ARM Revival

Diana Olick notes that borrowers seem to be turning to ARMs as interest rates move up.

After hovering around record lows for the past few years, mortgage rates are rising dramatically. That has consumers not only shopping more but also considering adjustable rate mortgages, which offer lower rates and lower monthly payments.

Unfortunately she only provides anecdotal evidence, so it’s not clear if this is a stampede or simply the actions of a few badly misguided or misinformed buyers. To the extent it’s valid, it’s tragic.

It’s pretty obvious with the advantage of hindsight that ARMs were a great way to finance a house over the past 25 years or so. Effectively, a borrower with an ARM was able to participate in what may have been the greatest bull market in government securities ever seen. A run which by definition has to have come to an end. Interest rates have reached a practical low limit and have no option but to increase. Anyone who opts for an ARM is now indisputably on the wrong side of the trade. They can’t win.

Which leads to the obvious question, “What are these people thinking?” Theoretically in our new world post the Consumer Financial Protection Bureau all the risks inherent in ARMs are fully transparent to the borrower. In fact, their new Truth In Lending Disclosure Statement is fairly easy to read and explicit about the downside. Of course, it says nothing about the probability of the adverse scenario occurring, admittedly a disclosure which would require a crystal ball, so the prospective borrower is left to discern the risk himself. Since our poor waif’s eyes most likely gloss over at the mere mention of the inverse relationship of bond rates and prices, the likelihood that he can make any sort of reasoned decision is quite close to nil.

In a perfect world our borrower’s advisors, real estate agent/mortgage lender, would offer the advice that the ARM he’s considering has a real strong probability of adjusting to his detriment. To state the obvious, we don’t live in that sort of a world, which leaves us with two options. One, we could simply outlaw ARMs or at least those that don’t provide some protection against rising rates for some extended period of time. I’m thinking 5 years or thereabouts.  Two, we can just accept the fact that a certain portion of the population is going to make bad choices possibly abetted by some less than scrupulous parties.

I guess my libertarian instincts lead me to opt for the second track. There are inevitably some buyers for whom an ARM makes sense and who know what they’re signing up for. I don’t see why they should be denied the option. If that means that 100 percent of prospective borrowers don’t end up with the wrong mortgage product, well there’s a price for everything. It would be nice though if somehow, somewhere along the line someone would do the right thing and let the naive know they’re doing something really stupid if they opt for an ARM.

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