Investigating why U.S. homebuyers have increasingly preferred fixed-rate mortgages to adjustable-rate mortgages (ARMs) in recent years, authors Emanuel Moench, James Vickery and Diego Aragon find that the trend predominantly reflects the same long-run factors that drove mortgage choice in earlier periods—namely, the term structure of interest rates and its effects on the pricing of different kinds of mortgages. Supply-side factors, in particular a rise in the share of mortgages eligible to be securitized by the housing government-sponsored enterprises, also play a role in the low current ARM share.
According to Moench, Vickery and Aragon, the share of adjustable-rate mortgages has fluctuated significantly over time, and accounted for up to 60 to 70 percent of all mortgage originations at one point in the mid-1990s. In the last several years, the ARM share has declined significantly to less than 10 percent, a near-record low.
The authors begin their analysis by reviewing the competing explanations for the decline in the ARM share. One view holds that this decline is closely related to the financial crisis, and particularly to such developments as the collapse of the securitized nonprime mortgage market, where ARMs predominated. A second and related view holds that the heavy publicity surrounding high default rates on subprime ARMs and the "payment shock" triggered by interest rate resets on ARMs drove down demand for the adjustable-rate mortgages. A third view attributes the decline to changes in the term structure of interest rates and its effects on the pricing of mortgages.
To test these competing theories, Moench, Vickery and Aragon conduct a statistical analysis using loan-level mortgage data from Lender Processing Services and from the Federal Housing Finance Agency's Monthly Interest Rate Survey. They construct a model that contains a variety of variables that might help explain mortgage choice, including the term premium on Treasury yields (the difference between current long-term Treasury yields and average expected short-term interest rates), the spread between interest rates on fixed- and adjustable-rate mortgages, and variables that capture changes in lending standards and household liquidity constraints.
The model performs well in explaining the decline in the market share of adjustable-rate mortgages in recent years. A "rule-of-thumb" variable that measures the difference between current long-term interest rates and an average of recent short-term interest rates proves to be the most important determinant of the ARM share historically, and also accounts for most of the recent decline in the popularity of adjustable-rate mortgages. In addition, the authors find that a drop in the fraction of "jumbo" mortgage loans—loans that exceed the limits established for mortgages purchased by the housing GSEs Fannie Mae and Freddie Mac—may also have contributed to the reduced ARM share. This represents a composition effect—for a variety of institutional reasons, the share of ARMs is significantly higher in the jumbo market than in the "conforming" market.
Emanuel Moench is an economist in the Capital Markets Function and James Vickery an economist in the Financial Intermediation Function of the Federal Reserve Bank of New York. Diego Aragon, an assistant economist in the Financial Intermediation Function at the time this article was written, is now pursuing a master’s degree in Public Affairs at Princeton University.
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