Saturday 16th of January 2021

History of the Adjustable-Rate Mortgage

The Savings and Loan Industry developed after World War II and quickly became the largest source for home mortgages. S & L’s began with a noble goal: to issue low-cost advances that made home ownership more affordable and accessible. The result was a large expansion in the American middle class during the 1950s and 1960s. Savings and Loans operated by collecting deposits from the local community and then loaning that money out in the form of home mortgages. The default risk for these products was extremely low, so these were a rather safe investment for the industry, or so they thought.

The Fatal Flaw

The problem with the S & L setup was that mortgages were long-term investments, whereas deposits were short-term financial instruments. The industry seemed to manage this little quirk well until inflation exploded in the late seventies. Consequently, S & L was spending more to attract depositors than they were earning on interest from fixed-rate mortgages. To rectify this imbalance, some lending institutions began issuing adjustable-rate mortgages (ARMs) to ensure that the loans in their portfolio always netted them enough interest to pay depositors and make a profit. ARMs quickly caught on, as they mitigated lenders’ inflation risk by transferring most of the risk to borrowers.

Non-Traditional Products

The introduction of ARMs also spawned the development of an array of non-traditional mortgages, such as interest-only loans. The purpose of these unconventional products was to help more and more consumers afford home ownership. Additionally, banks began lowering the credit bar for these in order to allow more borrowers to qualify for home loans. As a result, subprime mortgages proliferated and became extremely popular. The creation of these non-traditional home loans is fairly recent and likely played a major role in the existing housing crisis. In the mid-2000’s, the housing market became saturated with interest-only ARMs, subprime loans, and option ARMs. Concurrently, credit standards were relaxed, and the combination led to a housing market boom. People who once only looked to ARMs to buy homes they didn’t intend to stay in for very long were now choosing the loans in order to qualify for larger loans than they otherwise could. Slowly, these circumstances became the perfect crucible for what would eventually be a calamitous housing crisis.

The Present

As long as housing prices continued to rise, homeowners strapped for cash could almost always refinance their way out of trouble. However, this abruptly came to a halt in 2006 when home prices either remained stagnant or began falling in some areas of the U.S. People who had used ARMs or subprime mortgages to buy more house than they could afford were in financial hot water, and foreclosure rates took off. As a result, fewer and fewer lenders now offer the non-traditional ARMs that played such a key role in fueling this crisis.