Can ARMs be swapped to a fixed rate?

By Felix Salmon
December 6, 2009

A friend of mine took out a 5/1 ARM in early 2005, which is about to reset. Lots of other 3/1 and 5/1 ARMs are resetting over the next couple of years, which is one reason it’s important to keep interest rates low. The standard reset rate for a prime borrower is 1-year Libor + 225bp; with Libor at 1%, that works out at an extremely affordable 3.25% mortgage rate.

The problem is that these mortgages continue to reset every year going forwards for over a decade. Rates are low now, but they won’t be low forever, and when the Fed’s tightening cycle starts, there could be some very nasty mortgage shocks. These mortgages were designed to be refinanced, not held onto — but of course refinancing is expensive at best and, in many cases, outright impossible. Is there some way to lock in a fixed rate now without refinancing? Or, to put it another way, can you keep the credit risk and the prepayment risk with the originating bank, while layering an interest-rate swap on top?

In the case of mortgages written and held by banks, I don’t see why not. It should by rights be quite easy for that bank to enter into a simple swap agreement on top of the mortgage agreement, whereby in return for a fixed monthly payment, the bank will cover the mortgage payment going forwards.

This isn’t a normal swap agreement, because it doesn’t have a fixed maturity date: instead, the swap expires when the mortgage is either paid off or refinanced. Essentially, the bank is extending the prepayment option on the mortgage to the swap agreement itself. That doesn’t reduce the bank’s prepayment risk, but it doesn’t increase it either.

Clearly, however, it’s harder to enter into this kind of a deal with a securitized mortgage. And given the non-standard nature of the swap, there’s a risk that even an originating bank would end up ripping off the homeowner. Maybe there’s a role for the government here: mandate that all mortgages which readjust annually can be swapped at the borrower’s request into a mortgage with the same maturity as the original loan, at the prevailing 15-year fixed rate, so long as that fixed rate is higher than the rate to which the mortgage payment would currently be reset. Is there anybody who would be harmed by such a rule?

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