Welcome back to the Deep Dive. We are doing something
a little different today. Usually we tackle a
broad concept or a historical event, but today
we are opening a specific file. It's a file that
affects millions of homeowners. Yet, judging
by this stack of research on my desk, maybe 1
% of them actually understand the machinery inside
it. Yeah, that sounds about right. We are talking
about the adjustable rate mortgage or the...
The ARM. The ARM. You know, it's funny. That
acronym brings up such a visceral reaction depending
on who you're talking to. Oh, absolutely. If
you talk to a theoretical economist, they see
a tool of, you know, incredible efficiency and
flexibility. But if you talk to someone who lost
their home in 2008 or someone who works in consumer
advocacy. It's a different story. That acronym
is basically. A weapon of mass destruction. That
is the vibe I'm getting from these sources. It
is so polarizing. And I think for most people,
myself included, before I read all this, the
knowledge just stops at the name. You see ARM.
You think variable rate. You think, OK, my payment
might change. And that's it. You look at the
monthly payment, ask if you can afford it, and
you sign the paper. And that's the danger. But
looking through this research, the reality is
so much more complicated. It's not just a loan,
is it? It's a mechanism for transferring risk.
That is the perfect way to frame this entire
conversation. I mean, if you take nothing else
away from this deep dive, I want you to understand
that an ARM is a machine designed to shift the
burden of uncertainty. A machine. Think about
it this way. When you take out a mortgage, you
are engaging in a massive financial bet on the
future of the global economy. The question is,
who is taking that bet? You. Or the bank. Risk
transfer is such a polite phrase, though. It
sounds like something an actuary does in a quiet
office. But let's ground this. What does that
actually mean for the person sitting at the kitchen
table paying their bills? Okay, let's contrast
it with the good old fixed rate mortgage. In
a standard 30 -year fixed loan, you are essentially
buying insurance. Insurance. You are paying a
premium. It's baked in as a slightly higher interest
rate. To make sure that no matter what happens
in the world, no matter if inflation hits 10
% or the Federal Reserve goes crazy. My bill
is the same. Your bill is exactly $2 ,000 a month,
period. The bank holds all that interest rate
risk. If the cost of money goes up, the bank
loses. And you, while you win. Right. I'm paying
for peace of mind. I'm locking in my reality
for the next 30 years. Exactly. But with an adjustable
rate mortgage, the bank is coming to you and
saying. We don't want to sell you that insurance
anymore. We want you to be the insurance company.
Wait, I'm the insurance company? Right. For the
bank? You are insuring the bank's profit margin.
If their costs go up, you pay them more. If their
costs go down, you pay them less. You are tethering
your family's budget directly to the volatility
of Wall Street and the yield curve. Which, when
you put it that way, sounds absolutely insane.
Why would I ever agree to act as a shock absorber
for a billion -dollar bank? I mean, they have
the reserves, a checking account. The price tag.
That's the hook. That is always the hook. Because
you're agreeing to take on that, you know, that
terrifying risk. The bank rewards you. They give
you a lower starting interest rate compared to
a fixed loan. The teaser. The teaser rate. Exactly.
It's a tradeoff. You get affordability today
in exchange for total uncertainty tomorrow. So
it's a gamble. I'm betting rates stay low. Yeah.
The bank is protecting itself in case they don't.
It is a gamble. But here's where it gets really
interesting and a little counterintuitive. We
have some scholarly perspectives in the source
stack that argue borrowers should generally prefer
errands. Really? Even with the risk of my payment
just exploding? The argument is based on long
term averages. Historically, short -term interest
rates are usually lower than long -term fixed
rates. That's just how the yield curve normally
works. So the theory goes, even if your rate
fluctuates up and down, the average rate you
pay over 10 or 15 years will likely be lower
than that expensive insurance premium you pay
for a 30 -year fixed rate. OK, I see the math
there. I get it on a spreadsheet. But that assumes
I can survive the bad years. That's the key.
An average works great in a model, but in real
life, one bad month where my payment doubles
can ruin me. I can't eat my average savings if
I've been foreclosed on. Precisely. And that
is the huge disconnect between economic theory
and household reality. The model assumes the
borrower has financial resilience, which is a
fancy way of saying you have enough cash sitting
around to handle the shocks. But that's not why
people take these loans. No. Most people taking
ARMs are doing it because they are stretched
thin and they need that lower initial payment
just to get in the door of the house in the first
place. So the people least able to handle the
shock are the ones signing up for the shock absorber
product. That is the irony at the heart of the
ARM market. And that's why our mission today
is to decode the jargon. We see these terms in
the documents. Indices, margins, negative amortization,
recast triggers. It's a whole other language.
