Felix Salmon

On Friday I asked

why ARMs were so expensive. I got a few responses, but the best was from an

anonymous commenter on Seeking

Alpha, "User 122506". His or her comment is worth quoting in full:

It seems the lending markets have a reduced appetite ARMs right now, with

rates (@3-5 yr) within 1/4% or so of a 30 yr fixed rather than a more "normal"

0.75-0.875% below the fixed. The more "normal" pricing would reflect

the lower cost of funding the ARM off the nearer term yield curve (for say

3-5 year ARMS) versus the longer term cost of the 10 year Treasury (off of

which 30 yr mortgages are priced).

Nomenclature point of order: Properly speaking, those rates you quote aren’t

"teaser" rates; teasers are significantly lower rates for a short

period of time (like a 1% or 2% rate for the first 3 or 6 months) which then

reset to the fully indexed rate, or to an initial fixed rate for some additional

interim period. The rates you list are plain old "hybrid ARM" or

"initial fixed rate converting to floating" ARM rates.

Your friend should stay away LIBOR based ARMs. Most of the time, the typical

pricing (LIBOR+225bp vs. 1-yr Treas+275) is very close to the same rate when

you hit the adjustment. But about once or twice a decade when credit markets

blow up (like recently) the spread of LIBOR-to-Treasury widens substantially,

and if your adjustment happens to occur during such a period you can pay quite

a bit more than if you were tied to the Treasury. (Also, now that I look at

it I think that is what is wrong with your table, which I didn’t quite understand;

after a return to "normalcy" at some point that 323 will pull in

closer to 275).

The short answer, then, is that ARMs aren’t normally as expensive as this –

that right now we’re going through a bit of an aberration. This makes a certain

amount of sense, given that default rates on ARMs are, for various reasons,

significantly higher than default rates on fixed-rate loans. Of course, that

doesn’t mean that any given individual is more likely to default if they get

an ARM as opposed to a fixed-rate loan, but that doesn’t matter: if you’re shopping

for a mortgage today, you should get a fixed-rate loan in any event, not an

ARM.

Now, will there come a point when ARMs become attractive again? I don’t know

– that standard floating rate of Treasury + 275bp still looks expensive

to me. But they will surely become more attractive than they are now.

A friend of mine is shopping for a mortgage right now, and I just had a very

frustrating conversation with her mortgage broker. What I’d like to do is be

able to choose between a fixed-rate mortgage and an adjustable-rate mortgage.

If I take the adjustable-rate mortgage, I expect to pay a lower interest rate

in return for taking on interest-rate risk. But it seems that the only ARMs

on offer are all "teaser rate" products, where the mortgage resets

to a significantly higher spread once the initial teaser period is over. And

even the teaser rates, on closer examination, don’t look particularly attractive

compared to the fixed-rate mortgage on offer.

The broker offered three ARMs to my friend: a 7/1 ARM at 6%, a 5/1 ARM at 5.875%,

and (after I asked about it specifically) a 1/1 ARM at 5.75%. All three of them,

he said, reset to 225bp over one-year Libor at the end of the initial period.

The reason I asked about the 1/1 ARM, of course, was to get an idea of what

happens to the spread over Libor. At the moment, 1-year Libor is 4.47%, which

means that the 1/1 ARM starts off for the first year at 128bp over Libor, and

then jumps all the way up to 225bp over thereafter. If one-year interest rates

stay where they are, that means my friend will be paying interest of 6.72%.

Even the 30-year fixed-rate mortgage is much lower than that: just 6.125%. And

of course my friend would be paying well over 7% once one-year rates go above

4.75%, which is entirely possible.

The broker was quite clear that you should never buy an adjustable-rate mortgage

with an intial rate any longer than the amount of time you intend to own your

home. If you’re going to sell within five years, then get the 5/1 ARM: it’s

cheap money. But if you’re intending to stay in your house and pay off the mortgage

over time, then don’t even think about it: you’ll be killed once that adjustable

rate of 225bp over Libor kicks in.

Libor doesn’t go out beyond one year, but Treasury rates do; the one-year Treasury

trades today at 3.49%. So let’s look at spreads over Treasuries

as opposed to spreads over Libor: that way we can compare all the options on

a like-for-like basis. And let’s assume that 225bp over one-year Libor is the

same as 323bp over Treasuries.

This is just incredibly counterintuitive to me: the spread curve on mortgages

seems to be pretty steeply inverted. The more-floating and less-fixed the mortgage,

the higher the spread is – even before you take into account the seemingly-penal

interest rate once the initial period is over. Are these numbers remotely similar

to the ones that Alan Greenspan looked at when he famously said that adjustable-rate

mortgages made more sense than fixed-rate mortgages? How can it make sense for

adjustable-rate mortgages to reset to 323bp over Treasuries, while a 30-year

fixed-rate mortgage for the same borrower is quoted at 158.5bp over Treasuries?

Indeed, looking at this table, even the initial rates offered on the ARMs look

pretty underwhelming: they’re "teaser rates" only in comparison to

the really high rate charged after they reset. If anybody can provide

an explanation of what’s going on here, I would be extremely grateful, because

I can’t make heads nor tails of it. Why is it that a borrower pays more when

the borrower is taking interest-rate risk than when the lender takes interest-rate

risk?

Update: The fixed interest rate on a 15-year fixed

rate mortgage is 5.875% – the same as the teaser rate on the 5/1 ARM.