Democrats frothed and Republicans shuddered this week when Alan Greenspan suggested that Congress slash Social Security benefits. The frenzy was a shame, because it overshadowed an even more controversial statement the Fed chairman made earlier in the week. On Monday, the 78-year-old banker seemed momentarily to morph into peppy-personal finance maven Jean Chtatzky. As the headliner at the Credit Union National Association's meeting— although I'm sure the bankers were also eager to see "David Landis performing as the U.S. Sen. George Norris, original signer of the 1934 Federal Credit Union Act"—Greenspan explained why consumers might be better off considering adjustable-rate mortgages, or ARMs, instead of standard fixed-rate mortgages. While fixed-rate mortgages have their benefits, he noted that:
Calculations by market analysts of the "option-adjusted spread" on mortgages suggest that the cost of these benefits conferred by fixed-rate mortgages can range from 0.5 percent to 1.2 percent, raising homeowners' annual after-tax mortgage payments by several thousand dollars. Indeed, recent research within the Federal Reserve suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade, though this would not have been the case, of course, had interest rates trended sharply upward.
All advertisements for financial services products—mutual funds, stocks—insist that past performance is no guide to future performance. Greenspan should have said the same. Yes, in hindsight, getting an ARM in 1993, when long-term rates were far higher than they are today, would have been brilliant. But let's say long-term rates had risen over the course of the 1990s. Would he now be lecturing us on how ARMs have cost homeowners thousands of dollars in higher interest rates?
Greenspan also conspicuously ignored the non-monetary benefits associated with fixed-rate mortgages. Homebuyers pay a premium for the ability to lock in a fixed interest rate—and hence have utter certainty on the size of their payment for up to three decades. But in return, they receive peace of mind, security, and the ability to plan.
By agreeing to a fixed-rate mortgage, home-buyers purchase a cap on the interest rate and, in effect, buy an option to switch to a lower rate. They're placing the interest-rate risk firmly on the balance sheet of the lender. If the market makes you out to be a chump—i.e., if interest rates fall sharply after you've agreed to a fixed-rate mortgage—you can refinance. Sure, it costs a few thousand dollars and involves some paper work, but it can save a homeowner many times that amount.
Anyone who takes out an ARM essentially assumes interest-rate risk. If interest rates rise over time, your mortgage payments rise, too. In Greenspan's ARM-ed world, homeowners would have to watch interest rates every day, make judgments as to whether they think rates are going to rise or fall, and hedge accordingly. How much is it worth not to have to sift through Greenspan's opaque congressional testimony and monitor speeches by obscure Federal Reserve governors to divine the future path of interest rates?
Greenspan also presumes that Americans would be effective market-timers, which recent experience tells us they are most certainly not. In 1993, which would have been an optimal time to purchase an ARM, about 20 percent of mortgage origination volume consisted of ARMs, according to the Mortgage Bankers Association. The figure has bounced around for much of the past decade. In 1998 and 2001, ARMs garnered just 12 percent of mortgage origination volume. The proportion rose sharply to 19 percent in 2003. In other words, just as people rushed out to buy stocks after they moved up dramatically, people frequently rush out to take out ARMs after interest rates fall sharply.
Buying an ARM when long-term interest rates are in long-term decline makes sense. But if you buy one in a period when the general trend of interest rates is higher, then you could be just another American Sucker. And that's why Greenspan's comments seem oddly timed.
If ever there were a moment when an ARM didn't seem to a good buy, surely it is now. Interest rates are at historic lows. Can rates drift a little lower? Sure. Can they go significantly lower? Most likely not. The balance of risks, as Greenspan might put it, certainly weighs in favor of interest rates remaining stable or rising over the next several years, not falling. As Greenspan noted in his Social Security comments, there exists in Washington "a dynamic in which large deficits result in ever-growing interest payments that augment deficits in future years." These persistent, massive deficits will certainly place upward pressure on interest rates. And does anybody think the inept band of borrowers and spenders in Washington is going to address the structural imbalances they've created before a crisis sets in and before interest rates start to spike?
Strictly speaking, Greenspan is correct. If you borrow money while interest rates are falling, then an ARM is superior to a fixed-rate mortgage. But while homeowners may pay a little less with an ARM, they may wind up sleeping less when rates climb again—as they inevitably do. Man does not live by basis points alone.