It is. And we need to unpack what those mean,
because they aren't just fine print. They are
the gears in that risk transfer machine. And
as we will see later in this discussion, that
machine has a history of breaking down. We're
talking errors, scandals and billions of dollars
in overcharges. That part of the research actually
blew my mind. The error rates we're going to
talk about later. I don't want to spoil it, but
it's terrifying. It's stunning. But let's start
at the foundation, the architecture. If I sign
an ARM, how is my rate actually built? Because
it's not just some random number the bank CEO
picks out of a hat, right? No, no, not at all.
It is a very strict mathematical formula. And
it has two distinct components. You have the
index and you have the margin. Index and margin.
If you want a visual, think of the index as the
moving part, like the tide in the ocean. It goes
up and down, and the margin is a fixed pier built
on top of that tide. Your rate is the top of
that pier. Okay, let's unpack the index first.
This is the variable part, the tide. Correct.
The index is a published financial benchmark.
It's meant to reflect the lender's cost of borrowing
on the credit markets. Critically, it is objective,
it is public, and it moves up and down with the
economy. And the source lists a few of these,
and some of them sound like alphabet soup. We
have the CMT. The Constant Maturity Treasury.
That's tied to U .S. Treasury securities. It's
very common, very stable. It basically tracks
what the U .S. government pays to borrow money.
And there's one that caught my eye, COFI, the
Cost of Funds Index. But it says specifically
the 11th District. Why does the geography matter
here? Ah, this is one of the most interesting
nuances in the history of ARMS. The 11th District
Cost of Funds Index tracks the weighted average
cost of funds for savings institutions in Arizona,
California, and Nevada. So it's a regional thing.
But why would a borrower in, say, Florida, care
if their loan is tied to Nevada banks versus
the U .S. Treasury? What's the practical difference?
The speed. It's all about the speed of change.
KIOFI was historically known as a lagging index.
It moved like a giant cruise ship. not a speedboat.
A cruise ship. I like that. If the Fed raised
rates today, other indices might jump tomorrow.
But Kofi. It might take months to fully reflect
that change because it's based on a weighted
average of what banks are paying on old savings
accounts and CDs over time. I see. So if I'm
a borrower and I see a storm coming, you know,
interest rates are hiking up, CoFi gives me a
head start, a little breathing room before my
payment goes up. Exactly. It gives you a buffer.
It was a very borrower friendly index for that
reason. Whereas LIBOR. LIBOR. The London Interbank
offered rate. Now that sounds important. Is that
the speedboat? LIBOR is the raw nerve of the
global banking. system or it was it's largely
been phased out now after some uh major scandals.
But for decades, it was the king. Right. The
rate fixing. The rate fixing. Yeah. But its function
was to be the rate at which major global banks
lend to one another overnight. It reacts instantly
to global tension, credit crunches or policy
changes. If you are tied to LIBOR, you are feeling
the market's pulse in real time. No lag at all.
And interestingly, the source mentions the CPI,
the Consumer Price Index, can be used to tying
my mortgage to the price of milk and gas. It
can be, though it's less common. That ties your
mortgage to inflation directly. But there is
one other type of index mention that should raise
a massive red flag for any listener. Some lenders
use their own internal costs of funds as the
index. That sounds incredibly suspicious. It's
like I've investigated myself and found that
my costs have gone up. So you need to pay me
more. It certainly creates a massive conflict
of interest. It allows for what we might call
profit margin padding. If the index isn't a neutral
third party number like treasuries. or LIBOR,
the borrower has to trust the lender implicitly.
And in finance, trust is good, but verification
is always better. Which is a tall order for the
average person. OK, so that's the index. It moves.
That's the tide. Now talk to me about the margin.
You said this is the fixed peer. Right. The margin
is the lender's profit. It is a set percentage
that gets added on top of the index. And this
is key. It typically stays fixed for the entire
30 -year life of the loan. So it never changes.
