Rates rise and 5/1 ARMs skyrocket

One week ago, you could have gotten a great rate on a 5/1 adjustable-rate mortgage to finance that dream home with a white picket fence in the suburbs.

How times have changed.

"The ARM market melted down basically in a week," says Bob Walters, chief economist for Quicken Loans.

According to the latest Bankrate national survey of large lenders, the average rate on a 5/1 ARM shot up 49 basis points last week, to 6.21 percent.

The benchmark 30-year fixed-rate mortgage rose 7 basis points, to 6.39 percent. A basis point is one-hundredth of 1 percentage point.

The benchmark 15-year fixed-rate mortgage rose 6 basis points, to 5.85 percent, and the 30-year fixed jumbo, for loans greater than $417,000, climbed 17 basis points, to 7.6 percent.

Homeowners who normally would take advantage of the lower rates offered by ARMs suddenly are giving the cold shoulder to these products, according to Jim Sahnger, mortgage broker with Palm Beach Financial Network in Stuart, Fla.

"There has just been an absolute lack of bids," Sahnger says. "Price is always determined by a function of demand and banks are just finding right now that they can't get rid of the ARM product."

Walters believes uncertainty in the credit markets is largely to blame for soaring ARM rates.

To understand what's going on, you need to grasp the difference between how ARMs and fixed-rate mortgages are priced, Walters says.

Fixed-rate mortgages are based on the price of long-term bonds, Walters says.

"We can observe what those bonds are being priced at every minute of every day," he says. "It's very liquid, it's very transparent and it's easy to price those loans."

By contrast, there is no actively traded security that lenders look to when pricing ARMs. Instead, it's an over-the-counter market "where you call up and you create the securities as you have loans," Walters says.

As a result, the ARM market is potentially much more volatile. Right now, fear is driving that volatility to unprecedented heights.

"It's just fear in the credit markets," Walters says. "Anything that's not liquid, transparent, readily observable is being beat up."

Sahnger says the level of instability over the past weeks is unlike anything he's previously seen.

"The last two weeks have absolutely not been like anything that I've seen in the 15 years that I've been in this business," Sahnger says. "We've had more hundred-basis-point swings in price in a day in the last eight days than I can recall in any period in any quarter."

He calls such gyrations "mind-numbing."

"I've been just flat-out alarmed," Sahnger says.

ARM volatility is likely to continue until home values stop falling, according to both Walters and Sahnger.

"A lot of it will depend on the housing market," Walters says. "Until people believe that it has stabilized, I think we're in this."

For now, home buyers and sellers both fear home prices will fall further in coming months. As a result, nobody knows the true value of homes today, Walters says.

"When you don't have any idea what those numbers are, you start making worst-case scenario types of guesses," Walters says. "Every analyst in every firm and every bank is making their own guesses and it leads to wild gyrations in price and assumptions."

Sahnger has seen that volatility firsthand. He talks of one homeowner in a relatively tony South Florida neighborhood whose home would have appraised for $1.35 million 15 months ago. Today, four comparable distressed properties in his neighborhood are listing between $720,000 and $780,000.

"It just flat out evaporates," he says of the homeowner's equity. "He didn't want to do anything last year because of the prepayment penalty, which is understandable," Sahnger says. "But you don't expect that you could potentially see 35 percent of your home's value wiped out in the course of less than a year and a half."

Eventually, the uncertainty behind such stomach-turning price drops will resolve, Walters says.

"Once prices start to stabilize, you start to see a uniform agreement start to occur, a consensus start to occur as to what homes are worth across America," he says.

At that point, ARM rates should begin to stabilize, Walters says.

"When liquidity comes back, the spreads will come into a normal range and you'll see the ARMs take their normal place in the mortgage spectrum," he says.

However, for now, "nobody knows what end is up," he says.