Contributor Fred Carach says ARMs are nothing more than options on real estate.  Fred is the author of the book FORTY YEARS A SPECULATOR, available at  He’s also a retired real estate appraiser, real estate investor and is a long-time member of DREIA.  And he’s quite the bon vivant!  Visit Fred’s blog at


We cannot understand the present unless we understand the past. The first question to be asked is when did the real estate crisis become inevitable? The correct answer is in the time period between 1980 and 1982. It has been forgotten today but the last real estate crises in this country were the twin real estate crises of the 1980s.

In the early 1980s the first crisis was brought on by double-digit mortgage interest rates. Then in the late 1980s there was the savings and loan crisis, which in those days provided most of the nation’s mortgage capital. In response to these twin crises congress passed two laws that made today’s real estate crisis inevitable.
After these acts were passed it was only a question of time until the stars aligned correctly for the volcano to erupt.

In 1980, congress passed the DIDMCA Act. Prior to this time, it was illegal to charge less credit worthy customers a higher rate of interest on their mortgage. Then in 1982, congress passed the AMPT Act, which allowed adjustable rate mortgages or ARMs for the first time. Prior to this act, adjustable rate mortgages had been illegal.

If you go back to 1896 when reliable housing records first began to be kept you will find that from 1896 to 1996 housing prices tracked the rate of inflation. Then suddenly from 1996 to 2006 housing prices doubled. The problem of course in that the income of the American people did not come anywhere near to doubling in that time period.

When you stop to think about it, you will realize that it is impossible for the price of housing to exceed the rise in the income of the American people for any sustained period of time. Unless there is an enabler, only a speculator’s tool can allow this to happen. What was the speculator’s tool or device that enabled this process to occur?

What was the enabler? In the whole of American history there has only been one prior real estate bubble that resembles the real estate boom and bust that we are now witnessing. It was the great Florida land boom of the 1920s. Real estate has always been expensive. What has always held real estate prices in check was that people just did not have enough money to bull prices up for very long. The money is just not there.

The device that enabled the Florida land boom to occur was the “binder.” This is a real estate term that has gone out of use today. In the manner in which it was then used it was essentially an option payment on the down payment if you can conceive of such a thing.

What it boiled down to is that people thought they were speculating on real estate but in reality they were speculating on real estate options.
The stock market has long been the ultimate proving ground for speculative tools. Those of us who are stock market speculators are very familiar with stock options. The only thing that the reader has to know about options is that they are speculating tools that possess tremendous leverage. In other words, you can make a killing on a chump change [small] investment.

Both the binder of the 1920s and the ARM are in reality real estate options. All options expire worthless if they are not exercised prior to their expiration date. Most ARMs were written to expire in two or three years, the fixed interest rate period. At that moment the option had to be exercised or rolled over because the option would become worthless.

People were really buying options. People were deluded into believing that they were buying real estate. When in reality they were speculating in real estate options. As we have seen, the tools for the bubble were in place by 1982. the only thing lacking now was the mania. The boom years from 1991 to 2007 provided the mania. Real estate prices rose relentlessly. It was a boom that seemed like it would never end. You couldn’t lose in real estate because no matter how much you over paid because rising prices bailed out everyone.

Today in the aftermath of the boom, we are already discounting the impact on the human psyche that manias and bubbles produce. To put it bluntly: by the end of the boom almost no one could believe that real estate prices could fall. This nearly universal belief gradually eroded prudent behavior. The more risks you took the more you were rewarded. There was no down side.

In the early 90s the use of sub-prime mortgages and ARMs were limited-since almost all sub-prime mortgages were also ARMs they will be considered as a unit- but as the boom progressed their importance grew and grew.

Mortgage brokers just could not stay away from sub-prime mortgages. They were three to five times more profitable than standard mortgages. Once they had sold one they didn’t want to sell anything else. The caution that lenders had originally shown toward the new mortgage products was relentlessly ground away as the endless boom continued.

Caution wasn’t being rewarded, it was being punished. There was a Gresham’s Law in effect- Gresham was an economist-in which bad or reckless behavior which was constantly being rewarded by lush profits drove out good or cautious behavior because the profits were inferior. In the final years of the boom, conservative firms could not even keep their mortgage brokers from bolting to subprime lenders.

Then around the year 2000 Minsky’s Law kicked in. Hyman Minsky was a Noble Prize winning economist.

Minsky’s Law: Over periods of prolonged prosperity the economy evolves from financial relationships that engender a stable financial system to financial relationships that produce economic instability. The longer the trend persists the more violent the correction when the trend reverses.

As the boom rolled on the most important factor was that almost everyone was a winner. This was true in spite of the fact that subprime mortgages were constantly defaulting at the higher rates that had been predicted. Not only was the higher default rate not a problem but everyone was making out like a bandit with subprime mortgages. This included the sub-prime borrower. As soon as he fell behind his friendly sub-prime mortgage broker would be there to write him a new subprime mortgage. In fact he often got to take out new money when he refinanced the mortgage. It was not unusual to have subprime borrowers take out new mortgages every two or three years during the boom.

If there wasn’t enough equity to suit the lenders, real estate speculators would be pounding at his door offering to take the property off his hands, often at a profit, as soon as the notice of default was published. 

The banks were the greatest winners of all. They were making a killing. It is obscene how much money a bank can make during the foreclosure process as long as someone buys the foreclosed property. Not only do they receive all the back payments but the brutal penalty fees as well. Indeed the most profitable scenario that can be imagined for a mortgage lender is to make nothing but high profit subprime loans and then to have them all default. Their profits would be enormous. That is, as long as the lender never has to take back the property.

When the boom ended, things became incredibly ugly for the banks with amazing speed. One of the most important favors that real estate speculators did for the banks when they bought a foreclosed properly was that in addition to paying the obscene penalty fees they also paid the nearly as obscene attorney foreclosure fees. Not to mention repairing the often seriously vandalized property. An angry homeowner can easily do $20,000-$30,000 in damages.

 When the boom ended all these expenses landed on the banks head like a falling safe. The banks never knew what hit them. I am sure that they still think that they were run over by a Mack truck.

Fred Carach is the author of the book, ” Forty Years A Speculator.” His blog is