Arnold Kling  

Remarks on U.S. Mortgage Finance

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Parents, Children, and Liberty... Krugman Between the Lines...

At a conference yesterday on mortgage finance, I managed to turn a discussion of the future of securitization into a discussion of the 30-year fixed-rate mortgage. I think that the 30-year fixed-rate mortgage is an artifact of government intervention, and that without it we would have a simpler, safer mortgage finance system. Below are some remarks, some of which were mine and some of which came from attendees at the conference.

1. The U.S. is the only country with the 30-year fixed-rate mortgage. Other countries get along fine without it.

2. The core of my argument against the thirty-year fixed-rate mortgage is that without government intervention I believe that more borrowers would prefer mortgages where the interest rate is fixed or a shorter period, like five years.

The thirty-year fixed-rate mortgage includes both a default option and a prepayment option. The less money you put down, the more valuable the default option. The lower the cost of originating a new mortgage, the more valuable the prepayment option. Origination costs have fallen considerably over the past twenty years, especially when calculated as a percentage of the loan amount.

Thus, both options have become more valuable in recent years. My guess is that both of these options have been under-priced, due to government intervention. Government subsidizes these options by providing support to FHA, Freddie Mac, and Fannie Mae, as well as by tilting bank capital requirements to subsidize securitized loans that include these options.

I claim that in a completely market-driven mortgage market the interest rate on mortgages with little or no money down would be quite a bit higher than the interest rate on mortgages where the borrower makes a down payment of 10 percent or more. Moreover, my guess is that the interest rate on a mortgage where the interest rate stays fixed for thirty years would be much higher than the rate on a mortgage that stays fixed for five years, because the prepayment option on the latter is less valuable.

If borrowers were confronted with the true cost of the default option, fewer people would buy houses with little money down. Instead, they would choose either to rent or to save up for a large down payment.

If borrowers were confronted with the true cost of the prepayment option, fewer people would elect thirty-year fixed-rate mortgages. Instead, they would elect, say, mortgages with interest rates fixed for five years.

3. It is very inefficient for the government to subsidize home ownership by subsidizing the default and prepayment options through policies that encourage securitization. It could support home purchasers more directly at a much lower cost.

4. Our adjustable-rate mortgages also are peculiar. Rather than being priced at a constant, moderate spread of, say, 1 percentage point over the Treasury rate (or some other market rate), they start out at low "teaser" rates and then adjust upward to well over 2-1/2 percentage points above the index rate. What this creates is an adjustable-rate mortgage with a really valuable prepayment option--a reasonable strategy is to refinance every year, taking full advantage of the low teaser rates.

Why is that? My guess is that this is an instance of Price Discrimination Explains Everything. The bank wants to charge certain people an above-market fixed rate. It needs to find people with little knowledge and financial sophistication. It does so using the teaser product. In the process, it sets up an opportunity for highly-sophisticated borrowers to take advantage of the system by taking teasers and refinancing them on a regular basis. But most people do not want to be bothered with all that refinancing, preferring fixed rates instead.

However, I would not rule out the possibility that lenders are acting against their own self-interest. I wonder whether lenders have ever made money on teaser adjustables, given all the defaults and prepayments.

5. With substantial down payments and interest rates fixed for five years, mortgage finance would not require sophisticated financial engineering. There would be much less risk to transfer, and hence there would be much less value in slicing, dicing, and structuring mortgage securities. Banks could find ways to fund a large share of mortgages.

6. What would borrowers lose? With higher down payments, they would have less opportunity to speculate on house price appreciation. I view this as a feature, not a bug. It would reduce the susceptibility of the housing market to bubbles.

With interest rates fixed for five years, rather than for thirty years, borrowers would face risks from interest-rate cycles. If interest rates go up after five years, your monthly payment could be higher. The severity of this problem depends on how interest rates vary with inflation. If interest rates have moved up because prices have been rising rapidly, then most borrowers should see higher nominal incomes and higher house prices. If so, then on net the borrowers are not in such bad shape.

Historically, a bad time to have taken out a five-year mortgage would have been, say, 1975 or 1976. Five years later, because of inflation, interest rates had really shot up. Many borrowers would have been able to afford the higher payments, but some would not have been able to do so. The result might have been some distressed sales of houses and a temporary decline in house prices. Instead, with thirty-year mortgages what we had was the bankruptcy of many of the lenders--the S&L industry. It is difficult to argue that the latter outcome was better.


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COMMENTS (26 to date)
Floccina writes:

It seems soooo strange to me to attempt to achieve the goal of having more home ownership by making more credit available to people. It would seem to be better to attempt to make homes cheaper. Of course it is in the interest of local governments to make homes more expensive in their area and this they attempt to do.

Guan Yang writes:

For what it's worth, Denmark also has a 30-year fixed rate mortgage and this is the most common type of mortgage. It has prepayment and delivery options and is full recourse.

You can find the yields on these bonds (which is equal to the yield on the mortgages) on the website of RD, the largest mortgage bank in Denmark (look at the first line, "4% obl. 30 år", indicating a 30 year bond with a 4% coupon).

Mortgages with rates fixed for 3 or 5 years at a time are also available.

The government is not directly involved in the mortgage market in the way that the US government is with Fannie and Freddie. The mortgage banks may or may not have an implicit guarantee from the government, but this has not been seriously tested since the system began in 1795.

Arnold Kling’s argument may still be valid, but point 1 is not correct.

Shawn Smith writes:

Floccina hits a point...the government wants to increase home ownership while maintaining or increasing home prices. That goes against the very law of supply and demand and results in complex government intervention and wild swings in home ownership and home prices. You can't defeat the laws of nature...they are what they are.