Never. So if your margin is, say, 2 % and the
index is at 4%, your rate is 6%. If the index
jumps to 8%, your rate becomes 10%. The margin
is the constant markup. And the source says this
margin is usually between 2 % and 7%. That's
a pretty wide range. It is a wide range, yes.
It depends on the lender, the product, your credit
score, all sorts of factors. And this leads us...
to a really critical term, the fully indexed
rate. Which is just the formula, index plus margin,
the real price of the loan. Exactly. It's the
true market rate for your loan on any given day.
But here is the trap. Most ARMs don't start at
the fully indexed rate. They start with a teaser.
Ah, the teaser rate. The classic drug dealer
model. The first one is cheap. Get them hooked.
It is a promotional aid, absolutely. A lender
might offer a start rate that is substantially
below the fully indexed rate. Let's say the index
plus margin should be 7%, but they offer you
4 % for the first year. And the psychological
trap here is just so obvious. You get used to
paying that 4%. You budget for 4%. You buy a
new car, assuming your mortgage is based on 4%.
And then the adjustment period ends, the teaser
expires, and suddenly you are hit with the reality
of the market. This is what the industry calls
payment shock. And it's a double whammy, right?
It is. It isn't just that the underlying index
might have gone up. It's that the artificial
subsidy the bank was giving you was removed at
the same time. So you get hit twice. So that
adjustment timeline is crucial. How often does
this actually happen? It varies a lot. You have
the adjustment period, which dictates how often
the rate resets. It could be every single month.
It could be every year or every three years.
Every month. That sounds exhausting. I'd be checking
the financial news every morning in a cold sweat.
It creates immense uncertainty. But there are
guardrails, and this is where we need to get
into the math, because understanding these guardrails
or caps is the difference between an annoying
increase and, well, bankruptcy. Okay, let's talk
caps. The source breaks these down into a structure,
usually three numbers, like X, Y, Z. I want to
pause on the math here because I think this is
where people get really hurt. It is. We see these
numbers in our mortgage documents. 2 slash 2
slash 6. It looks like a locker combination.
So let's role play this. Let's say I borrow $500
,000 on an ARM. My start rate, the teaser, is
a nice low 4%. Okay, so at 4 % on a 30 -year
term, your principal and interest payment is
roughly $2 ,387, manageable for a decent income.
Right, I can do that. Now, the first year ends.
The teaser is gone. And let's say it's a bad
year. Inflation is rampant. The index has jumped
up by 3%. My margin is 2%. So the formula says
my rate should now be my index plus margin, which
is 9%. That's a huge jump. It is. A jump from
4 % to 9 % would be devastating. But your initial
adjustment cap, that's the first number in that
226 sequence it steps in. That first two points
means your rate is physically prevented from
jumping all the way to 9%. It can only increase
by a maximum of two percentage points on that
very first adjustment. So 4 % plus 2 % equals
6%. Okay, so I'm saved. My rate only goes to
6%, not 9%. For this year, yes. Your payment
now jumps from roughly $2 ,400 to about $3 ,000.
That's a $600 a month increase. That hurts. I
might have to cancel a vacation, maybe eat out
less, but I'm not homeless. But here is the danger.
The market rate is still 9%. You are effectively
being subsidized by the cap for this year. So
if rates stay high next year, the periodic cap,
that second number, the second two, allows another
2 % jump. So I go from 6 % to 8%. Exactly. And
your payment goes up again and then again the
year after that until you finally hit the market
rate or you hit the lifetime cap, the third number.
The 16 -hour example. That 6 -4 means your rate
can never go more than 6 percentage points above
your original start rate. So your 4 % start rate
plus the 6 % cap equals a 10 % maximum. That's
your doomsday number. So at 10%, my payment would
be nearly $4 ,400. That's almost double where
I started. Exactly. Even with caps, which are
supposed to protect you, your payment can double.
That is the risk you accepted for that lower
initial rate. That is terrifying, but at least
I can calculate the absolute worst case scenario.
Yeah. But, and here's where it gets really murky.
There is a distinction mentioned in the source
between a rate cap and a payment cap. And confusing
the two seems like it could be disastrous. This
is one of the most dangerous misunderstandings
in the world of mortgages. A rate cap limits
the interest percentage, like we just discussed.
