One-Way ARMs: Stacking the Deck.

The Senate Banking Committee has invited representatives from the top five subprime lending companies to “explain their lending practices in the subprime mortgage market” at a hearing scheduled for tomorrow, March 22. With all the recent focus on teaser rates and no document loans, the one-way adjustable rate mortgage (ARM) probably won’t get much attention. An analysis of the actual terms of recent ARM loans, however, shows that one-way ARMs are yet another example of how subprime lenders stack the deck against borrowers.

In its simplest form an adjustable rate mortgage is one in which the interest rate for the loan is pegged to an “index” and for which the interest rate is adjusted at set intervals (e.g., 6 months, 1 year, etc.). If the index increases, the borrower’s interest rate increases, if the index declines, the borrower’s interest rate goes down. The floating rate structure of the ARM allows lenders and borrowers to share the interest rate risk. In exchange for assuming some of this risk, borrowers generally receive lower initial interest rates. This economic reward for risk-sharing is the justification for ARM loans--at least in theory.

In practice, the one-way ARM, which is ubiquitous in the subprime market, only adjusts upwards from the initial rate. By the terms of the note the interest rate can never drop below the initial rate even if the index goes down. As a result, borrowers, not Wall Street, bear the brunt of any interest rate volatility.

Preliminary data from an empirical project (funded by the National Conference of Bankruptcy Judge’s Endowment for Education) that I am currently working on with Professor Katie Porter confirms the widespread use of one-way ARMs among homeowners in bankrutpcy. As part of the project, which looks at the intersection of bankruptcy and homeownership, we coded information about debtors’ notes and mortgages when such loan information was available. Among ARM loans in the sample-to-date, more than 85% of these loans put no risk of interest rate change on the lender because the initial interest rate and the floor interest rate (the lowest rate permitted by the note) were identicial.

Some have likened ARMs to a gamble: the borrower wins if interest rates go down and loses if the interest rates go up. The realities of recent subprime lending practices show that Wall Street is like every winning gambling house—it is has effectively stacked the deck so that the house always wins. With one-way ARMs, consumers don’t get a fair deal, no matter how you cut the deck.

Comments

[O. Max Gardner III]

Tara: Very good and timely post. An honest mortgage broker has referred to these One-Way Multiple Option ARMS (MOARMS) as the "neutron bomb" of loans--they leave the home standing but kill the home owners.