Interest-rate developments during 2002 have been striking, and 2003 is likely to be an interest-rate adventure as well. By David F. Seiders

There's little doubt that rates will be subject to upward pressures next year, following large reductions this year. Changes in the rate structure may well improve the competitive position of ARMs. Savvy builders should be ready to help arrange ARM financing for prospective buyers.

Shifting interest rates

Although the Federal Reserve was holding monetary policy steady, longer-term yields fell substantially during the first three-quarters of this year as capital cascaded out of the beleaguered stock market into the safe haven of Treasury bonds. Since long-term home mortgage rates are linked rather firmly to 10-year Treasury rates, the cost of fixed-rate mortgage money fell to a historic low by the early days of October (5.98 percent).

Rates vulnerable

The problem is, long-term rates are extremely vulnerable to anything that might cause a rush of capital back into the stock market after the earlier mass exodus from stocks to bonds. Indeed, this vulnerability has prompted widespread speculation about "bubbles" in prices of both Treasury and mortgage-backed securities. While it's hard to identify bubbles, it's fair to say that long-term rates could move up much faster than would be justified by changes in their normal drivers; i.e., worries about inflation or expectations of aggressive tightening by the Federal Reserve.

Arm safety valve

The Fed is likely to hold down the short end of the interest-rate structure for some time, while long-term rates are highly vulnerable to an upshift if investor preferences shift suddenly from bonds to stocks. That means there is a real chance for a substantial improvement in the initial rate advantage on ARMs at almost any time.

Some prospective home buyers don't want to consider ARMs under any circumstances, and lenders in some parts of the country have demonstrated reluctance to shift their lending patterns regardless of rate relationships in the mortgage market. But, by and large, the financial markets will function efficiently as long as consumers are given the right information and there's enough competition on the lending side of the market. History shows that the ARM share of home mortgage lending can shoot up dramatically when long-term rates spike up, and an increase of 50 percent or more in the ARM share is not out of the question!

Bottom lines

The ARM share of the home mortgage market was languishing around 10 percent at the end of the third-quarter. But the competitive position of ARMs has already improved to some degree, and this safety valve could become critical to builders in the months ahead if long-term rates move up faster than the NAHB is forecasting.

ARMs are well-suited to the new-home market, generally financing higher-priced homes (on average) at relatively favorable contract maturities and loan-to-price ratios. Savings and loans associations typically have been the most aggressive ARM lenders, although many commercial banks, mortgage bankers, and mortgage brokers move into this market when the interest-rate structure shifts in favor of ARMs. Builders with their own finance subsidiaries obviously are poised to move quickly.