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Minyan Mailbag: ARMs and Reduced Volatility

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A fixed mortgage is long an option: the borrower can refinance.

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Prof. Succo,

It has always nagged at me to understand what Greenspan's motives might have been when he issued the "educational" oratory on how much better off consumers would be with adjustable rate mortgages. At the same time that I was screaming at my clients to lock in the low fixed rates...it just dawned on me (BGO-Blinding Glimpse of the Obvious) that encouraging consumers to use ARMs gives the Fed another tool in their toolbox. It imposes risk on the consumer, but since the Fed controls the short end of the curve, they can withdraw liquidity through rising mortgage payments but can also more directly inject liquidity back into the economy by lowering the short term rates that ARMs are linked to. (Without the possibility of a 1990 repeat of lowering rates, but the banks milking the treasury spread and rate cuts therefore very sluggishly working their way into the economy.)

I'm not implying that it's good, or that it will fix the problems that the US faces. I'm just waking up to a reasonable explanation of one piece of the puzzle that has been nagging at me for some time.

For what it's worth,
Minyan Jeff

MJ,

I wrote about this.

In wanting liquidity to go up, another way to accomplish that is to get volatility to go down. Please refer to the article I wrote on Value At Risk (VAR): which is the process of declining volatility encourages people to take risk, which drives volatility even lower. It is a self reinforcing process until it reverts the other way. As people take more risk, liquidity increases and volatility drops. So getting volatility to drop increases liquidity.

The Fed knows this and it is why Greenspan made that speech: to get people to use ARMs and reduce volatility in bonds.

A fixed mortgage is long an option: the borrower can refinance. This is a very valuable option and comes cheap to the borrower. The bank who issues the mortgage is short that option. I have described FNM as short convexity and rehedging in the bond market for this reason. There were so many fixed mortgages that the liquidity in the bond market could not handle this short convexity and volatility was high.

Greenspan crushed volatility in the bond market by getting people to be short that option through ARMs rather than long the option through fixed mortgages.

A long long of what you described.
Position in FNM

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