Wikinvest Wire

Alan Greenspan on ARMs in 2004

Friday, October 12, 2007

It was a bit surprising to read this comment by Bob McTeer, the former president of the Federal Reserve Bank of Dallas, regarding the criticism directed toward former Fed chief Alan Greenspan for his 2004 remarks on adjustable rate mortgages.

Now, what about the chairman luring unsuspecting consumers into adjustable rate mortgages they couldn't afford? The origin of this charge is his speech on Feb. 23, 2004, to the Credit Union National Association. In a technical discussion of "Mitigating Homeowner Payment Shocks," the chairman noted fixed-rate mortgages had the advantage of allowing homeowners to prepay debt when interest rates fall but don't require higher payments when rates rise.

His research indicated, however, that this advantage was probably overpriced by the market. "Homeowners pay a lot of money for the right to refinance and for the insurance against increasing mortgage payments. 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."

Somehow, I doubt the chairman's geek speak sent Joe Six-pack running off to apply for an ARM he couldn't afford. Affordability, let's remember, is primarily a matter of income. At the Economic Club of New York a week later, the chairman, asked about his earlier remarks on ARMS, emphasized that their focus and applicability was limited to a very small segment of households.
What part about saving "tens of thousands of dollars had they held adjustable rate mortgages" is incomprehensible to Joe Six-pack?

This too came from the February 2004 speech in question - a sort of "call-to-arms" (no pun intended) for mortgage lenders to "get creative".
American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks but are willing to manage their own interest rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home.
Bob McTeer was lauded here at this blog not more than three months ago for his dissent on the savings rate versus wealth creation debate (see An Economist Breaks Ranks).

What's happened to this once-clear thinking former Fed governor?

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Anonymous said...

(Same old)^2. Occasionally, they have to sound credible. But do they ever act that way?

Spectator said...

I left this on McTeer's blog.

There are a number of issues with this piece.

To begin, LTCM was not the one bailed out. The banks that recklessly lent credit to LTCM were. Reports of the meeting in the Fed boardroom clearly indicate unaffected market players were forced to participate, against their better judgment. The reckless creditor banks were not required to take their medicine. Today these banks have toxic waste on their books, and freely move these on and off the books to hide losses (see Oct 10 article in WSJ on pricing problems). There you have the direct effect of that bailout.

Next, to say Greenspan tried to raise long term rates is disingenuous. Telegraphed quarter point raises over long periods do not resemble the kind of action the Fed should take to quell speculation. Taking the punchbowl away requires stiff raises over short periods, which no one at the Fed since Volcker had the guts to do.

I do not know what Greenspan intended with his statement on ARMs, so will not blame him for that. But his repeated denials of the possibility of a housing bubble, when it was obvious to many of us, encouraged all participants in the bubble. A cardinal sin for a central banker.

Spectator said...

Oops, that should have been Oct 12. The key quote from the article:

“Some financial firms have sought in recent weeks to avoid write-downs by selling mortgage positions to hedge funds, with an agreement that allows the hedge fund to sell them back after a set period. A hedge-fund trader says his firm recently bought $1 billion of risky subprime mortgage loans from Bear Stearns with a one-year pact, known as a ‘mandatory auction call,’ under which Bear agrees to participate in an auction for the loans that will provide the hedge fund with a minimum rate of return, according to a person familiar with the situation. ‘They didn’t want the mortgages on their books,’ the hedge-fund manager says.”

If that is not earnings manipulation fraud, I don't know what is.

Tim said...

Thanks Spectator - I'm not really familiar with the LTCM implosion but it's nice to see that someone else noticed McTeer's comments too - after all, he does get to write op-eds in the Wall Street Journal.

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