ARMageddon

(Title semi-stolen from the Option ARMageddon site, whose views I disclaim.)

Although precise causes of the current crisis are still a matter of some debate, it’s generally agreed that adjustable-rate mortgages (ARMs) played no small part in the housing bubble and its subsequent bursting. ARMs, once very rare, because very common during the bubble, especially for subprime borrowers.  Dean Baker notes that in 2004-2006 ARMs made up 35% of all new mortgages, up from single digit levels previously.   And quite a few (though not necessarily most) mortgage defaults occurred after the “teaser rate” period of these mortgages ended and the “resets,” or higher, market-based interest rates became effective.  Some of the mortgage holders could not make the higher monthly payments and thus defaulted.  (Others could afford the higher monthly payments but didn’t deem them worth paying, especially if they were “underwater” in the sense of their mortgage debt being larger than the resale value of their house.)

Today’s NYT column by University of Chicago behavioral economist Richard Thaler, titled “Mortgages Made Simpler,” got me thinking about this. Thaler laments the often bewildering complexity of many mortgages today, but casually dismisses the notion of requiring all mortgages to be simple fixed-rate mortgages.  A little too casually, I’d say.  He just says that complexity is necessary for “innovation,” without providing evidence that mortgage innovation has been helpful. Fellow Chicago economist Austan Goolsbee (drawing on an NBER working paper by Kristopher Gerardi, Paul Willen & Harvey Rosen), provided a fair bit in a March 2007 NYT op-ed, arguing that mortgage innovation has made many more mortgages possible, especially for younger, poorer, and minority applicants. The argument now looks rather dated in view of the tidal wave of subprime foreclosures, as well as the increasing realization that tying oneself down with a mortgage is not a great idea for everyone (e.g., people with low and variable income, people who might want to relocate soon, people who live in cities where rent is cheap relative to house prices — which was a lot of cities during the housing bubble). It also raises the question, Why can’t banks just issue fixed-rate mortgages with higher interest rates to their riskier customers?

Thaler says they shouldn’t have to, but that they should be required to offer every customer a fixed-rate mortgages as an option, alongside whatever complex mortgages they want to offer them.*  I call it the Baskin-Robbins approach:  31 flavors, many of them quite unusual, but always including vanilla, chocolate, and strawberry for those folks who don’t get out much. The plain-vanilla-mortgage option is a good idea, but it raises another question:  Why weren’t banks doing that all along?

One big reason is surely that interest rates, including regular mortgage rates, were at historic lows in the first half of this decade, when the bubble began.  Banks and other lenders did not want to be locked into receiving such low interest rates for the next 15 or 30 years, so they pushed ARMs.  Fed Chairman Greenspan’s crazy-ass claim that ARMs made sense for American consumers likely fueled this fire.  Even so, ever since ARMs began in the 1970s and 1980s as a response to volatile interest rates, it’s been well known that ARMs transfer risk from the bank to the borrower.  Which makes them a dicey deal for all but the richest borrowers (who don’t actually need the loan but might want it to get the mortgage interest deduction on their taxes and can afford the risk of higher interest payments) and clairvoyants who know what interest rates are going to do in the next 15 or 30 years.  So why why why did so many people enter into ARMs?

My hunch is that ARMs were a form of predatory lending in many, perhaps most cases.  Banks seem to have actively pushed ARMs on many borrowers.  (A former student of mine told me that a bank actually pulled a bait and switch on her and her husband, substituting an ARM for a fixed-rate loan at the last minute. I suspect there are many other such cases.)  Others who would steer clear of the mortgage market because they know they can’t afford a particular fixed monthly payment might be suckered in with a low enough teaser rate and unctuous assurances that interest rates will still be low at the end of the teaser period or that they’ll have no trouble refinancing at a lower rate. This seems to me an area that needs more investigation.

This predation story is consistent with the behavior of mortgage brokers, whose incentive was to reel in as many mortgage loans as possible and hand them over to the bank and collect their commissions, without regard to whether the loans would be repaid. The teaser rates were probably a very successful way to reel in risky borrowers who knew they couldn’t make regular payments at market interest rates.  The story is also consistent with the securitization process, by which banks and other lenders quickly sold off their subprime mortgages to securities firms who repackaged them to various investors. Those investors wanted securities with a high return and low risk.  The higher, post-reset interest rates meant a high return to come, and the bogus AAA ratings that the rating agencies gave the securities made them appear to be low risk.

* The fixed-rate option is actually part of the Obama Administration’s proposed new financial regulations, which is not surprising considering that (1) Thaler is an occasional adviser to Obama; (2) a similar plan appears in Thaler’s book with Cass Sunstein, Nudge: Improving Decisions About Health, Wealth, and Happiness; (3) Sunstein is Obama’s nominee for “regulatory czar,” i.e., head of the new Office of Information and Regulatory Affairs.

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2 Responses to “ARMageddon”

  1. democommie Says:

    Every lender I talked to in the last several years was pushing ARM’s and seemed offended when I asked them why I would want to bet on the market going down.

  2. Ranjit Says:

    Well all right – now I have two data points!

    I really hope someone’s doing a study on this – interviewing people on both sides of the mortgage market to find out just why so many ARMs were being issued. I expect the dominant pattern was of lenders pushing ARMs. Then the question is who pushed them to push ARMs, and why?

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