What “The Big Short” Left Out In One Picture (Hint: The Federal Reserve And ARMs)

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I saw Paramount Pictures’ “The Big Short” last night and it was quite entertaining. The film discussed mortgage-backed securities, subprime lending, collateralized debt obligations (CDOs), counter-party risk, no documentation lending, adjustable-rate mortgages, etc.

But what the film kind of ignored was the impact of rising interest rates on adjustable-rate mortgages.

Back in June 2004, The Federal Reserve began to frantically raise the Fed Funds Target Rate from 1% until it peaked in June 2006 at 5.25%. That is a 425 basis point increase in 2 years.

The problem for adjustable-rate mortgage borrowers was that shorter-reset ARMs like the 3/1 ARM are more sensitive to short-rate increases. Hence, the 3/1 ARM rate rose from 3.15% in March 2004 to 5.84% in June 2006, a 270 basis point increase. And a number of exotic ARM products could rise even more rapidly on their reset date. The exotic dancer in Florida in the film was stunned to hear that her mortgages (for 5 houses and a condo) could rise in rate by 200%.

Suffice it to say, The Fed’s rate increases seemingly contributed to killing off the housing bubble leading to a housing bubble burst as speculators and flippers left the housing market.

But would the housing market have collapsed if The Fed and Alan Greenspan hadn’t raised the Fed Funds Target Rate so quickly in 2004-2006?

BTW, baseball fans should recognize actor Hamish Linklater (Porter Collins) who portrayed Brooklyn Dodgers pitcher in the film 42 about Jackie Robinson.