A payment cap limits the dollar amount your check
increases. Okay, so give me an example. Let's
say you have a 7 .5 % payment cap. Your payment
is $1 ,000 a month. This tap means it can only
go up to $1 ,075 next year, no matter what happens
to interest rates. That sounds great. It protects
my wallet. I know exactly what my budget needs
to be. It feels safe. It protects your cash flow,
yes. But it does not protect you from the interest.
If the underlying interest rate spiked, and the
interest the bank is actually owed for that month
is, say, $1 ,500, but you only paid $1 ,075.
What happens to that difference? I assume I still
owe it. The bank's not just going to forget about
it. You do. You are short $425. The bank doesn't
just forgive that. They take that $425 of unpaid
interest and they add it to your principal loan
balance. So my mortgage gets bigger. I paid my
bill on time, but my debt went up. Correct. This
is called negative amortization. You are making
payments. But you are going deeper into debt
every single month. It's like running on a treadmill
that's slowly tilting backwards. That is a nightmare
scenario. You could pay for five years and owe
more than you bought the house for in the first
place. And that leads to massive equity erosion.
If housing prices drop at the same time, which.
By the way, often happens when interest rates
are rising. You can find yourself underwater
almost instantly. You can't sell. You can't refinance.
You are completely trapped. We're going to get
deeper into that, specifically with option ARMs
in a minute. That feels like the true crime section
of this deep dive. Yeah. But I want to look at
the menu available to borrowers first. Because
ARMs aren't just one thing. There are different
flavors. Right. And the most popular flavor,
especially in the last two decades, is the hybrid
ARM. This is pitched as the best of both worlds,
right? That's the pitch, in theory. A hybrid
ARM is fixed for a set period, and then it starts
to float. You see them listed as 31, 51, 71.
The first number is the number of years the rate
is fixed. A 51 is fixed for five years. The second
number is how often it adjusts after that period
ends. So a 51 is fixed for five years, then adjusts
every one year thereafter. I was reading in the
source that the popularity... these just exploded.
In 1998, they were less than 2 % of all loans.
By 2004, it was almost 30%. Why the sudden surge?
It was a sweet spot for the psychology of the
American homebuyer at the time. People looked
at the data and said, I'm probably going to move
in five or seven years anyway. The average American
moves every seven years. Why am I paying the
premium for a 30 -year fixed rate if I'm only
going to be in this house for five? So they're
gaming the system. They are. The hybrid ARM gave
them a lower rate than the 30 -year fixed, guaranteeing
that low payment for the entire time they plan
to own the home. It seemed like a no -brainer.
It's a bet on your own life plans. You're betting
you'll sell the house or refinance before that
crucial date, the reset date. The reset date
is the cliff edge. That's the day the clock strikes
midnight. If you are still in that house on that
date, the loan transforms from a safe predictable,
fixed animal into a volatile, variable beast.
A lot of people lost that bet in 2008 and 2009.
A lot of people. Now let's talk about the product
that really defined the bubble era for so many
people. The option ARM, also known as the pick
a payment loan. This feels less like a loan and
more like a carefully constructed trap. This
is a complex financial instrument that was, believe
it or not, originally designed for very sophisticated
borrowers, people with extremely lumpy incomes
like commission -based salespeople or seasonal
workers. Imagine a wealthy entrepreneur who makes
$500 ,000 in December, but basically zero in
January. The idea was flexibility. But it went
mainstream in a big way. It did. And here is
how it worked. Every month, you get a bill with
four choices. Walk us through the four options
on the menu. Option one, a 30 -year fully amortizing
payment. This is like a normal mortgage payment
paying both principal and interest. Option two,
a 15 -year amortizing payment if you want to
pay it off faster. Option three, interest only.
You're just paying the rent on the money you
borrowed, but you're not paying down the actual
debt. Okay, and then the fourth one, the dangerous
one. And option four, the specified minimum payment.
And human nature being what it is. Almost everyone
chose number four. The minimum payment. But that
minimum payment was based on that super low teaser
rate, wasn't it? Yes. Often as low as 1%. So
imagine opening your bill. You owe $500 ,000
on your house. The full payment is $3 ,000. The
minimum payment is $1 ,200. And you've got a
car payment. Your kids are in braces. Groceries
are expensive. I'm clicking the $1 ,200 button.
Every single time, no question. Exactly. But
the actual interest rate on the loan isn't 1%.
