Adjustable-rate mortgages (ARMs) often have served as a “safety valve” for home buyers and builders during times when the interest rate structure rises and steepens (long-term rates rising more than short-term rates). Those types of interest rate shifts are likely to materialize later this year and in 2005, and builders will need to mine the ARM market for all it's worth at those times.

However, another ARM wrinkle has developed in recent times, even with fixed-rate mortgage yields at historic lows. In high-priced areas, where large proportions of home sales are beyond the loan limits for Fannie Mae and Freddie Mac (currently $333,700), the cost of fixed-rate loans is relatively high and the initial rate advantage provided by ARMs is relatively large. In such markets, ARM usage has increased dramatically because these loans increase the number of high-priced homes affordable to buyers in these areas.

Federal banking regulators recently have sounded alarms about prospective risks to banks from ARM loans made in high-priced areas to stretch housing affordability. But these alarms are excessive, and the ARM market promises to remain healthy as we move ahead.

Arm Usage Surges The ARM share of conventional home loans made in the United States doubled from early last year to early 2004, rising from 15 percent to 30 percent. In the market for new homes, the ARM share soared from 13 percent to 47 percent over that period.

The average price of homes financed by ARMs is higher than the average for homes financed by fixed-rate loans. Furthermore, loan-to-price ratios are relatively high on ARMs, and both sales prices and loan-to-price ratios are relatively high in the new-home market.

It's clear that the use of ARMs in high-priced markets for new homes is a reaction to house price increases that have outpaced household income gains.

The FDIC recently issued a report warning about the surge in ARM usage in high-priced housing markets. It said that ARMs not only pose risks to homeowners when market interest rates rise (since monthly payments rise) but also pose risks of loss to lenders that hold the ARMs. The FDIC said that rising interest rates could cause house prices to fall and provoke defaults on high-ratio ARMs when the prices fall below mortgage balances.

The FDIC's concerns are excessive. Properly underwritten ARMs having periodic rate-adjustment caps should not sound delinquency alarms in the context of reasonable forecasts for the economy and interest rates. It's one thing for the FDIC to fret about “sub-prime” lending practices by banks, but the FDIC should not sully the mainstream ARM market that supports home sales in high-priced markets.

Bottom Line Builders have made very good use of high-ratio ARMs to support sales in high-priced markets. If federal banking regulators discourage lending to this market, builders should seek out independent mortgage bankers/brokers that will help meet their needs.