To ARMs, to ARMs! Options Can Control Mortgages
Schap, Keith, Modern Trader
Seldom can "ordinary" people use the risk management potential of futures and option markets.
Mortgages, however, may be the one exception because only in their housing investments do people have a cash side - and a risk - large enough to use hedging tactics involving futures or options. U.S. homeowners who are aware of how options work might look at the current surge of refinancing in a different light and see opportunities in today's interest rate markets that others may miss.
Across the United States, mortgage rates for 30-year, fixed-rate instruments are in the neighborhood of 8.5%, lower than any time since the mid-1970s. The steady slide through 1991 has produced a spate of headlines stressing the advantages of refinancing: "Homeowners can save by refinancing," "Fixing your home finance package," "How to figure the cost of refinancing a loan."
Flying in the face of that conventional wisdom, other headlines claim "Fixed-rate mortgages may be no bargain" and say holders of an adjustable-rate mortgage (ARM) should think about staying where they are.
For some, there might be a third alternative. Using options on interest rate futures, ARM holders could design positions that would, in effect, hold interest rates at tolerable levels.
"Using options to limit an ARM is akin to refinancing," says Steve Belmont, a commodities trading advisor with the Fox Investment Division of Rosenthal Collins Group. "Rather than refinancing, options allow borrowers to avoid |front-loading' their mortgages again, and that could lead to considerable interest savings."
Then again, as with all refinancings, it might not.
Newspaper advice columns that promote refinancing claim that after finding out the costs - which besides points include title, loan application, credit evaluation, legal and reappraisal fees - homeowners must determine a break-even level. A good rule of thumb apparently is that refinancing is viable if it's possible to recoup those costs in 24 months.
In any case, having done their homework, homeowners might see the way to real savings. U.S. League of Savings Institutions data suggests that, had a homeowner taken out a 30-year, fixed-rage mortgage for $100,000 at 14.67% in July 1984 and refinanced in August 1986 at 10.2%, the interest savings as of last August would be $25,558.
But the same study shows another owner who used an ARM with an initial rate of 12.41% to finance the same position (also starting in July 1984) would be $32,616 ahead of a fixed-rate borrower who didn't refinance and over $7,000 ahead of one who had. In general, League data suggests, between 1981 and 1990, ARMS cut interest costs 25% on average.
Not to be overlooked in thinking about those results, mortgage rates declined steadily throughout that period as the chart of Chicago rates shows. Thus, that kind of savings might not be possible in the future. Also, buyers shouldn't be misled by the attractive "teaser" rates of ARMs.
Mortgage lenders know well that interest rates are as likely to go up as down. Borrowing short to lend long, they face a ruinous situation if short-term rates climb sharply. If so, they have locked in a long-term asset they must now fund at an unprofitable, perhaps even negative, spread. In short, since the 1970s, traditional banking practice has had to cope with major interest rate risk.
Quite simply, ARMs pass that risk on to borrowers. Because of that, homeowners must look carefully at the workings of their loans before deciding on a course to take. After all, bankers aren't in the habit of giving anything away.
While many people, uncomfortable with the uncertainty of an ARM, happily pay to acquire the stability of a conventional mortgage, the superficial differences between ARMs and conventional mortgages are intriguing. According to Thomas Gobby, vice president-public relations and community relations at Talman Home Federal Savings and Loan Association of Illinois, Talman offers ARMs with three reset possibilities: six months, one year or three years. …