Professional Documents
Culture Documents
The topic of Adjustable Rate Mortgage (ARM) in its first glimpse, takes us to the
reader of terms like Global Financial Crisis, Meltdown, Subprime crisis and its
horrors. Global Financial Crisis (GFC) The greatest of all financial crisis after the
great depression of 1930, emancipated from a complicated interplay of policy to
improve home ownership, by greater credit supply, laxed terms, overoptimistic
assumption of real estate growth, predatory lending stunts instincts, and option to
offload the balance sheet by securitization, poor remuneration to promote short term
gain versus long-term value and last but not the least and macro-prudential
governance shortfalls. The reason we discuss GFC here is that ARM were employed
by Financial Institutions to finance the subprime i.e. the under-privileged. So did it
work? No, it actually coasted them a USD 4.1 Trillion losses, 9 Million families
displaced and thousands unemployed. Notwithstanding the fact that, a lot many
other factors such as weak underwriting, monetary tightening, moral hazard across
the value chain, unrealistic assumption on real estate valuation contributed to the
GFC. Farhi, E., & Tirole, J. (2009) termed the GFC as Collective Moral Hazard while
reviewing the role of macro prudential regulation, Interest rates, Lender and
Investment Banks
In the following part of my essay I would assess the structural dynamics of ARMs
and subsequently rationalize its inability to alleviate or address the financing needs
of the underprivileged. Home ownership given its welfare/development nature, and
its investment and consumption utility has always been an utmost concern for the
politico-economic agents of any society. The global financial crisis accentuated the
interdependency of real estate boom-bust cycle and overall financial stability of the
system.
The journey of the so called innovation from the plain vanilla Fixed Rate
Mortgages(FRMs) to ARMs and eventually to Interest Only Mortgages(IOMs), was
perhaps a need based evolution driven by ever growing real estate prices, and
banks pursuit to the serve the masses. Adjusted Rates Mortgages was an
innovation of 1980s not designed for the sub-prime borrowers initially; it was rather
meant to offer flexibility to the well-heeled clients as financial planning tool.
With the soaring real estate prices, banks started to employ adjustable-rate loans
with lower initial payments, and it went up to the extent of underwriting interest- only
loans to finance those pricey houses for the buyers. So the mounting prices of the
real estate turned ARMs from financial planning into an affordability tool. Hard sell
measures, commission based sales channel, laxed underwriting standards made it
expand by leaps and bounds. Interestingly, Wallstreet was quick enough to bundle
these risky assets in securities which enabled banks to off-load this from their
balance sheet thus easing out pressure on their capital adequacy. The underlying
assumption of this value chain, was continued real estate growth and low interest
rates to continue, greased by the weak regulation on Capital Adequacy and highly
leveraged banks, GAAPs accounting standards making the numbers look great, and
the lenient rating agency.
Prime Mortgage What takes it out of the reach of the Under-privileged?
The factors that sets the qualification criteria includes Loan Pricing (Ebrahim and
Mathur, 2011) which broadly sets the pricing to including the Interest rate charges (i)
and Loan to Value (Q/P). LTV is obviously dependent on Collateralization which
incorporates Property value and the earning/ payment capacity of the borrower. The
following figure presents an illustration of the conventional underwriting variables:
Underprivileged gets excluded from the mainstream lenders either due to low, or
volatile earning, high value of real estate, higher interest rates and at times smaller
tenor, as the above factors leads them to either high loan to value or a mounting
payment to income ratio, which is perceived as a risky loan to the prime lenders.
Scenario
Cause
Primary Impact
Demand
-Agency
decreases
Secondary Impact
cost
of
and
Debt Social
with
Welfare
a /Development Impact.
to-loan
crossover
Monetary their
Tightening
chances
refinanced
to
get
forcing
it
them Macroeconomic
towards a foreclosure
-Financial Exclusion
i increases Monetary
tightening / or
-Payment
to
increases,
inducing
a consumption.
pressure to default.
Durham University Durham Centre of Islamic Economics and Finance
Defaults
Endogenous
- Financial Exclusion
Liquidity crunch
triggers
credit
to
other
2011)
-Interestingly in 2004, US went through a combination of both of the situation i.e. monetary tightening and real estate price
decline, followed by the catastrophic GFC.
