December marks seven years since the Federal Open Market Committee cut the target for its benchmark federal funds rate to nearly zero.
The Great Recession technically ended six months after the Federal Reserve's dramatic interest rate cut, though to say the subsequent recovery has moved at a glacial pace would be an understatement.
But as a meaningful economic recovery appears to be finally taking hold, all eyes are on the FOMC amid speculation that it may soon raise rates. That watershed moment, whenever it comes, will necessitate a re-evaluation of many aspects of the "new normal" that have taken hold since the Great Recession.
Case in point: the adjustable-rate mortgage. The product, popular during periods of rising interest rates and home prices — and vilified for contributing to excesses that precipitated the housing crisis — has fallen out of favor among lenders and consumers.
But ARMs may soon be ready for a revival, albeit with tighter regulatory restrictions and a recalibration of longstanding assumptions about who the product is best suited to serve.
The unprecedented move by the nation's central bank to cut interest rates came at a particularly tumultuous time during the worst economic downturn since the Great Depression. The unemployment rate, which had been as low as 4.4% just two years prior, was 7.3% and rising. The mortgage delinquency rate was nearly 7% and similarly climbing, while the average rate for a 30-year mortgage was 5.29%.
Indeed, much has changed in the past seven years. The latest Bureau of Labor Statistics estimates put the unemployment rate at 5%, the lowest it's been since April 2008. The mortgage delinquency rate sits at 5.45%, a drop of more than 50% from its December 2010 peak, according to the Federal Reserve Bank of St. Louis. Mortgage rates have hovered just below 4% for nearly the entire year, according to Freddie Mac.
Even though long-term mortgage rates are not directly connected to changes in the federal funds rate, the expectation that the FOMC will take action as soon as its upcoming Dec. 15-16 meeting has been cited as a contributing factor to the recent uptick in rates.
"Treasury yields climbed nearly 20 basis points over the past week, capturing the market movement following last week's FOMC meeting. In response, the 30-year mortgage rate experienced its largest increase since June," Freddie Mac's chief economist Sean Becketti, said in a Nov. 5 news release. And it's clear the condition of the housing market is a key factor in the Fed's evaluation of the broader economy. During a Nov. 4 appearance before the House Financial Services Committee, Federal Reserve Chair Janet Yellen fielded questions about how its monetary policy would affect mortgage lending.
"I'm concerned about the effect raising interest rates now would have on the real estate recovery…would we squeeze creditworthy borrowers out of the housing market and create a negative feedback loop with prices going down?" asked Rep. Brad Sherman, D-Calif.
Yellen said the Fed was "very aware that a sharp rise in mortgage rates could have a very negative effect on housing. We do however have a recovering economy where employment is going up, income is going up, people are in better shape to form households."
The FOMC wants a very gradual increase in interest rates. "We're not envisioning that when we begin to raise rates we're going to be looking at a very steep path of interest rates that would cause the kind of harm you are worried about for the housing sector," she said.
During a Nov. 12 speech, William Dudley, president of the Federal Reserve Bank of New York, wouldn't comment on whether he expected the FOMC to raise rates in December. However, in support of his view of an improving economic outlook, he noted, "housing fundamentals are solid as well.
"Decent payroll gains have supported household formation over the past year and mortgage rates remain low."
On the other hand, "mortgage credit availability for households with low FICO scores is very limited," Dudley said, constraining their ability to buy a home and holding back the pace of residential investment.
Jeffrey Lacker, president of the Richmond Fed, believes the FOMC is moving too slowly. In a Sept. 4 speech called "The Case Against Further Delay," he said "Residential investment has registered healthy gains this year. Housing starts [through July] were up 11% over the previous year…the housing market has been making noticeable contributions to growth."
But Chicago Fed President Charles Evans was less optimistic in a Nov. 12 speech, where he declared that housing "is the one area where the recovery probably still has a good way to go." As one example, he pointed to home prices in the East North Central Census Division (consisting of Illinois, Indiana, Michigan, Ohio and Wisconsin) which are still 3.5% off their peak high. "Before raising rates, I would like to have more confidence than I do today that inflation is indeed beginning to head higher," Evans said.
