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Minyan Mailbag: ARMs


Tommy John!


Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next column with that very intent.


Just as every CFO who faces a capital allocation decision engages in a 'build or buy' sensitivity analysis, a homebuyer who needs to finance the purchase of a home faces a similar quandry.

Once s/he gets over the 'buy or rent' equation (and make no mistake about it, we all rent. We either rent shelter (apartment) from a landlord or money (mortgage) from a bank) all that is left is the financing decision.

I'm very glad
you used the example of the a 5/1 loan because that is overwhelmingly the most popular ARM product. Unfortunately, when many alarmists hear ARM they assume a one month or one year adjustable and then write gloom and doom articles. They exist of course, but only on the margin. Back to your example. You omitted the most crucial fact of all, namely what 30-yr fixed alternative did the buyer face when she chose the 6% 5/1 ARM? Because, in your example, if the 30-yr is above 6.25% the borrower is better off after six years taking the 5/1, even with they rise in year six to 7.5%.

If more likely, the 30 yr. is 6.5% it will take until year 9 for the ARM to be a worse decision assuming the 7.5% rate is in effect in years 6-9.

Finally, Scott, I ask you this: How long do you think the buyer will be in the house? (Ask yourself, or any of the Minyanville professors, how many residences they've lived in for the last decade.) If the answer is less than 5 years, which is the most probable answer, a buyer would quite possibly be irrational in not choosing a 5/1. (Remember, the Minyanville professors have never been shy about taking FNM to task for mismatching the duration of its assets and liabilities. That is exactly the error a buyer would be making in assuming 30 year debt vs. a 5 year asset.)

N.B. I haven't even mentioned how much better off the ARM buyer is if rates drop in five years.

I welcome, nay hope, this letter is printed in the Minyan Mailbag as far too many people are writing alarmist stories about ARMs without considering the actual financing decision a buyer makes.

Minyan Joe


First, thanks for taking the time to compose a thoughtful response. I've got nothing to prove and the MV community was built as an interactive community, so I welcome your observations.

I think you might be presuming that I am against ARMs or, for that matter, any engineered financial product or (I hope not) that I am against the use of these products by laymen. Let me state at the outset that I am not. I think ARMs and all of the other complex financial products that are now available to a wide variety of consumers are a good thing on net. They represent progress of a sort. An essential progress.

I can't argue with your figures; there are situations in which ARMs make far more sense and are thus rational choices for consumers of housing. Down payment, expected time horizon, current income, current interest rates and expectations for same: there are a large body of variables that individuals must take into account. In fact, that ARMs have grown so much speaks at least in part to the fact that they meet a previously unmet demand from consumers.

That said, one must question the extraordinary rise in the appetite for these products. After all, no one on the planet would say that consumers shouldn't have access to stocks as a vehicle for capital allocation. But if consumers started to buy stocks en masse where they did not before, it would be prudent to at least explore the potential ramifications of that group action. To this end, we must try also to determine the context in which this demand is manifesting itself. Housing prices are substantially above trend (by 1-3 standard deviations depending on the market), personal incomes are falling at a 14 year record, and employment is substantially below every post-WW II cycle recovery. Thus it would be reasonable to assume that the primary driving factors behind ARM growth are (1) immediate affordability concerns (minimizing the monthly payment) and (2) some degree of home speculation. Given the increase in share that ARMs command, it is not unreasonable to conclude, within the contextual reasons (#1, and #2) above, that buyers might be underestimating the interest rate risk (if they even understand it - these products are sold with aggressive tactics) implicit in this product.

All of this of course ignores the costs and benefits to the mortgage industry, to the housing stock, and to the financial intermediaries that end up owning these mortgage pools. No matter what happens to long term rates (and I actually believe that rates could fall a long way like Japan's have when they experienced an asset deflation), the point of my piece was simply to highlight how sensitive these products are to changes in the environment in which they were written. Some consumers will gladly, owing to their individual time preferences and capital stock, take the implied or perceived risks in these instruments. Some will not. That so many are now doing so makes it axiomatic that there are buyers that don't understand the dynamics that you or I banter about now.

Thanks to you and I, at least Minyans won't be among them.



It's about a month late but welcome to Minyanville.

I just read your Buzz posting to Scott and as a result I wanted to forward to you for your comment, the e-mail I just sent him (see above).

I more than welcome your thoughts.

Minyan Joe


Thanks for your comments. I am approaching it from a different perspective. It is not about what is better an ARM vs. a fixed loan. It is about the impact that rising interest rates will have on the consumer. I know a lot of people that bought a house and chose an ARM (or an interest only loan) because they could not afford a house otherwise. That is what worries me.

Your point is well taken, and I think Mr. Greenspan made a similar comment about ARMs awhile ago. Anyway you look at it, we are in a very low interest environment; rates are likely to rise, not to fall. I have no idea when they'll rise. Though ARMs may make sense for some consumers, no argument on that, but ARM loans that are chosen only because of their short-term affordability is definitely a big negative for the economy and consumers.


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