What Happened to ARMs? (Adjustable Rate Mortgages)

For many of us, if you joined the business post 2008, you may have heard of, but likely rarely ever saw, an ARM. An ARM is an "adjustable rate mortgage". Compare this to the ubiquitous Fixed mortgage and you are likely already understanding the difference. Thankfully, the names of these products are intuitive so a Fixed means the rate you get is fixed for the term of the loan and an ARM means, for at least a portion of the term, the rate will adjust.

ARMs are more difficult to understand for several reasons.

1) Compliance rules post financial crisis (GFC) make qualifying for an ARM loan confusing and onerous. The borrower's DTI must be calculated off the greater of the start rate or "fully indexed rate" (ARM Margin + Index value), some ARM products require it to be the start rate + a fixed number (depending on the length of the fixed period of the ARM), etc.

2) The Government is trying/did do away with LIBOR and introduced something called SOFR. This is another example of the Government finding a problem where one did not exist and destroying one of the best indices ever created. So now you have to learn about a new index, which doesn't make nearly the same amount of sense as LIBOR, and it now resets twice a year instead of once which adds to confusion

3) Fannie & Freddie have never been competitive on ARM loans (because the FED doesn't buy them). Banks were/are the natural buyer of ARMs but post GFC and Dodd-Frank (more regulations) have caused banks to steer away from mortgage lending (thus the rise in the "non-bank" originators). So you might find your bank has some great ARM products for rich people, but the average joe doesn't have the same access.

There are plenty more reasons, but we'll stop at those three. From there we need to understand why ARMs are particularly unhelpful in this type of yield environment. Right now we have something called an "inverted yield curve". What that means is that short term interest rates are HIGHER than longer term interest rates. This is abnormal and is generally considered to be a "bad sign" for the economy.

Above is a picture of the Yield Curve. It starts on the left with 1M (one month) and goes to 2Y (two year), 10Y (10 year), etc.

Normally, when interest rates are "high" the yield curve is positively sloped so 2Y is lower than 5Y is lower than 10Y and so on. However, as you can see above, in todays environment the 2Y is 4.204% and the 10Y is 3.778%. This is called "inverted" and its inverted by about 40 bps.

The above chart shows the last few years (10Y - 2Y). As you can see the historical mean has been 50 bps (as in 10 Y is 50 bps higher than 2Y), but today its near -40 (inverted).

Why am I boring you with this? Because ARMs are "fixed" for a period and then "float" after that period. So a 5/1 LIBOR ARM is fixed for 5 years and resets off LIBOR every 1 year after the 5 year fixed period at the index (LIBOR) + a margin. (Today the index is SOFR and it would be something like a 5/6mo SOFR ARM). The main point is that the 5 year fixed period "prices" off the 5Y part of the curve above, a 3/1 ARM off the 3Y part, etc. This is a bit oversimplified, but the general point is accurate. In today's interest rate environment, short interest rates are HIGHER than longer interest rates so ARM loans (unless a bank is giving you a deal for your deposits) are generally higher in rate than their fixed 30 year counterpart. Yes, by taking the "interest rate risk" (getting an ARM), you might actually be paying a higher rate to start than if you got a fixed loan.

The second problem with ARMs is that the target buyer of an ARM generally doesn't pay much of any "premium". Post Fed involvement in the mortgage market (QE), borrowers were conditioned to take slightly higher rates for paying "nothing" to get a loan. On an ARM almost everyone is charged points.

In conclusion, when interest rates are higher in the short tenors vs long (inverted yield curve), ARM loans are higher in rate than FIXED (generally). In order to get into an ARM loan you have to pay more points than a Fixed loan (generally), which makes refinancing later more expensive (breakeven analysis). Thus, unless a borrower is very confident interest rates will be dropping significantly (and the curve steepening dramatically, we call this a "bull-steepener") and they time the reset perfectly, most borrowers are much better off getting a 30 year fixed and simply waiting until rates drop to refinance. And if interest rates end up rising? Well at least their loan wont reset to even higher rates (potentially).

In the end, the "problem" with the USA mortgage market is that it pushed banks out (via regulation after the GFC), but it wants to maintain a 30 year fixed product (we're basically the only country that does this). Now that the Fed is no longer buying mortgages, and Fannie/Freddie are in conservatorship, it remains to be seen how we can have both "ineffective" ARM rates AND 30 year fixed rates if no one is going to be around to subsidize those rates. I have a potential solution: Insurance Companies. Stay tuned for my next article.