By Cameron Polo
*This is part of a series. Click here to read the previous article.*
In a previous article, we analyzed the trend in North Carolina delinquency rates for prime and subprime mortgage loans leading up to the 2007-09 Global Financial Crisis. We now turn our attention to the performance of fixed-rate versus adjustable-rate mortgages during the crisis. The historical standard for financing a home purchase is the fixed-rate mortgage (FRM). An FRM is a fully amortizing mortgage loan where the interest rate on the note remains the same through the term of the loan. During the go-go years of the housing boom, the adjustable-rate mortgage (ARM) became an increasingly popular way to get borrowers into homes they may not otherwise be able to afford. With an ARM, the initial interest rate is fixed for a period of time, typically two or three years, and this initial rate is commonly referred to as a “teaser rate.” After this initial period, the interest rate resets periodically, at yearly or even monthly intervals, and the typical direction of the first reset is up, often significantly. As long as home prices were increasing, overextended borrowers who could not afford the new interest rate could refinance into another ARM, with another low teaser rate. However, as the below graph demonstrates, once the housing bubble burst, borrowers with ARMs could no longer refinance, and they became trapped in a mortgage they could not afford.
At the height of the crisis, approximately 16% of all conventional (within conforming loan limits) ARMs were delinquent, compared to a peak delinquency rate of 7.84% for conventional FRMs. This spike in ARM delinquencies is not so surprising when you consider the fact that for many borrowers, their monthly mortgage payment increased by three times the previous amount upon expiration of the teaser period.
The graph also highlights the tight correlation between the delinquency rate for all conventional mortgages and the rate for conventional FRMs, reflecting the fact that FRMs represented a large majority of conventional mortgages.
The performance of ARMs during the crisis becomes even more dramatic when you break it down by prime versus subprime.
At the peak of the crisis, one in three subprime borrowers with an ARM in North Carolina were delinquent, a rate that was previously considered unimaginable. Adjustable-rate mortgages are frequently criticized for accelerating the decline in home prices when the bubble finally burst. But the data reveals that it was ARMs, combined with subprime, that was the real accelerant. In fact, the delinquency rate for subprime FRMs was much closer to the delinquency rate for subprime ARMs than it was to prime FRMs.
Due to the complex chain of financial intermediation that developed in the decade or so leading up to the crisis, a missed mortgage payment in North Carolina could affect the value of a mortgage-backed security held by a German bank. In the end, massive numbers of delinquent borrowers are what caused a housing market crash to infect the broader world economy and lead to the worst recession the U.S. had seen since the Great Depression.