SOARING HOUSE PRICES IN MANY AREAS HAVE encouraged the development and use of a variety of ARMs that can stretch the affordability envelope for prospective owner-occupants. That's the good news. On the other side, some ARMs also have provided attractive short-term financing for speculators in the housing market and have exposed some homeowners to potential “payment shock” down the line. In the process, mortgage lenders and investors have shouldered credit risks they may not fully understand.

Federal Reserve chairman Alan Green-span recently told Congress that the expanded usage of “exotic” ARMs is a development of “particular concern”—at least from the Fed's point of view. At issue are ARMs with deep initial rate discounts, interest-only payment schedules, and payment options that allow negative amortization (rising principal balances), and that require little or no documentation of borrower income, debts, or assets.

REGULATOR FOCUS The federal regulators of commercial banks and thrift institutions reportedly are working on interagency guidelines addressing the credit risks associated with various types of ARM structures and underwriting procedures. Indeed, a joint supervisory letter—modeled after risk-management guidelines issued in May by the regulators for home equity lending—may be forthcoming before long.

On another front, both Standard & Poor's and Fitch Ratings have issued tougher rating criteria for mortgage-backed securities backed by ARMs with payment-option features that permit negative amortization. These generally are “private label” securities (not issued or guaranteed by Ginnie Mae, Fannie Mae, or Freddie Mac) backed by mortgages packaged by unregulated mortgage bankers or brokers. The rating agencies have the obligation to inform the investment community about the risks of such securities.

WHERE'S IT GOING? As the Fed raises short-term rates and the yield curve flattens, the attractiveness of ARMs relative to standard fixed rate mortgages should naturally recede. Indeed, the initial rate advantage on a standard one-year, Treasury-indexed ARM has fallen substantially during the past year, despite the deepening of initial rate discounts by lenders over that period.

Available data suggest that the ARM share of the number of conventional home loans may recently have topped out at about 35 percent of the national market (the share of dollar volume is a good bit higher because of the prevalence of ARMs in high-priced areas). The flattening of the yield curve and the messages from regulators and rating agencies are definitely conspiring to constrain the growth of the ARM market.

A DELICATE BALANCE The efforts by federal regulators and rating agencies, it is hoped, will promote better risk-management practices by lenders and provide better information to mortgage investors. The trick is to discourage speculation and head off potential credit problems down the line while preserving the affordability enhancements provided by time-tested ARMs in high-priced markets. Builders should continue to mine the ARM market, and these loans should continue to provide solid support to home sales in the period ahead.

Chief Economist, NAHB Washington, D.C.

Learn more about markets featured in this article: Washington, DC.