San Francisco Fed President John Williams recently argued for an increase in rates, citing what he called "signs of imbalances emerg[ing] in the form of high asset prices, especially in real estate."
He went on to compare the Fed's current rate discussions to the debate over the timing of a rate increase in the mid-2000s. "What stayed with me were not the relative merits of either case, but the fact that by then, with the housing boom in full swing, it was already too late to avoid bad outcomes," Williams said in the Oct. 8 speech. "Stopping the fallout would've required acting much earlier, when the problems were still manageable."
"I don't think we are at a tipping point yet — but I am looking at the path we're on and looking out for potential problems," he added.
Interest Rising
While the Fed debates monetary policy, many in the mortgage industry are beginning to consider how mortgage rates will be affected. Economists have so far been unsuccessful in pinpointing when mortgage rates might finally rise to 5% or more.
In October 2014, the Mortgage Bankers Association predicted 5% rates by the end of 2015, revising a previous projection of it taking place earlier in 2015. Now, the MBA is projecting 30-year FRM rates will break the 5% barrier in the second quarter of 2017, increasing 180 basis points between the third quarter of 2015 (3.9%) and the end of 2018, when rates could hit 5.7%.
Adjustable-rate mortgages, which offer a lower starting interest rate than fixed-rate loans, were once a popular tool to help borrowers on the fringes of affordability.
But since consumers have been able to lock in historically low rates, the monthly payment on a 30-year FRM has been within reach for most borrowers. That could change with a rise in interest rates.
"It is safe to say [ARMs] used to be the entry-level product where borrowers could enter the market, get a home, and refi out into something long-term later. "That changed with the crisis," said Joel Kan, the MBA's associate vice president of industry surveys and forecasting.
"If we repeat the historical purpose of ARMs, in a rising rate environment you will see some come back. But it will be the rate at which rates are going up" that will determine how quickly and by how much ARM application share will rise, Kan added.
Lenders are already seeing the beginnings of renewed interest in ARM loans. Even exotic variants, like the option-ARM, may have a role to play with the right consumer. "I believe adjustables will make a comeback. "The reason they haven't as of yet is because fixed rates have been so low for so long," said Dave Jacobin, president of 1st Mariner Mortgage, a subsidiary of Baltimore's 1st Mariner Bank.
When FRMs do hit 5%, Jacobin predicts ARM volume will pick up, "but nothing dramatic." Others agree. "But there is a market for ARMs that makes sense," he added.
For example, if a borrower intends to stay in a house for less than five years, a 5/1 ARM offers a lower rate than a 30-year loan and the rate won't adjust before the borrower is ready to move. Even if the borrower stays in the home longer than planned, there are caps on how much the interest rate can increase.
ARM products entered the mortgage industry in 1982 as part of the Garn-St. Germain Act. That law included the Alternative Mortgage Transaction Parity Act, which preempted state laws that permitted only FRMs to be originated. In 1990, when a 10% 30-year fixed-rate mortgage was considered a bargain, the share of adjustable-rate mortgage applications was below 5%, according to MBA data. FRM rates soon moved into single digits. By 1994, when rates came off of their lows in the 7% range, the ARM share kicked up to 25%. The same pattern was repeated in 1998 through 2000; when FRM rates started to rise, ARM share gained.
But the biggest driver of ARM volume was not rising interest rates, but rising home prices. During the boom years of the mid-2000s, these loans achieved their largest market share, ever as lenders looked to qualify borrowers for the highest loan amounts possible.
The ARM era peaked the week of March 25, 2005, when 36.6% of individual loan applications and 52% of applications by dollar volume were for ARM loans. Then the housing collapse came and as loan delinquencies mounted, consumer groups and others blamed the inappropriate and excessive use of option-ARMs. Many borrowers, especially in California and other high-cost areas, took out option-ARMs because of high home prices. Lenders qualified them on the lowest payment at the beginning of the term, and not the fully-indexed payment. The worst six weeks for the number of ARM applications submitted were in December of 2008 and January 2009. During that period, approximately 1% of all applications were for variable rate mortgages.
