Abstract
The mortgage market has given rise to a changing and diverse set of borrowers actively using ARMs. Data from the Panel Study of Income Dynamics (PSID) for 2007 and 2013–2015 are used to study borrowing decisions. One view is that an ARM should be offered and taken by those better able to respond to an upward reset. Yet favorable economic conditions induce a demand for mortgages, including by higher risk borrowers, and for these households transactions occur at higher rates, often as ARMs, especially as of 2007. Panel analysis confirms some response to the spread but also to changing demand for mortgages in the shorter run. During the boom, the use of ARMs as a tool for ‘affordability’ led to actual transaction rates exceeding those for fixed rate mortgages. Analysis confirms substantial payment difficulties. Yet, analysis of mortgage transitions, 2007–13, establishes that the ‘affordability’ component to ARM, though less significant, still was present. ARMs were often taken by minorities and those with less education and with family income under $60,000 per year.
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Notes
In Australia the ARM rate is set and reset directly by the ‘cash rate’ of the Reserve Bank.
The expected change in prices during the next five years as reported in the University of Michigan Survey of Consumer Attitudes fell from 10% in 1980 and remained between 4 and 5% all the way until 1991. Since 2009 the expected rate of inflation has been 3% or lower.
One analysis suggests that the shift to ARMs in 1980’s can be explained primarily by the rate differential rather than compositional responses on the supply side. See Brueckner and Follain 1988.
Michelle Clark Neely, “Homebuyers Bear ARMs in the Mortgage Market,” Federal Reserve Bank of St. Louis, January, 1995, The Regional Economist, January, 1995 p. 12–13.
In the securitization a central theme is the level of integrity with which the underlying loans are characterized.
It has been argued that the precipitating factor for the housing downdraft was the bankruptcy reforms of 2005, which made foreclosure relatively attractive (Morgan et al. 2011)
According to a study for the Wall Street Journal, 31% of mortgages in the range of $417,001 - $1000,000 originated in the fourth quarter of 2013 were ARMs. In contrast, the average fixed rate mortgage was about $200,000.
This raises the question of how the funds distributed from these large mortgages at low rates end up being allocated. Is it consumption or the acquisition of public or private equity?
As argued by Bhardwaj and Sengupta (2012), an implicit feature of a high rate ARM can be that of a bridge over a short horizon during which the home price is assumed to increase. While this was an interpretation of the rise in subprime loans up to 2007, this can be in effect to a lesser degree during other periods.
This is presumably enhanced by the strong developments in securitization from 1990 forward. This permits the diversification of local market risk and leads to potential indifference of mortgage originators the ARM-FRM balance of their lending.
One estimate of the global debt market is $100 trillion as of mid-2013, while the approximate value of U.S. mortgage debt on 1–4 family residences is approximately $10 trillion.
With a rate movement downward, the borrower has the option to refinance at a lower rate, but with a fixed rate the lender experiences a loss of bond capital if rates rise beyond those anticipated.
On the other hand, a recovery cost to a lender in a FRM is the lost return when, as rates decline, the borrower exercises the option to refinance to the new lower rate.
This applies to ARMS characterized as ‘sub-prime’ and ‘non-conforming’.
The choice of an ARM, while lowering the lender’s reset risk from an unanticipated rise in rates, adds to the lender’s recovery cost if the borrower default probability is thereby increased.
This includes lenders such as the Bank of Internet, which ‘lends boldly’ using ARMs and accepts higher risk borrowers, paying relatively high deposit rates, and is insured by the Federal Deposit Insurance Corporation. See “An Internet Mortgage Provider Reaps the Rewards of Lending Boldly,” New York Times, August 23, 2015.
As noted by Badarringza, Campbell, and Ramadoria (2017), a loss to a fixed rate mortgage holder occurs when rates rise. They have protection from the mortgage payment increase with and ARM but are not realizing the higher market returns if invested at the higher rates.
The model was limited by the absence of important covariates, such as net worth, as of 1996. Those age 35–64 as of 1996 would have been age 20–50 as of 1980–81 and likely had to adjust to the inflationary circumstances. As found in other micro data studies (Coulibaly and Li 2009), families reporting moderately greater risk tolerance were more likely to have chosen an ARM.
The percent owner in PSID for 2013 is lower than as reported from Census data such as the Current Population Survey. This is because those living with another family member will be recorded as ‘other’ in PSID while in CPS they will report on the tenure arrangement in the dwelling unit even if they are neither the owner nor renter per se.
The 1996 estimates are from weighted PSID data.
The full time series indicates substantial interim up and down movements of the spread and not a steady downward path.
The market spread or base for our samples is calculated from the year in which the current first mortgage was taken out. That is, the reported spread in that year (the same source as used for the basic time series recessions – Figure 1).
Here the term second mortgage applies to any loan with the house as collateral, such as a home equity line of credit or a traditional second mortgage.
