What Is Adjustable-Rate Mortgage Securities (ARMS)?
Adjustable-rate mortgage securities (ARMS) are a type of debt security that represents an investment in a pool of adjustable-rate mortgages. As a component of the broader category of mortgage-backed securities (MBS), ARMS are created through the process of securitization, where individual mortgage loans are bundled together and then sold to investors as tradable securities. The key characteristic of the underlying mortgages in an ARM security is that their interest rates, and consequently the borrower's monthly interest payments, can fluctuate over the life of the loan, typically resetting at predetermined intervals based on a specified index. This contrasts with traditional fixed-rate mortgages, where the interest rate remains constant.
History and Origin
The concept of securitizing mortgages gained significant traction in the United States in the late 1960s and early 1970s, leading to the development of the broader MBS market. The Government National Mortgage Association (Ginnie Mae) issued the first mortgage-backed security for the retail housing market in 1970. As the mortgage market evolved, so did the financial instruments within it. Adjustable-rate mortgages (ARMs) became more prevalent, offering borrowers initial lower interest rates compared to their fixed-rate counterparts.
The market share of ARMs has fluctuated significantly over time, reaching highs of 60% to 70% of all mortgage originations in the mid-1990s. However, their popularity saw a notable surge again in the years leading up to the 2007-2008 financial crisis, particularly within the subprime lending sector6, 7. During this period, ARMs, including hybrid products like 2/28 and 3/27 ARMs, attracted a larger pool of borrowers by offering lower initial costs, even to those with less robust credit histories5. The subsequent increase in default risk and the "payment shock" experienced by many borrowers when their interest rates reset significantly contributed to the instability observed in the housing market4.
Key Takeaways
- Adjustable-rate mortgage securities (ARMS) are investments backed by pools of adjustable-rate mortgages, where the interest rate on the underlying loans changes periodically.
- Investors in ARMS face interest rate risk and prepayment risk, alongside the credit risk of the underlying borrowers.
- ARMS can offer a higher yield compared to fixed-rate mortgage-backed securities when interest rates are expected to rise.
- The value and performance of ARMS are sensitive to changes in benchmark interest rates and the overall housing market conditions.
Formula and Calculation
While there isn't a single universal formula for "adjustable-rate mortgage securities" themselves, their value is derived from the cash flows of the underlying adjustable-rate mortgages. The calculation of an individual ARM's periodic payment involves several variables:
- Index: A benchmark interest rate (e.g., SOFR, CMT) to which the mortgage's interest rate is tied.
- Margin: A fixed percentage added to the index rate by the lender to determine the borrower's actual interest rate. This margin remains constant over the life of the loan.
- Caps: Limits on how much the interest rate can adjust at each reset period (periodic cap) and over the life of the loan (lifetime cap).
- Reset Period: How often the interest rate adjusts (e.g., annually, every six months).
The monthly payment for an adjustable-rate mortgage (and thus the expected cash flow for an ARM security) can be calculated using the standard mortgage payment formula, with the interest rate being updated at each reset period:
Where:
- (M) = Monthly mortgage payment
- (P) = Principal loan amount
- (r) = Monthly interest rate (annual rate divided by 12, which changes at each reset)
- (n) = Total number of payments (loan term in months)
The variable (r) in this formula changes based on the index and margin. For example, if the index rate increases, (r) will increase, leading to a higher monthly payment (M).
Interpreting the Adjustable-Rate Mortgage Securities
Interpreting ARMS involves understanding the interplay of interest rate movements, borrower behavior, and the structure of the security. Investors typically analyze the underlying mortgage pool's characteristics, such as the initial fixed period, reset frequency, and interest rate caps. ARMS can be attractive when prevailing interest rates are low, and investors anticipate future rate increases or a flattening of the yield curve, as the coupons on these securities would adjust upward. Conversely, in a declining interest rate environment, the coupon payments from ARMS would fall, potentially reducing investor returns. Investors also consider the potential for borrowers to refinance their loans, leading to earlier-than-expected principal repayment, which is a form of prepayment risk. The credit quality of the underlying borrowers also impacts the perceived credit risk of the ARM security.
Hypothetical Example
Consider an ARM security backed by a pool of 5/1 adjustable-rate mortgages. This means the interest rate on the underlying mortgages is fixed for the first five years and then adjusts annually thereafter. Suppose the initial average interest rate on these mortgages is 4.00%. For the first five years, investors in this ARM security would receive cash flows based on this fixed rate.
After five years, if the benchmark index (e.g., the 1-year Treasury Constant Maturity rate) has risen, and the margin is 2.5%, the new interest rate for the sixth year might be determined as:
Index Rate (at reset) + Margin = New Interest Rate
3.00% (hypothetical index rate) + 2.50% (fixed margin) = 5.50%
Assuming a periodic cap of 2% and a lifetime cap of 6% above the initial rate:
- Periodic Adjustment: The rate can only increase by a maximum of 2% in any single adjustment period. So, from 4.00%, it could rise to 6.00% (4.00% + 2.00%) in the first adjustment. The calculated rate of 5.50% is within this cap, so the rate for the next year would be 5.50%.