There has not been a week where ARM share has been above 10% since May 16, 2008.
Now, as a new market for ARM loans may be emerging, lenders say they're mindful of the lessons learned during the crisis. "I want to make sure that any borrower I put into that product fully understood the ramifications of the upside and the downside," Jacobin said. Education is the key to bringing the ARM loan back to the mainstream, said Jacobin.
Salespeople need "to make sure they explain every nuance and detail to their customers, describe the worst-case scenario, and make sure the borrower is comfortable with it, and it is not just something where they can get them into a property so they can get a commission."
"It's much more important — and it will benefit them — they make sure the adjustable-rate mortgage products are given to people who it makes sense for them to take it.
Frankly that will lead them to a better reputation, more referrals and everybody wins," he added.
Today's ARM underwriting is governed by the Consumer Financial Protection Bureau's Qualified Mortgage and Ability-to-Repay rules. No longer can the start rate be used to qualify borrowers; instead borrowers must qualify using the fully indexed rate — making it much tougher for borrowers to qualify for an ARM loan.
"I only recommend ARMs for people who can tolerate the risk. It is great for people who have plenty of liquidity to take that risk," said Peter Grabel, managing director at Luxury Mortgage in Stamford, Conn.
Grabel works with affluent clients, with home purchase prices that can be as high as $2 million. While almost all of his conforming mortgage clients end up with fixed-rate loans, his jumbo loan production is 60% ARMs.
"I would never recommend an ARM to a schoolteacher or someone on a fixed salary that couldn't take the risk of the rate going up. But when you have someone who has significant savings who could pay off the loan if they needed to, then there is really no risk because at the end of the ARM period, if they wanted to, they can write a check and pay it off," he said.
Recently, Grabel worked with "a very conservative couple, they've only done 30-year fixed in the past. I said to them, 'I just want to mention to you, you're looking for a $1 million loan and you've got $3 million in savings.
"I really don't think there is a lot of risk for you doing a 10-year ARM. You might be better off taking that savings each month and putting it elsewhere.'" Grabel created a chart showing a cost savings of $350 per month with the ARM loan. In addition, he pointed out they will have a lower principal balance after 10 years when compared with a 30-year FRM.
Likewise, he recommended a 10-year ARM to a couple who plan on relocating once their children finish school in seven years. The ARM rate was about 50 basis points lower than a 30-year FRM, and gave the couple a three-year cushion to sell their home after their planned move.
ARMs are also good products for those who have to keep payments low because of a short-term cash-flow crunch, like someone needing to refinance because of a divorce. Another candidate is a young doctor; the income will be there in the future but right now he or she might still be dealing with school loans and other expenses.
Jacobin pointed out an interest-only ARM is a good option for someone who gets a significant bonus at the end of the calendar year. The borrower gets a manageable monthly payment and can pay down a large portion of the principal at the end of the year.
Another advantage is that unlike a traditional adjustable-rate mortgage, the interest-only version recasts when the borrower pays down the principal, lowering the normal monthly payment, Jacobin said.
The interest-only loan, especially during the boom, was thought of as being for people who could only afford to make the minimum payment; in fact it is the opposite, it is only for people who can afford to make more than a minimum payment, Grabel pointed out.
As time puts the crisis further in the past, a lot of the negative connotations consumers associated with ARMs are dissipating.
"People got more scared of ARMs for a while, and I think they're now starting to come back psychologically. On any non-QM loans, they typically are ARMs because the portfolio investors really don't offer 30-year fixed. So if it is non-QM, it's almost definitely going to be an ARM product," Grabel said.
When the 30-year FRM rate was at 3.5%, no one wanted to look at anything but that product.
"But now that we've seen [fixed rates] creep up again, and you're close to 4% — especially on the jumbo — and you tell someone that it's 3.25% on a 10-year ARM, well that's a reasonably big difference," Grabel said.
