Adjustable Rate Mortgages: Increasing Efficiency More Than Housing Activity

This publication primarily presents economic research aimed at improving policymaking by the Federal Reserve System and other governmental authorities. Articles may be reprinted if the source is credited and the Research Department is provided with copies of reprints. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. Adjustable rate mortgages (ARMs)—mortgages with monthly payments that fluctuate with changes in interest rates—began to be widely issued after 1982. About this same time, housing activity rebounded at an unexpectedly healthy clip despite historically high nominal interest rates. Noting the coincidence of the growth of ARMs and the unexpectedly strong housing activity, many observers concluded that the widespread use of ARMs was primarily responsible for the strong 1982-84 housing activity. In this paper we argue, however, that there was little or no causal relationship between growing ARM issuance and the strong housing activity. 1 After providing some background , we question the argument made by those observers who attach critical importance to ARMs for stimulating the strong housing activity. We then suggest that ARMs became popular because they allow increased market efficiency; that is, ARMs permit borrowers and lenders to better share risks associated with fluctuating incomes and interest rates. Finally, using a statistically based forecasting model of housing activity, we provide some empirical evidence indicating that the housing spurt would have been about as strong without ARMs. The model finds that although nominal fixed rate mortgage (FRM) interest rates were high, effects associated with their decline during this period adequately account for most of the 1982-84 pickup in housing activity. Background Having been legalized nationally for federally chartered savings and loan institutions in 1981, ARMs began to be