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March 8, 2004
"I wonder what you thought
of Fed Chairman Greenspan�s statements that mortgage borrowers could save a
lot of money if they opted for adjustable rate mortgages (ARMs) rather than
fixed-rate mortgages (FRMs)?"
While the Chairman�s remarks were carefully
hedged, he certainly seemed intent on conveying the view that more borrowers
should select ARMs. He made two arguments, neither of which withstand close
scrutiny.
FRM borrowers could have saved a ton of money
over the last decade had they chosen ARMs instead. This
is certainly true but has no implications at all for what borrowers should do
now. Interest rates declined during much of the previous decade, but could rise
during the next decade; we just don�t know.
My last mortgage, an FRM, was taken out in
1978. Because mortgage rates roughly doubled over the 3 years that followed, I
saved a ton of money compared to those who took ARMs at the same time. I took
the FRM because I was cautious, not because I was smart.
The rate difference between an FRM and an ARM
can be properly viewed as an insurance premium that buys protection against
future rate increases. Sometimes you need the insurance, sometimes you don�t,
but you don�t know until the game is over � just as you don�t know if you
are going to need fire insurance on your house. If you don�t have a fire, you
don�t think of the premiums you paid as wasted. They bought you peace of mind,
which is what the rate premium on an FRM buys you.
Borrowers in the US have a much stronger
[irrational?] preference for the certainty of fixed mortgage payments than
borrowers in any other country. It
is a fact that FRMs with long terms are a standard mortgage only in the US. But
does this reflect some irrational quirk among US borrowers that ought to be
discouraged? I think not.
There are two major reasons why most
borrowers in the US have preferred FRMs. One is that the rate premium that they
have to pay for an FRM, as compared to an ARM, is much smaller than it would be
anywhere else in the world because it is subsidized. Fannie Mae and Freddie Mac,
which can borrow at very low rates because they are Government sponsored
enterprises, purchase a large share of all new FRMs. In the US, FRMs are a
bargain. FRMs don�t exist elsewhere largely because the rate premium would be
too large for borrowers to swallow.
The second reason borrowers in the US have
preferred FRMs is that ARMs in the US are incredibly complicated, few borrowers
understand them, and mandatory disclosures under Truth in Lending don�t help.
Most ARMs abroad allow lenders to adjust the
rate at their own discretion. This has obvious drawbacks, but it does have the
virtue of simplicity. In contrast, ARMs in the US use a mechanical indexing
procedure for making rate adjustments, which eliminates lender discretion but
makes the instrument extremely complicated.
Given their complexities, the
acceptability of ARMs could be substantially enhanced by good disclosure rules.
Such rules would be limited to critically important information and presented
clearly.
The most critical information for
most borrowers is 1) What would happen to the interest rate and the monthly
payment if the interest rate index doesn�t change; and 2) What would happen if
the loan rate rises to the maximum permitted by the loan contract?
Instead, Truth in Lending requires
lenders to provide ARM borrowers with a check-list of ARM features that is
meaningless to most of them. Lenders can use their own formats in providing this
information, which vary from lender to lender, and there are no requirements for
clarity. Some that I have read are incomprehensible. In addition, borrowers may
get a useless example of how their mortgage would have worked had it been
written 15 years earlier.
If Mr. Greenspan really would like to see
ARMs comprising a larger share of total mortgages in the US, he is well
positioned to do something about it beyond just talk. The Federal Reserve
administers Truth in Lending, and while its discretion to change it is limited
by Congress, it carries a lot of weight with Congress. This would require a
willingness to spend political capital on a consumer protection issue, something
that the Fed historically has been reluctant to do.
Copyright Jack Guttentag 2004
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