become, "Remember the 30-year, fixed-rate mortgage!" They say it will disappear without a government backstop for mortgages and point to the horror that the homeowners will face if forced to rely on those dastardly ARMs. We can't be sure how ending federal guarantees would affect fixed-rate mortgages, but we do know one thing: ARMs didn't cause the housing market's current problems.

A Senate Banking Committee meeting on Thursday explored the future of the 30-year fixed-rate mortgage. And you can't really avoid discussing the fixed-rate mortgage without also discussing the other option: the adjustable-rate mortgage. While a couple of the panelists provided pretty interesting testimony, the most fascinating came from Paul Willen, Senior Economist and Policy Advisor at the Federal Reserve Bank of Boston.

He exposed a common misconception about the 30-year, fixed-rate mortgage: it was not an invention of the Federal Housing Authority in the 1930s. In fact, 40% of residential lending during the Great Depression was accounted for by long-term, fixed-rate, fully-amortizing loans from building and loan societies. In other words, this home financing option was possible even before the government stepped in to back mortgages after the Great Depression.

His debunking didn't stop there. He also revealed that adjustable-rate mortgages played little role in creating the foreclosure crisis. For starters, his research shows that 60% of the loans that foreclosed due to delinquency were fixed-rate mortgages. But even more importantly, of those other 40% of loans that were adjustable-rate mortgages, 88% -- the vast, vast majority -- defaulted when payments due were at or below the borrower's initial payment amount. A little math shows that adjustable-rate payment shock was responsible for less than 5% of mortgages that were foreclosed due to delinquency.

Here's Willen's data:

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These are important points. First, we learn that most loans that went bad when the bubble popped were not ARMs. Second, of that minority of ARMs, most went bad for reasons other than their payment structure. ARMs did become more popular than the bubble, but the relationship between these loans and rising foreclosures is mere correlation, not causation.

Now there may still be other reasons why Americans prefer fixed rate mortgages to ARMs, even if they didn't cause the collapse of the housing market. A common rationale for consumers choosing fixed-rate mortgages over ARMs is the interest rate stability they provide. But another panelist, George Mason School of Management Finance Professor Anthony Sanders, pointed out that they're paying a premium for that stability. Lenders will price the interest rate risk they're taking into fixed rate mortgages. Consumers are paying a premium for a product that carries significant interest rate risk for its originator.

Despite such arguments in favor of adjustable-rate mortgages, we shouldn't expect them to become widely popular anytime soon. Americans' love affair with the fixed-rate mortgage is very strong. Consumers adore the product, so banks will have to continue to find ways to make them profitable, probably with continued government guarantees that put taxpayers at risk.

Image Credit: Reuters/Carlos Barria