-It is pertinent to understand the macroeconomic dimension here that monetary tightening can dampen the real estate pricing,
so it has a causation as well complementary relationship real estate prices. Monetary tightening has an overall negative impact
over the consumption of an economy as well. Johnson et. Al 2014)
(
ARM is structured with a view real estate growth rate, rather than the usual
underwriting norms, thus assuming random walk log normal independently
identical real estate value, the negative amortization might end up in a
negative equity situation wherein P/Q < 1
ARMs manages the agency cost of debt and risk of cross over by
expecting
the
property
value
to
grow,
rather
than
the
debt
to
Higher interest rates charged due to accommodate for high LTV and the
underlying high risk and agency cost of debt, is understandably against
development and welfare motives. Charging more to the underprivileged
would hurt him further.
Selection, Moral Hazard, Risk shifting and broadens the agency wedge.
Mortgage originator usually has to control for liquidity, credit and interest rate
risk. The ARM payment profile was conceived with the thought to pass-on the
interest rate risk on to the borrower. However, the high agency cost of debt
and subsequent defaults/foreclosures converted the passed-on interest
rate risk in to counterparty-credit party risk. Ebrahim 2009, also discusses
the inability of banks to address credit risk, though liquidity risk (through
securitization) and interest rates (through ARM) are managed by the
originator.
Iron clad fixed payment debt contract with interest rates in nominal terms.
doesnt suits households with a large mortgage, inflation volatility and income
volatility, as it would take market in to havoc. (Ebrahim and Hussain 2010).
insisted on participatory mortgages which share income, appreciation or
equity. It is under the same grain of thought that Ebrahim along with nobel
prize winner Continuous Working Mortgage which avoids iron clad debt
contracts by indexing the balances and payments against housing index.
As a concluding remark, I would like to reiterate that ARMs are structured and
operates in a risky and default prone frame, with volatile factors like borrowers
income, inflation, interest rate and real estate valuation not only hurts the already
borrower, but promotes an environment of collective moral hazard, that we
experienced in the GFC few years ago. Deploying it to promote inclusivity and
welfare of the underprivileged is analogous to tossing them out of the pan in to the
fire
References
Shiller, R. J., Wojakowski, R. M., Ebrahim, M. S., & Shackleton, M. B. (2013). Mitigating Financial Fragility with
Continuous Workout Mortgages. Journal of Economic Behavior & Organization, 85, 269-285.
Shiller, R. J. (2008). The subprime solution: How today's global financial crisis happened, and what to do about it.
Princeton University Press.
Crotty, J. (2009). Structural causes of the global financial crisis: a critical assessment of the new financial
architecture. Cambridge Journal of Economics, 33(4), 563-580.
Ebrahim, Muhammed-Shahid (2009). Can an Islamic Model of Housing Finance Cooperative Elevate the
Economic Status of the Underprivileged?". Journal of Economic Behavior and Organization 72(3): 864-883.
Ebrahim, Muhammed-Shahid, Chapra, M.U., Siddiqi, M.N. & Mirakhor, A (2008). Discussion Forum: The
Financial Crisis: Comments from an Islamic Perspectives. IIUM Journal of Economics and Management 16(2):
111-118.
Ebrahim, Muhammed-Shahid & Hussain, Sikandar (2010). Financial Development and Property Valuation.
Journal of Banking and Finance 34(1): 150-162.
Johnson, Lewis D., and Edwin H. Neave. "The subprime mortgage market: familiar lessons in a new context."
Management Research News 31.1 (2007): 12-26.
Landier, A., Sraer, D., & Thesmar, D. (2011). The risk-shifting hypothesis: Evidence from subprime originations.
TSE Working Paper, 11.
Farhi, E., & Tirole, J. (2009). Collective moral hazard, maturity mismatch and systemic bailouts (No. w15138).
National Bureau of Economic Research.
Hellwig, M. F. (2009). Systemic risk in the financial sector: An analysis of the subprime-mortgage financial crisis.
De Economist, 157(2), 129-207.
Johnson, K. W., & Li, G. (2014). Are AdjustableRate Mortgage Borrowers Borrowing Constrained?. Real Estate
Economics, 42(2), 457-471.
Ebrahim, M. S., & Mathur, I. (2007). Pricing home mortgages and bank collateral: A rational expectations
approach. Journal of Economic Dynamics and Control, 31(4), 1217-1244.
Zorn, P. M., & Lea, M. J. (1989). Mortgage borrower repayment behavior: a microeconomic analysis with
Canadian adjustable rate mortgage data. Real Estate Economics, 17(1), 118-136.