Higher Risk Mortgage Loans Accompanied Overheated Housing Markets

FRBSF just published an interesting paper called "Did the Housing Boom Affect Mortgage Choices?" (Fred Furlong and Yelena Takhtamanova). The results suggest that adjustable rate mortgages (ARMs), which carry a higher risk to the borrower, were more prevalent for periods/areas of booming housing markets. This effect is visible across the borrower credit spectrum, although the lower FICO score borrowers seemed more willing to take ARMs risk in a booming market than those with a higher score.

Furthermore, rising mortgage interest rates for ARMs did not deter borrowers from using adjustable mortgages in hot housing markets. That was not the case in low housing appreciation situations. Of course increases in fixed rate mortgage (FRM) rates also pushed more people into using ARMs. But the variable that had the largest impact on the percentage of people using the more risky mortgages was the pace of housing appreciation.

This provides some empirical evidence for the pervasive culture of "don't worry, you'll refinance or sell if/when rates go up" in overheated housing markets. Rapid house price appreciation created an atmosphere of buying the most house for the least initial monthly payments.

FRBSF: During the housing boom, a shift took place in borrower mortgage choice, with borrowers increasingly opting for ARMs instead of FRMs. The increase in ARM shares was most pronounced in markets where house prices rose rapidly. In such markets, house price gains were strongly correlated with a rising ARMs share for home purchases. Moreover, in high-appreciation markets, the effects of fundamentals such as mortgage interest rate margins were muted.

It is not entirely clear what portion of ARMs users was fully conscious of the risks involved. That is why mortgage disclosure (including a national mortgage broker certification program) and borrower education should be a higher priority for regulators than making sure that some institutional investors don't take losses on structured products (see discussion).