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ARM Missing In Action
During any episode of rising interest rates in the last twenty years, many borrowers have chosen adjustable rate mortgages ("ARMs") as defensive tools to ride out the storm.
For the first time... not this time.
Adjustable rate mortgages for residences were unknown from the Depression until 1980, when the modern types were invented. The same ARM options available twenty years ago are still today: thousands of different permutations and combinations of initial rate, initial term, loan fee, index, margin-over-index, adjustment limitation, and optional payment plan, including interest accrual (a.k.a.: "negative amortization").
An article titled "DEE-fense, DEE-fense!" last fall described the mathematics and game theory useful to consumers when deciding among types of ARMs and fixed rate loans. This column is NOT going to regurgitate all that detail (for reference: boulderwest.com, click "borrower essentials", item #7).
The following tells a story: why, now, this time ARMs have the least defensive benefit in anybody's memory.
As we go to press, a 30-year fixed-rate Fannie Mae loan can be had at 8.375% with no discount points and no "origination fee". Meanwhile, a "5/1" ARM (fixed for the first five years, adjusting annually thereafter) with equivalent fees sells for 7.875% -- hardly worth the risk of future adjustment or cost to refinance. Shorter adjustables -- the deal which used to define the ARM market, the one-year adjustable -- inclusive of fees costs almost as much in the first year as a fixed, and in the second year might well adjust higher.
What happened, after all these years?
In a nutshell, ARMs work best when spreads are wide between short-term rates and long-term ones. The Fed absolutely controls short-term rates, but long-term rates are determined in the day-to-day trading and investing in capital markets world wide -- a pure market function.
A comparison of Fed, market, and mortgage spreads today versus the last time the Fed was on the warpath will help.
December, 1994 Today Difference
Fed Funds Rate 5.50% 5.50 --
30-year T-Bond 8.00 6.70 1.30
5/1 ARM 8.50 7.875 1.625
30-year Mortgage 9.75 8.375 1.375
During 1994, the Fed raised its rate progressively and dramatically from 3.00% to 5.50%. In 1999 the Fed executed three, modest, .25%-rises from 4.75% to 5.50%, reversing identical reductions in late 1998. While the Fed's rate in early January, 2000 is exactly as it was five years before, note the extraordinary difference in short- versus long-rate spreads, and the equally extraordinary ARM-versus-fixed savings available to consumers five years ago.
And not, today. Why, please, again?
Five years ago, the inflation rate was about a percentage point higher than it is today. The Fed's rate may have been the same, but long-term investors' perception of inflation risk was greater.
Another element in perception: as of New Years Day 1995, there had been only one interval of low long-term rates in the prior 22 years. "Low" meaning T-bonds in the sixes or below, mortgages in the sevens: 1993 had contained the only stretch as low as that since 1973. Today, investors have more confidence that the world has returned to the rate structure prevailing before 1973.
So, one piece of bad news: there is no especially useful ARM under any shell in the game. There is no way to dodge the Fed this time around.
In exchange, good news... good news indeed. The Fed is trying to slow the economy down because of an asset bubble and a tight labor market, not because of any of the sort of inflation that gave us the high-rate epoch 1973-1992. And, the Fed will succeed in slowing the economy rather sooner than later, opening the way to a reduction in all interest rates.
In January 1995, the Fed tightened one last time from 5.50% to 6.00%. The economy slowed so abruptly that the Fed had to begin to reduce its rate by summer, and mortgage rates fell back to 7.50%. We'll be lucky to have such a big reversal in 2000, but the tougher the Fed gets, the sooner and deeper the reversal.
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