Adjustable Rate Mortgage History
The Mission for the Savings and Loan Industry
After World War II, The Savings and Loan industry developed and became the primary source for residential mortgages. S & L’s had a wonderful mission–to provide low cost mortgages for home ownership. This they did very well. Low-cost home ownership in the 50’s and 60’s created and defined the enlarging American middle class. S & L’s functioned by taking in deposits from the local community and loaning out those deposits in the form of mortgages. Because of the S & L mission, capital reserve requirements and supervision was minimal. The last thing on which a member of the American middle class was going to default was his or her home. These were the safest investments imaginable. Prior to the 1970’s, the cost of funds remained stable and S & L’s prospered by lending out its deposits at rates slightly higher than what it had to pay its depositors. At that time, S & L’s held their mortgage loans until such time as they were paid off.
A Flaw in Their Plan
The basic S & L flaw was that while the investments were in long-term mortgages, the deposits were in short-term instruments. This was never much of a problem until inflation began to play an ominous role in the economy. Interest rates went from 8% in 1978 to 20+% in 1980. Because of this, the Savings and Loan found itself in the unenviable position of having to pay out more to attract depositors than it earned from interest received on its portfolio of fixed rate mortgages. In the early 1970s, some of the larger lenders in California introduced Adjustable Rate Mortgages (ARMs) and, by the early 1980’s, this concept in lending was expanded across the country to solve this imbalance, ensuring that mortgages held in portfolio would always earn the Savings and Loan enough to pay its depositors and net a profit. It should be noted that ARMs were designed by lenders to solve the lenders’ problems caused by inflation. This solution essentially transferred a sizeable portion of the risk related to inflation and increasing interest rates to homeowners. As a result, in the late 1970’s and early 1980’s, when inflation and interest rates grew to staggering levels, many saw their mortgage payments rise to levels they could no longer afford to pay.
Continued Development by the Mortgage Industry
In the 1980’s, the mortgage industry continued to develop as a result of the activities of government-sponsored enterprises that had been created to purchase blocks of residential home loans. Mortgage bankers began making fixed rate mortgage loans at very competitive prices. They could do this because the risk in holding the fixed rate loan was removed once the loan is sold to an agency such as Fannie Mae. A supply chain was created through a network of independent mortgage brokers that successfully satisfied the needs of consumers and the demands of the mortgage bankers.
Lenders continued to offer ARM products with added refinements, improved features and successfully designed loan plans that not only fit their needs for protection against wide swings in interest rate, but which also met the needs of home buyers.
The Appearance of Non-Traditional Mortgage Products
In recent years, there has been a development of new financial products, such as interest-only loans and other unconventional ARMS, aimed at increasing the amount of people that can afford a new home. Further, there was a dramatic decrease in the credit standards required to obtain a mortgage. Subprime loans and limited income verification loans flourished. These new mortgage products greatly expanded the ability for consumers to purchase homes and were a driving factor behind the recent housing bubble.
In 2003, the Federal Reserve initiated policies to combat the risk of deflation. As part of their policies, the Fed dramatically cut its federal-funds interest rate in order to temporarily encourage consumer spending and stimulate the housing market. The Fed did not begin to raise their key rate again for over a year. During this time, rates were so low that it was extremely easy for banks to market subprime mortgages with low introductory rates – of which the large majority were structured as ARMs with a two-year introductory fixed-rate period (2/28 ARM). Many of the new homeowners were not aware of or were not concerned with the fact that their rate, and house payment, could have a dramatic increase once their interest rate started to adjust. Many times, they were consulted that their loan was a “band-aid loan” and that they could refinance again once the fixed rate period ended and their interest rate was due to adjust. At the same time, many of these home owners experienced large gains in equity resulting from the hot housing market and were able to take cash out to pay off credit cards and make large item purchases. If they started to get in financial trouble, they were able to refinance again.
This resulted in low delinquency rates and low default rates. As such, the credit ratings for the bonds that were backed by these mortgages stayed low and attracted more Wall Street investors, including many from overseas. Now there was enormous demand for subprime loans from both consumers and Wall Street. In mid-2004, even when the Fed started to make moves to raise rates again to raise mortgage rates and slow the housing market, their actions were offset by the unforeseen flood of overseas capital that caused an abundance of liquidity in the mortgage secondary market. Further, Wall Street offered wholesale credit lines to numerous mortgage bankers who were no longer as reliant upon agencies with traditional underwriting guidelines, such as Fannie Mae, to purchase the bulk of the loans that they funded.
Over the next two years, the demand for mortgage-backed securities on Wall Street flourished and underwriting policies for mortgage loans continued to become dramatically more lenient. The market was flooded with subprime loans, interest-only ARMs and Option ARMs (loans that offered negative amortization features). All at once, credit guidelines loosened, down payment requirements virtually disappeared, asset seasoning requirements became very lax, and income verification requirements vanished. It should also be mentioned that underwriting guidelines were dramatically reduced for residential real estate investors as well. These factors created a huge demand for housing and fueled the market. Home values were boosted an average of 50%. ARMs accounted for millions of loans used by homeowners to purchase a home or to refinance an existing mortgage. In fact, it is estimated that 25% of all current mortgages were ARMs. Even though they were historically attractive only to homeowners planning to stay in their home for a short period of time, they were now being used by purchasers to qualify for larger loans than they could otherwise obtain.
Current Events
Since home values continued to soar, homeowners who were experiencing financial difficulties were generally able to refinance their way out of trouble. This changed in 2006 when home prices stopped rising in many areas in the United States and even fell in some regions. Some homeowners were caught without the option to refinance and were starting to fall behind on their mortgage payments. Throughout the year, the number of foreclosures increased and investors in securities backed by subprime mortgages began to grow leery. By 2007, the investors on Wall Street cut off their credit lines to mortgage lenders that were funding these poor performing ARMs and forced them to by back some of their loans. Many began to fail and declare bankruptcy. In April 2007, New Century Financial Corp. declared bankruptcy after having been the nation’s second largest subprime lender in 2006.
This set off a chain reaction and within four months, numerous lenders were either closed or seriously cut back their lending operations. By August, virtually all of the non-traditional ARMs that had been so popular in the years prior were gone. Large investors, both domestic and foreign felt the effects of their exposure to the risks associated with these mortgages and were no longer willing to buy them. As a result, the mortgage industry is facing a serious liquidity crisis.
Currently, Wall Street and the stock and credit markets are trying to maintain stability and investors are looking for signs of health in the economy.
The products offered by the mortgage industry have moved back to the traditional fixed rate products offered by government-sponsored enterprises and large deposit-holding banks that are regulated by the FDIC. In order to ensure their stability, many homeowners who are currently living in homes financed with ARMs are trying to refinance to fixed rate mortgages.