Note that the sample of those with an ARM as of 2007 is small, yet there is some indication of more movement to a FRM by African-Americans. The suggestion being that there may be more transitions in both directions. For a study of ownership transitions see Charles and Hurst (2002).
Another sub-market for ARMs is for ‘jumbo’ but high risk loans at premium rates, such as from Bank of Internet.
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Acknowledgements
We thank Paula Fomby, Charles Brown and other seminar participants at the Michigan Survey Research Center’s research seminar as well as Gavin Wood, Trevor Kollmann and other seminar participants at the Royal Melbourne Institute of Technology. The research reported herein was in part performed pursuant to a grant from the U. S. Social Security Administration (SSA) funded as part of the Retirement Research Consortium. The opinions and conclusions expressed are solely those of the authors and do not represent the opinions or policy of SSA or any agency of the federal government. The collection of data used in this study was partly supported by the National Institutes of Health under grant number R01 HD069609 and the National Science Foundation under award number 1157698.
Glossary of Terms
Demographic and Education
male_head_ 07 (13): 1–0 if head of family is male
age_head_07 (13) < =34: 1–0 if head of family is under age 35
34 < age_head_07 (13) < =49: 1–0 if head of family is age 35–49
49 < age_head_07 (13) < =64: 1–0 if head of family is age 50–64
(age 65 and older excluded)
edu_head_07 (13) = 12: 1–0 if head is high school graduate
12 < edu_head_07 (13) < =16: 1–0 if head has some college or a college graduate
edu_head_07 (13) > 16: 1–0 if head has graduate education
(less than high school excluded)
African Americans_07 (13): 1–0 if head is African American (Census definition)
employed_head_07 (13): 1–0 if head employed as of date of the survey
employed_wife_07 (13): 1–0 if wife employed as of date of the survey
no_wife_07 (13): 1–0 if not married or cohabiting
Income and Asset
Income head 2007 ($1000,000)
Income head 2008 ($1000,000)
Income wife 2007 ($1000,000)
Income wife 2008 ($1000,000)
value of checking and saving 2007 > $40,000: 1–0 if liquidity value is greater than $40,000
Labor Market and Demographic
10,000 < value of checking and saving 2007 < =$40,000: 1–0 if liquidity value is above $10,000 and less than or equal to $40,000
value of checking and saving 2007 > $40,000: 1–0 if liquidity value is greater than $40,000
Income and Wealth
60 K < total_fam_income_07 (13) < =120 K: 1–0 if family income of 2006 (2012) is above $60,000 and less than or equals to $120,000
total_fam_income_07 (13) > 120 K: 1–0 if family income of 2006 (2012) is above $120,000
10 K < wealth_without_home_equity_07 (13) < =130 K: 1–0 if wealth less home equity is above $10,000 and less than or equal to $130,000
wealth_without_home_equity_07 (13) >130 K: 1–0 if wealth less home equity is above $130,000
constrain_07 (13): 1–0 if head age is less than 35 and head education is more than college and wealth less home equity is less than or equal to $10,000
Interview Date 2009
Interviewed before April 2009: 1–0 indicator
Interviewed between June and August 2009: 1–0 indicator
Interviewed after August 2009: 1–0 indicator
(April and May excluded)
Labor Market and Demographic
Laid off head 2009: 1–0 if head is laid off at date of the survey
Unemployed head 2009: 1–0 if head is unemployed at date of the survey
Disabled head 2009: 1–0 if head is disabled at date of the survey
Laid off wife 2009: 1–0 if wife is laid off at date of the survey
Unemployed wife 2009: 1–0 if wife is unemployed at date of the survey
Disabled wife 2009: 1–0 if wife is disabled at date of the survey
Mortgage Variables
year_took_mrtg1_07 (13): the year the first mortgage was taken
took_mrtg1_btw (2004–2006): 1–0 if took in the period 2004–2006
fix_rate-adj_rate of mortgages: prevailing market rate differences of 30 year fixed rate less 1-year Mortgage Bankers adjustable rate in year mortgage taken
ARM rate: 1-year ARM rate Mortgage Bankers data by year
Region and Urban Status
Northeast_07 (13): 1–0 if Census Region is Northeast
North Central_07 (13): 1–0 if Census Region is North Central
South_07 (13): 1–0 if Census Region is South
state_07 (13) in (AZ, CA, FL, NV) and urban_07 (13) = 1: 1–0 if in one of these states and in central metropolitan counties of population of 1000,000 or more
state_07 (13) in (AZ, CA, FL, NV) and urban_07 (13) = 2: 1–0 if in one of these states and in fringe metropolitan counties of population of 1000,000 or more
plan_move_07 (13): 1–0 if plans to change residence in the next few years
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Chen, B., Stafford, F.P. A Farewell to ARMs or Ever Changing Market Segments?. J Real Estate Finan Econ 59, 649–672 (2019). https://doi.org/10.1007/s11146-018-9659-y
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DOI: https://doi.org/10.1007/s11146-018-9659-y