ARMed and Dangerous: Part 2

In the previous post, ARMed and Dangerous: Part One, I discussed Option ARMs, and their role in the current Mortgage Crisis. This article will discuss another culprit in the debacle..

Market Inversion

In typical market conditions Adjustable Rate Mortgages (ARM) offer lower interest rates than traditional fixed interest rate loans. Thus, long term interest rates are higher than their short term counterparts. The reason for this is simple; lenders expect a higher return when they loan their money for a longer period of time.

There is a condition in the marketplace called an “inversion” where short term interest rates increase faster than long term interest rates. When this happens ARMs can have higher rates than long term fixed interest rate mortgages. According to most of the source material I was able to find, market inversions rarely occur.

However, 2006 marked the beginning of an interest rate market inversion, which drove short term rates to rise above long term interest rates creating an imbalance in the marketplace. The interest rate one pays on an ARM is tied to these short term interest rates.

What triggered it? The bond market in the United States was turned on it's head; resulting in an inverted yield curve. This phenomenon in the bond market follows a rash of interest rate increases by the government. The inversion in the bond market may have been caused by a lack of investors, coupled with inflationary and recessionary concerns which contributed to the condition.

What it all means

The result is substantially higher interest rates (some as high as 12%) for adjustable rate mortgages depending on the index your loan is based on, and/or the contract terms on which it was originated.  The effect will not be limited to Option ARMs, and could potentially affect all ARMs that adjust while the inversion continues.  Home Equity Lines of Credit (HELOC) loans which tend to be much more volatile, as they can adjust monthly may increase erratically as well during this period, resulting in higher payments for those as well.  How long will it last?  That's anyone's guess...

My Thoughts

There is no doubt in my mind that the significantly higher interest rates homeowners are seeing when their ARMs adjust are partially due to the inversion of the bond market. The aftermath can be plainly witnessed in the sudden increase in foreclosures we've seen since 2006.

Whether you have a subprime mortgage or not, if you have an ARM that's scheduled to adjust within the next 6 months or so, be prepared to pay a substantially higher mortgage, as your interest rate will likely increase dramatically.