It might be 6 % or 7%. So that difference, that
$1 ,800 in interest that you didn't pay, it doesn't
just vanish. The bank adds it to the loan. They
add it right onto the principal. So next month,
your mortgage isn't $500 ,000 anymore. It's $501
,800. And the month after that, it's $503 ,600.
You are literally borrowing more money from the
bank each month. to pay the interest on the money
you already borrowed. And eventually that bucket
has to overflow. The math is relentless. This
is the recast. This is the moment the music stops.
This is the moment. The contract says, OK, this
has gone on long enough. And there are two triggers
for it. One is a time trigger. Usually every
five years, the loan will automatically recast.
But the scary one is the balance trigger. The
MIG -AM cap. The negative amortization cap. The
contract says if your loan balance grows to,
say, 110 or 125 percent of the original loan
amount, the loan automatically recasts right
then and there. And what does recast mean in
plain English for the borrower? It means the
party is over. The bank completely recalculates
your payment to be whatever it needs to be to
pay off the entire new larger balance over the
remaining term at the full interest rate. No
more minimums, no more choices. That must be
a massive, massive jump. It's colossal. We're
talking about people going from paying that comfortable
$1 ,200 a month to $3 ,500 a month literally
overnight. That is the ultimate payment shock.
And because you've eaten away all your equity.
Or worse, your loan is now bigger than the house
is even worth. You can't refinance. You're completely
trapped. This one mechanism is what caused hundreds
of thousands of foreclosures in the financial
crisis. It's incredible that this was ever a
mainstream product. It seems almost designed
to fail. It was sold on the dream of affordability.
Get into the house of your dreams for only $1
,200 a month. But it was structured on a foundation
of pure risk. There's also something mentioned
called a cash flow ARM. Is that just another
name for the same thing? It's very similar, yes.
It focuses on that minimum payment flexibility
for the first few years. The source notes that
some fixed rate loans even had these cash flow
options built in. But generally, when we hear
cash flow ARM, we are talking about that same
dangerous mechanism, prioritizing low monthly
outflow at the cost of a rapidly rising debt
balance. Okay, so we see why a borrower might
fall for this. Lower payments, qualifying for
a bigger house. It's the American dream on easy
mode. But why do banks push these? I mean, surely
they know that a huge percentage of people will
default. You mentioned earlier the asset liability
mismatch. Can we dig into the economics from
the bank's perspective here? Why do they need
ARMs to exist? This is fundamental to understanding
banking, and it explains why the bank isn't necessarily
being evil in creating these. They are, from
their perspective, just trying to survive. Banks
are essentially middlemen. They borrow money
from depositors. That's you and me putting money
in a checking or savings account. And they lend
that money out long term to homebuyers. Right.
Simple enough. But deposits are short term liabilities.
You can walk into the bank and take your money
out today. The bank has to pay you a short -term
interest rate on that savings account. A mortgage,
however, is a long -term asset. It sits on their
books for 30 years. So the bank is borrowing
short and lending long. Exactly. And that creates
a dangerous mismatch. Imagine a bank in 1975
lends out billions in mortgages at a fixed 4
% for 30 years. But then, in the early 80s, inflation
goes crazy. To keep depositors from pulling all
their money out and moving it to a competitor
offering higher rates, the bank has to start
paying them 6, 7, 8 % interest on their savings
accounts. So the bank is paying out 8 % to get
the money. But they're only collecting 4 % from
all those old mortgages. They are bleeding cash
on every single loan. This is exactly what happened
during the U .S. savings and loan crisis. Paul
Volcker, who is the Fed chairman, jacked up interest
rates to fight inflation. The cost of funds for
banks skyrocketed, but all their income was locked
in those low fixed rate mortgages from the 70s.
And the banks just collapsed. Thousands of them
failed. It was a complete catastrophe. So the
ARM is the bank's immune system against that
ever happening again. Ah, I get it now. It's
a survival mechanism. By using ARMs, the bank
matches its income to its expenses. Yes. If rates
go up, they have to pay depositors more. True.
