11/7/20101Adjustable-Rate MortgagesAn adjustable-rate mortgage (ARM) is a loan on which the periodic contractual interest rate can change over the life of the mortgagethe mortgage.The rate is reset periodically to a fixed spread (called the margin) over a benchmark or reference rate.Most common reference rate is short term Treasury rate as determined by current market conditionsOther reference rates include a calculated cost of funds or tt1average mortgage ratesWhy ARMs?Supply side motive: Interest Rate RiskIn the early 1980s, lenders were burned by holding long term fixed-rate mortgages while interest rates rose.“Heads I Win; Tails You Lose” gameThis amounted to an unanticipated transfer of wealth from lenders (savers) to borrowers.Lenders wanted to modify the mortgage contract to share the risk between lender and borrower.ARMs were born!2By allowing the contract rate to vary with changes in market interest rates, the price of existing mortgage contracts is less sensitive to interest rate risk.
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11/7/20102Why ARMs?Demand side motive: “Tilt Problem”When inflation is high, lenders need to build in expected inflation into the loan rate.Niltlti kdjttt dNominal rate = real rate + risk adjustment + expected inflation rateWith an FRM, this means the borrower must make high “real” payments at the start of the loan and low “real” payments at the end of the loan.This makes it hard for borrowers to qualify/afford for loans3This is the “Tilt” problem we saw earlierARMs typically offer lower initial contract rates (why?), and this helps to reduce problems with affordability and Tilt.As of: 9/30/04As of: 2/14/061-year ARM rates were much lower than 30-year FRM rates as of 9 30 04 (170 basis1-year ARM rates were only moderately lower than 30-year FRM rates as of 2 14 064rates as of 9-30-04 (170 basis points)year FRM rates as of 2-14-06 (70 bp)Why are 1-year ARM rates lower than 15 and 30-year FRM rates?Why are 1-year ARM rates more similar to 15 and 30-year FRM rates in 2006?