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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Comments
6 comments so far

“Is there anybody who would be harmed by such a rule?”
yes, the banks. duration risk is considerably higher for a fixed rate mortgage than for an arm.

Posted by alea | Report as abusive

alea is clearly right.

But with interest rates so low, the prepayment risk must also be low both in terms of the probability of prepayment and in terms of the cost to the bank if prepayment occurs. So the extra charge that the bank needs to make for taking this risk should (could?) also be low.

More widely, is it possible in US jurisdications to agree prepayment penalties with the borrower when extending arrangements in this way? This would (for example) be normal in the UK even at the time of writing the original mortgage, and can completely protect the bank from the risk.

Posted by RogerS | Report as abusive

Government involvement in the property market is best kept to a minimum, though it is necessary at times.

If you choose a longer term fixed rate you do so for the sake of longer term security, knowing that you give up flexibility to take advantage of short term improvements.

The type of mortgage structure you take should reflect your risk profile.

Posted by cheapinsurance | Report as abusive

An ARM would “currently reset” to the short rate. For a steep* yield curve, a bank wouldn’t enter this swap for free; the debtor would start immediately paying an extra stream of payments with the expectation that, if rates exactly follow the forward curve, their overall payment would have otherwise risen higher, and won’t with the swap. And I think this might make it unattractive to people who have entered into ARMs specifically because it gets the monthly payment down; they might be more inclined to take the gamble than to actually pay fair value for the swap. So short of forcing banks to take an actuarially unfair deal, which is what you seem (reading you literally at least) to suggest in the penultimate sentence, I don’t know that you’re going to see a huge demand for this product.

*You know, in some sense. Not perfectly flat, anyway.

Posted by dWj | Report as abusive

“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”

What you’re describing is a balance guaranteeed swap, and it’s regularly used in securitisation, for obvious reasons. It’s pretty hard to price for a single reference asset, though – it usually works better for portfolios of amortising assets.

Posted by GingerYellow | Report as abusive

Why would you let the fix at the 15yr rate? Those are always lower than the 30yr rate, and the arm’s were undoubtably 30yr notes. People took arms because they cost less and they were trying to pull one over on the bank. There should not be a free exit from this while others paid higher costs choosing frm’s.

The loans were designed to be refi’d to the extent that the refi’s generated new fees for the bank, a very important point. Didn’t banks/securitizers (during the boom) prefer subprime loans because they prepaid at lower rates?

Posted by winstongator | Report as abusive
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