But they also start collecting more from the
ARM borrowers almost immediately. It stabilizes
their profit margin. It saves the bank by passing
that volatility directly to the homeowner. That
really clarifies the why. It's not just predatory
greed, although that's part of it. It's structural
survival for the banking industry. They are terrified
of being caught holding the bag again like they
were in the 80s. Precisely. They are transferring
what we could call the Volcker risk directly
onto your shoulders. Before we get to the scandals,
and I really want to get to the scandals, I want
to zoom out for a second because reading this
source. I realize that my view of mortgages is
very, very American -centric. I just assumed
everyone did the 30 -year facing. But that's
not the case globally at all, is it? Not even
close. In fact, the United States is the global
outlier. We are the weird ones. Here, the adjustable
rate mortgage is almost a dirty word. It implies
a government regulated product that you only
take if you have to. But you go to the UK. Variable
rates are the norm. The norm. So everyone just
accepts that their payment might change month
to month. Yes, absolutely. In the UK, borrowers
are very focused on the current monthly cost.
They ride the wave. If the Bank of England raises
rates, everyone in the country feels it in their
mortgage payment almost instantly. And they tighten
their belts. It actually makes monetary policy
very effective. Wow. The same is true in Australia
and New Zealand. Variable rates are the standard
way to buy a home. What about Canada? They're
our neighbors. Surely they're similar to us.
They're sort of a middle ground. In Canada, you
might get a fixed rate, but it's usually only
fixed for five years, maybe 10 at the absolute
maximum. The amortization of the loan is 25 years,
but the rate isn't locked for that whole time.
So they have to renew it. You have to renew the
loan at the new market rate every five years.
So they are effectively rolling over hybrid loans
constantly. They don't have that 30 year security
blanket that we cherish so much here. And the
source mentions Germany and Austria have a completely
different model. The Bausparkissen. What is that?
This is a fascinating cultural difference regarding
debt and saving. The Bausparkassen are building
societies. The model there is you have to save
first. You agree to put money into a special
savings account at a low fixed interest rate
for years. So you are lending to the bank first
at a low rate. Essentially, yes. You're building
up capital in their system. And once you have
met your savings quota, you are guaranteed a
low fixed rate loan for the rest of your life.
It's a closed system. What's the advantage? The
advantage is absolute certainty. Your payment
never changes. The rate is locked forever. The
disadvantage is you have to plan years and years
in advance. It's aimed at the once -in -a -lifetime
homebuyer who plans to stay put. It doesn't sound
very flexible for the modern worker who might
move every four years for a new job. Exactly.
It struggles with modern mobility. It's a very
different mindset. Let's look at Singapore. The
source goes into some specific detail there.
They call them floating rate packages. Yes. And
they use very transparent indices usually. The
CYBOR, that's the Singapore Interbank Offered
Rate, and the SOR, the Swap Offer Rate. Very
clear benchmarks. And the structure there seems
to be a progressive spread or margin. Right.
This is interesting. They often structure the
margin to increase over time. So year one might
be cyber plus 0 .75 percent. Year two, the same.
But then in year four and onwards, it jumps to
cyber plus 1 .25 percent. That seems almost like
a penalty for keeping the loan. It pushes you
to pay it off. It incentivizes you to pay it
down or refinance. It's a subtle nudge from the
bank saying, we don't want this small margin
loan on our books forever. And there was a unique
innovation mentioned there. ANZ Bank introduced
a loan pegged to the average of Sybor and Savar.
Why average them? What does that do? That's an
attempt to smooth out volatility. By averaging
two different indices, you dampen the spikes.
If one jumps and the other stays flat, the borrower
doesn't feel the full hit. It's a clever bit
of financial engineering to make the product
a little safer. It really shows that the way
we pay for our homes is not a law of nature.
It's a product of local banking laws and national
culture. We think the 30 -year fixed is the only
way, but most of the rest of the world thinks
we're crazy for even offering it. Absolutely.
The 30 -year fixed is essentially a government
-subsidized anomaly kept alive by Fannie Mae
and Freddie Mac. Okay. We have delayed this long
enough. We have to talk about the dark side.
