How Adjustable Rate Mortgages Went Bad

By: Favian Clai
If you thought Subprime Mortgage was a dirty word to say in today's mortgage industry, there is a new word that could cause even a bigger collapse in the Mortgage market. It's called the Adjustable Rate Mortgage, or ARM for short.

While ARM's are a useful mortgage type, sometimes the primary mortgage type in most countries, banks started bending the rules and getting creative with marketing to get prospective homebuyers into loans, effectively trapping them in debt that they were unaware of until it became too late.

What is an Adjustable Rate Mortgage?

An Adjustable Rate Mortgage, or ARM is a mortgage loan where the interest rate is periodically adjusted based on a variety of factors called indices. Among the most common are:

• The 1 year constant-maturity Treasury (CMT) securities rate
• Cost of Funds Index (COFI)
• London Interbank Offered Rate (LIBOR)
• 12 month Treasury Average Index (MTA)
• National Average Contract Mortgage Rate
• Bank Bill Swap Rate (BBSW)

Some lenders use their own proprietary cost of funds as an index. This is done primarily to ensure a steady margin for the lender, whose costs of funding the loan will usually be related to one of the indices.

These loans transfer part of the interest rate risk from the lender, to the borrower where they benefit if the rate falls and loses out if rates rise.

What Were ARM's Used for Anyways?

Adjustable Rate Mortgages are typically used by lenders where market conditions are unfavorable and puts them at a high risk of loss on the loan, similar to playing Russian roulette.

In low interest rate periods, ARMs become popular with those looking to purchase homes for only a short period for the purpose of flipping them at a higher resale value.

They are also used by homeowners who feel that long-term, rates will remain low in comparison to fixed-rate mortgages.

How Did This Get Out of Control?

ARMs got out of control in a two-fold condition where both homeowners and banks were responsible for the lack of oversight; oversight by homeowners who were tempted by teaser rates and not properly evaluating their budget and by Banks who turned a blind eye to the finances of prospective homebuyers. Banks went a step further by assuring homeowners they could refinance before the rates would go higher, not expecting the market to crash.

Beginning in 2009, many of these teaser loans began resetting which have set off minor waves in the mortgage industry. Toward the end of 2009, many of them begin resetting and Industry analysts believe that the reset could cause twice if not three times the amount of foreclosures that we have seen in recent years.

Much of the problem could be solved by banks modifying loans to more safer conditions for them, and the homeowner's, but many remain stubborn in their ways, continuing the potential risk for another spiral in the market, that may not have a bottom for some time to come.