- Lifetime Cap: The rate cannot exceed 10.00% (4.00% initial + 6.00% lifetime cap) over the life of the loan.
The monthly cash flows to the ARM security holders would then increase, reflecting the higher interest payments from the homeowners. If the homeowners, facing these higher payments, decide to sell their homes or refinance, it would affect the security's cash flows through prepayments.
Practical Applications
Adjustable-rate mortgage securities are primarily traded in institutional financial markets, rather than by individual investors. They are key components of portfolios for entities such as pension funds, insurance companies, and mutual funds seeking exposure to the mortgage market. These investors utilize ARMS to manage their asset-liability management and tailor their fixed-income portfolios.
For example, during periods of rising inflation or when the Federal Reserve is expected to increase benchmark interest rates, investors might favor ARMS over fixed-rate MBS. This is because the floating-rate nature of ARMS means their coupon payments can adjust upwards, providing some protection against inflation and rising rates. Conversely, when interest rates are stable or declining, the appeal of ARMS may diminish. The Federal Reserve's actions, while not directly setting mortgage rates, significantly influence the broader interest rate environment, which in turn impacts the pricing and demand for mortgage-backed securities like ARMS3. The market share of ARMs has declined significantly in recent years, falling to less than 10% of all residential mortgage originations by 2010, partly due to the financial crisis and shifts in interest rate structures2.
Limitations and Criticisms
One of the primary limitations of adjustable-rate mortgage securities stems from the inherent refinancing risk and interest rate volatility of the underlying loans. While rising rates can increase the yield for investors, falling rates can lead to a decrease in the ARM's coupon payments, negatively impacting returns. Furthermore, if interest rates rise significantly, borrowers with adjustable-rate mortgages may experience "payment shock," where their monthly payments become unaffordable. This can lead to increased default rates and foreclosures on the underlying mortgages, which in turn can lead to losses for investors in ARMS. The Federal Reserve Bank of San Francisco noted that the surge in default rates on subprime ARMs was a significant factor in the collapse of the subprime mortgage market1.
Another criticism revolves around the complexity of these securities, especially when they are structured into more elaborate forms, such as Collateralized Mortgage Obligations (CMO) with various tranches. Understanding the nuances of their prepayment speeds and interest rate sensitivities requires sophisticated financial modeling and analysis. The opacity and complex structures of some mortgage-backed securities, including those backed by ARMs, were highlighted as contributing factors to the 2008 financial crisis.
Adjustable-Rate Mortgage Securities vs. Fixed-Rate Mortgage
The fundamental difference between Adjustable-Rate Mortgage Securities (ARMS) and Fixed-Rate Mortgage (FRM) securities lies in the interest rate structure of their underlying loans.
| Feature | Adjustable-Rate Mortgage Securities (ARMS) | Fixed-Rate Mortgage (FRM) Securities |
|---|---|---|
| Interest Rate | Variable; adjusts periodically based on an index plus a margin. | Fixed; remains constant over the entire loan term. |
| Payment Stability | Monthly payments can fluctuate, leading to potential "payment shock" for borrowers. | Monthly payments remain stable and predictable for borrowers. |
| Interest Rate Risk | Investors face significant interest rate risk, as coupon payments can rise or fall. | Investors face less direct interest rate risk on coupon, but significant prepayment risk if rates fall. |
| Prepayment Risk | Present, but often less pronounced in a rising rate environment if borrowers are "rate locked". | Significant; borrowers are more likely to refinance if rates fall, reducing the security's life. |
| Market Suitability | Favored by investors expecting rising interest rates or higher yields. | Favored by investors seeking stable, predictable income streams. |
While ARMS offer the potential for higher yields in a rising rate environment, they also carry greater payment variability and associated liquidity risk compared to a fixed-rate mortgage security, which provides consistent cash flows.
FAQs
What determines the interest rate on an adjustable-rate mortgage within an ARM security?
The interest rate on an adjustable-rate mortgage is determined by adding a fixed percentage, known as the margin, to a chosen benchmark index. Common indexes include the Secured Overnight Financing Rate (SOFR) or the Constant Maturity Treasury (CMT) rates. This combined rate then adjusts at pre-defined intervals, such as annually, subject to any caps on the rate increase or decrease.
How do rising interest rates affect Adjustable-Rate Mortgage Securities?
When benchmark interest rates rise, the interest rates on the underlying adjustable-rate mortgages within an ARM security also typically increase, leading to higher monthly cash flow for investors. However, this can also increase the risk of default by borrowers who struggle to afford the higher payments.
Are Adjustable-Rate Mortgage Securities considered risky?
Like all investments, ARMS carry risks. They are subject to interest rate risk, as changes in benchmark rates directly affect their coupon payments. They also carry credit risk related to the ability of the underlying borrowers to make their payments, and prepayment risk, which is the risk that borrowers will pay off their mortgages early. The specific risks depend on the quality of the underlying mortgages and the structure of the security.
Who typically invests in Adjustable-Rate Mortgage Securities?
ARMS are typically held by institutional investors such as pension funds, insurance companies, and mutual funds that manage large fixed-income portfolios. These investors use ARMS to diversify their holdings and to manage interest rate exposure within their portfolios.