Because when you build a machine this complex
with indices, margins, look back periods, caps,
floors, triggers, things can break. And they
break. They break often. The source material
here contains some truly shocking statistics
about just simple calculation errors. This is
the back office disaster. It is. I mean, think
about it. In the pre -digital age or even in
the early digital age, a loan servicer had to
manually track the index date. They'd have a
note saying, OK, this loan adjusts on November
1st. Looking back 45 days. That sounds incredibly
specific and easy to mess up. It is. They have
to find the LIBOR rate on exactly September 15th,
not the 14th, not the 16th. Then they have to
apply the correct margin, then check the initial
cap, then check the periodic cap, check the lifetime
cap, check for a payment cap. And they are doing
this for thousands and thousands of loans, all
with different terms. Millions of loans. And
people make mistakes. The source cites a 1991
GAO study. That's the Government Accountability
Office. They audited a sample of eight arms and
found that 20 to 25 percent of them had interest
rates. errors. One in four. One in four was calculated
incorrectly. And the financial impact was $10
billion in net overcharges to homeowners. That
is massive. That's $10 billion basically stolen
from homeowners, mostly by accident. Mostly by
sheer incompetence and complexity. But it gets
worse. A 1995 government study concluded that
50 to 60 percent of all U .S. arms contain calculation
errors. Wait, stop. You need to repeat that.
Half. You're telling me that it's possible that
half of the adjustable mortgages in the country
were calculated wrong? According to that government
study, yes, a coin flip. Total overcharges were
estimated in excess of $8 billion. And the causes
were just mundane clerical errors. The wrong
index date was selected. An incorrect margin
was applied. The caps were ignored. Just simple
data entry errors that cost people thousands
and thousands of dollars. That is terrifying
because most people just pay the bill. You assume
the bank's computer knows math. If I get a statement
from a major bank, I don't get out my calculator
and look up the historical LIBOR rate from 45
days ago. Who does that? Nobody does that. We
assume the computer is right. But the computer
is only as good as the data and the programming
that was entered into it. And with ARMs, the
complexity just breeds mistakes. If a clerk hits
the wrong key and your rate is off by just...
0 .125%. You think, oh, that's just pennies.
It's pennies this month. But thanks to the magic
of compound interest and the fact that this error
sets the new baseline for every future adjustment
over 5 or 10 years, that single keystroke could
cost you $10 ,000 or $15 ,000. And the bank never
catches it. Or never admits it. Well, the errors
are usually in their favor. There's not much
incentive to go looking for them. And it wasn't
just errors. There was, of course, predatory
lending. We touched on this with the option ARM,
but the scale of it, it's breathtaking. This
is where the intent turns from incompetent to
malicious, especially in the years leading up
to 2008. The source notes that in 2006, over
90 % of all subprime mortgages were ARMs. 90%.
So the most vulnerable borrowers were given the
most volatile product by design. These loans
were sold to people who the banks and brokers
knew for a fact could not afford the fully indexed
rate. They could only afford the teaser. The
business plan was never for them to pay off the
loan. So what was the plan? The plan was for
them to refinance or sell the house at a profit
before the reset date hit. It was a giant game
of musical chairs fueled by ever rising home
prices. And when the music stopped and house
prices started to fall. They couldn't refinance.
They couldn't sell. The reset hit. The payment
doubled or tripled. And the foreclosures started
like an avalanche. There's also a specific scandal
mentioned in Ireland, the tracker mortgage scandal.
This one really, really boils my blood because
it's so brazen. This is a classic case of banks
trying to change the rules of the game when they
start losing. In Ireland, tracker mortgages were
very popular. They were tied directly to the
European Central Bank, or ECB, rate. When the
ECB slashed rates to basically zero after the
crisis to stimulate the economy, these mortgages
became extremely unprofitable for the Irish banks.
So the banks were losing money on them because
the rate was too low. They made a bad bet. Yes.
they were stuck receiving tiny interest payments
and instead of sucking it up i mean remember
that The contract is supposed to hold risk for
both sides. The banks deliberately and systematically
moved customers off these products in what the
Central Bank of Ireland later called an adverse
manner. How did they do that? They would call
people and offer them a better deal to switch
to a new fixed rate, which was actually higher.
Or they would deny them their contractual right
to return to the tracker rate after a period
of fixing was over. They essentially just lied
and forced people onto higher variable rates
to boost their own profits. So they cheated.
They realized the bet went against them, so they
just flipped the table over. It resulted in a
massive years -long investigation. It's a stark
reminder that in the borrower -lender relationship,
the power dynamic is just so heavily skewed.
The bank has the lawyers, the data, and the control.
It really emphasizes that you have to watch your
lender like a hawk. You cannot be a passive participant
in this. You absolutely cannot. You have to be
your own advocate. Let's touch on a couple of
technical nuances before we wrap this all up.
