More Lessons About Markets and Mortgages

In an eMo last week, Mother Crafton gives a strong endorsement to our July 30 article on mortgages and the stock market. Barbara's comments are very gratifying, and we thank her. We highlight here one point she says she heard in our words: "it's not a simple good guys/ bad guys story". Oh, yes. Ambiguity pervades all of the market action presently, and if you come away with this one concept alone, we'll be pleased. In seeking to sort out the concerns, we can't put the whole blame on lenders, nor on borrowers. We said last week that regulators support subprime mortgage lending, but obviously they can't feel good about foreclosures and the bankruptcy or closure of a rising number of mortgage companies.

Ambiguity in the Markets and Among Policymakers, Too
Today, August 6, markets continue in erratic trading. After selling off sharply Friday, the major market indexes have turned up, but the number of companies with falling prices exceeds that with rising prices. Tomorrow – Tuesday – the Federal Reserve's monetary policy committee meets in a regularly scheduled session. They are likely to leave their basic short-term interest rate, the federal funds rate, unchanged at 5.25%. They've worried lately more about inflation, as they should. Keeping the value of money sound is their job. But they can't ignore risk, so they too face ambiguous conditions as they set about their policy-making.

Meantime, Barbara also suggests to me that many of you might be worried about your own mortgages, and this is indeed a topic worthy of our consideration here. One other lesson we hope you hear in our articles is that when you make a financial commitment, whether to buy an asset or borrow money, you need to understand the terms. When we discussed retirement plans a couple of months ago, we urged that, if you are selecting some investment program, you should be able to make sense of the features of the program you choose. The same goes for the terms of the debts you incur. This is really important for your mortgage, since it is probably a very large obligation.

Many Unaware of How Much Their Mortgage Rate Can Change . . .
All too often borrowers are not aware of the way their mortgage works, and they get hit when they don't expect it. Federal Reserve analysts parsed the results of one of the Fed's periodic Surveys of Consumer Finances. It asks questions about how much people know of the terms of the mortgage they carry. As we mentioned last week, the people with adjustable rate mortgages ("ARMs") are having the most difficulty. Now, as in 2001, when this specific survey was taken, about 30% of all mortgages are ARMs or some "hybrid" type. In the 2001 poll, the largest number of responding borrowers believed that the most their adjustable interest rate could adjust at one time was 1 percentage point. But a parallel survey of lenders said that most ARM mortgages could move as much as 2 percentage points at once. Big difference, especially early in the mortgage, when you're paying almost all interest and little principal. Further, 57% of borrowers believed the most their rate could increase over the whole term was 5 percentage points, but only 6% of the lenders said it was that small. In fact, 25% of lenders reported that the rate could go as high as 12%, but only 2% of borrowers thought that. See the potential for surprise among uninformed borrowers.

. . . or How The New Rate Is Determined
Borrowers can watch financial markets to gauge in advance how their mortgage rate might move. But they have to know which rate is the relevant one in the formula for the change in their loan's payments. The lender survey indicated that two-thirds used a Treasury bill rate and the rest use a money market rate such as the "London Interbank Offered Rate". Only 25% of borrowers mentioned these rates at all; the largest number thought their rate floated with the so-called prime rate and a number of others said it was some completely unrelated measure.

Low-Income Borrowers More Vulnerable and Less Informed
Fortunately, for the bulk of mortgages, the standard 15- or 30-year fixed-rate loans, the vast majority of borrowers are informed about the terms. But as we see, those with ARM loans often miss some of the very salient facts about the structure of their debt. The Federal Reserve analysts tested the sensitivity of people's budgets to this situation. They calculated some possible scenarios for the size of payment changes. For high-income households, the range the payment changes might take was only a modest fraction of household income, limiting the impact of the any rate surprise. But – and this is the crucial issue – if borrowers have less than median income, they are less likely to be aware of their mortgage terms in the first place, and the payment change by definition will be a larger proportion of their income.

So for you who visit this website, we'd surmise that the harm to your own family budget from an unexpected change in your mortgage payment would be unpleasant but manageable. However, for your friends who might have lower incomes – or your children who might be just starting out – the hit could be bigger.

Market Moves Faster Than We Can Write!
All this will be a concern until these mortgages pass the anniversary date when their rates reset. The recent path of interest rates has been more stable, which should limit the frequency and size of upward rate adjustments after that and possibly even bring a bit of relief. So all is not lost here. Stock markets sense this, it seems, and this afternoon while we have been writing, the Dow Jones index has moved markedly higher, as investors seek bargains.