Pre -payment. This seems like a bright spot.
Right. Can I pay off an ARM early without getting
hit with a penalty? Generally, yes. Most ARMs
allow you to pay extra principal without a penalty,
though you always have to check the fine print
for specific penalties in the first three to
five years. But there is a nuance to how it helps
you that is different from a fixed loan. How
so? What's the difference? If you prepay principal
on a standard fixed loan, you shorten the term.
You might knock years off the end of the loan,
but your required monthly payment stays exactly
the same. Right. On an ARM, because the payment
is recalculated at every adjustment period, prepaying
principal often lowers your required payment
at the next adjustment. Oh, that's interesting
because the calculation is based on the new lower
remaining balance. Exactly. The loan essentially
re -amortizes itself over the remaining term
at the lower balance every time it adjusts. So
if you come into some money and pay down $20
,000, your required monthly payment will actually
drop at the next reset. It improves your cash
flow immediately rather than just shortening
the far -off loan end date. That's a useful feature
if you're trying to manage your monthly budget
flexibility. It is. It gives you a knob to turn,
a little bit more control. And finally, pricing.
How do banks even figure out if these complex
loans will make them money? It just sounds like
pure chaos with all these moving parts and caps
and indices. They use brute force mathematics.
The source mentions they use Monte Carlo simulations.
Like the casino in Monaco? Similar concept. They
run 10 ,000, maybe 100 ,000 computer simulations
of possible future interest rate paths. What
if rates go up 1 % a year for five years? What
if they drop? What if they stay flat? What if
they spike violently and then drop? So they are
playing out every possible multiverse scenario
for the economy. They calculate the bank's total
cash flow and profit for every single one of
those scenarios to find the fair value and the
effective interest rate of the loan. So when
they offer you a rate, they have mathematically
proven to themselves that on average, over all
those tens of thousands of futures, they will
win. So they have played out the next 30 years
10 ,000 times before they even offer you the
loan. Meanwhile, you are just guessing based
on what your brother -in -law told you about
the economy. Exactly. It is the definition of
asymmetry of information. They have calculated
the odds down to the hundredth of a decimal point.
You are walking into the casino blind. That is
humbling and a little terrifying. It is. It's
why understanding the rules of the game is so
important. Okay, let's try to land the plane
here. We've covered the mechanics, the risks,
the history, the global context, and the scandals.
What does this all mean for you, the listener?
It means that an adjustable rate mortgage is
a powerful tool, but it is a very, very sharp
tool. I like to think of it like a chainsaw.
It can cut down a tree very efficiently or it
can cut off your leg. It is not a set it and
forget it product like a fixed mortgage. You
are entering into an active partnership with
the financial markets. You are the shock absorber.
You are. And the tradeoff is crystal clear. You
get a discount on your payment today in exchange
for taking on the risk of inflation tomorrow.
If you understand that risk and you have the
cash reserves to handle a payment shock, it can
be a savvy financial move. The scholarly view
supports that if you have the financial resilience
to weather the storm, the ARM often wins in the
long run. But if you are stretching every dollar
just to afford that low teaser rate, then you
are walking into a trap. Whether it's a simple
rate reset, a cap breach, or that dreaded negative
amortization recast, the math will eventually
catch up with you. And you can't even trust that
the math on your statement is correct. No. And
that, for me, is the biggest takeaway from all
of this. The complexity of these products is
so high that even the banks, with all their resources,
struggle to administer them correctly. Which
brings us to our final provocative thought. It
does. We live in a world of automated finance.
We click accept, we set up auto pay, and we assume
the institution has it right. We put our faith
in the algorithm. But history specifically, that
1995 study showing a 50 to 60 % error rate, suggests
that faith might be misplaced. So here is the
question for you listening right now. If you
have an ARM, or if you had one in the past, have
you ever actually audited the bank's math? Did
you ever go back and check if they used the right
index on the right date? Did you check if the
margin was added correctly? Did you verify every
single cap? Because in a game where the house
has already calculated how to win, the one time
they might be variably wrong, either in your
favor or more likely against it, is in the fine
print of that monthly calculation. Maybe it's
time to get out the calculator and that old contract.
Thanks for listening to The Deep Drive. Stay
curious.