Rebecca Burlingame writes:

Just about everyone needs homes that are smaller and simpler to maintain than they are today. But it may be even more difficult to achieve this as property taxes are remaining stable, while other tax collections are declining. What community would willingly give up such a reliable tax source based on big homes?

Nick writes:

Could not agree more with this post. The 30yr fixed rate mortgage makes absolutely no sense. I believe in Canada even a fifteen year fixed term is considered unusual.

Arthur_500 writes:

There are certain cultural variables that are difficult to deal with when comparing one country against another. However, it used to be common to have long mortgages in Germany. People would build exceptional homes and expect that their children would live in those homes after their death. Many of the homes used expensive stone work, exceptional woodwork, and very expensive roofing. However, they were built to last for generations. Who could argue with the value of long-term mortgages?

Of course, times have changed and I do not know if this is the case any more. I am older and many of the time-honored values seem to have been watered down also.

Boonton writes:

6. What would borrowers lose? With higher down payments, they would have less opportunity to speculate on house price appreciation. I view this as a feature, not a bug. It would reduce the susceptibility of the housing market to bubbles.

I wonder how vaulable this really is. With the bubble already burst and consumers and financial firms seriously burned by letting overall housing go into a bubble I wonder just how likely we are to see a bubble anytime soon. Add to that the fact that the baby boomers are retiring. Those with houses paid off will be seeking to fund their retirements by selling their real estate assets. I wonder if we will ever see a nation wide housing bubble again in our lifetimes? How many tulip bubbles happened after the first one????? Perhaps there's a principle at work here that bubbles rarely strike in the same place twice.

Note I said national bubble. There has always been regional housing and land bubbles (Florida seems to have a long history in them).

Sam writes:

In my relatively typical Canadian mortgage, all of these risks are addressed:

1. The mortgage has a 25-year amortization but a 6-year term

2. Early prepayment is discouraged in the first three years with a penalty clause (explicit pricing of prepayment option)

3. Down payment is typically 5% higher than US for similar types of housing

4. Even over a six-year term, the interest rate for a fixed-rate mortgage is 2-3 points higher than for a variable-rate mortgage

My bank does not offer a fixed-rate mortgage for longer than ten years.

Current writes:

I'm from Britain where there are very many types of home mortgages. Banks have a great deal of leeway to be creative.

In the past most mortgages were variable rate repayment mortgages. The bank or building society have a rate which varies regularly, but normally stays within a couple of percent of the central bank base rate. The size of payments is altered every year. Americans may consider this very risky since the interest may rise sharply. In the past it has been in 1973 and 1992 when the central bank set interest rates high. In both cases this was caused by loose monetary policy in the periods before.

These days there are fixed rate mortgages, but few people use them. There are also mortgages with cheaper teaser rates, some people use those.

I have what's called an "Offset Tracker" mortgage. It is a "tracker" because it uses a fixed difference of 0.45% between the rate I'm charged and the central bank rate. If the central bank rate is 0.5% then I'm charged 0.95%.

It's called an offset because it comes with an offsetting savings account. If I put funds into this savings account then they accumulate no interest. But, they diminish pound-for-pound the amount of mortgage principle I owe. If I withdraw money from that savings account the mortgage principle rises again. So, I pay interest on the difference between my mortgage and my savings. In my view this is a great form of mortgage.

What do folks think of all these sorts of mortgage?

B.B. writes:

Nicely said.

But there is an alternative.

Price Level Adjusted Mortgages (PLAMs).

There is a 30-year mortgage.

The Real mortgage rate is fixed at, say, 2%. If there is no inflation, the homeowner pays 2% for 30 years, at which time the mortgage is paid off.

If there is inflation, the owner continues to pay 2%, but the outstanding principal is scaled up by the CPI, and the monthly payment is so scaled up. The real, as opposed to nominal, monthly payment is fixed.

If the risk to banks is variation in inflation over 30 years, rather than variation in real rates, PLAMs solve the problem of banks issuing 30 year mortgages.

If the PLAMs are securitized, pensions and life insurance companies would eagerly buy them as long as there was no fraud.

Boonton writes:

Current

I'm not sure I quite get the offset tracker mortgage you have. It sounds like an adjustable rate mortgage. The only difference is you have the option to put 'extra' payments in a savings account that effectively pays you an amount equal to whatever your mortgage rate is.

In the US that would basically be the same thing as a Home Equity Line of Credit. You have a home equity line which is basically like a credit card. If you make extra payments on it your balance goes down and so does your interest payments, if you suddenly need the cash, though, you can tap it again and take money out. The only difference is that in the US this is usually done with two different loans. One is your primary mortgage and the second is the home equity line.

B.B.

Sounds like the bank is offsetting inflation risk back to the homeowner....for whom usually inflation is a positive. What does the homeowner get in exchange for giving up the possibility of gaining via inflation? A lower rate? I think in the US this type of mortgage would be more popular if it was tied to regional home prices rather than CPI. In exchange for giving up potential housing inflation booms, the homeowner is protected from going underwater in a real estate crash. Buying and selling the securitized mortgages then would be a way of going long (or short) on home prices.

Current writes:

Boonton,

I'm not sure I quite get the offset tracker mortgage you have. It sounds like an adjustable rate mortgage. The only difference is you have the option to put 'extra' payments in a savings account that effectively pays you an amount equal to whatever your mortgage rate is.

Yes, that's right. The benefit of this I should mention, is that in Britain when an individual earns interest it is taxed. So, if a person has a savings account and a mortgage they pay more tax than necessary.

In the US that would basically be the same thing as a Home Equity Line of Credit. You have a home equity line which is basically like a credit card. If you make extra payments on it your balance goes down and so does your interest payments, if you suddenly need the cash, though, you can tap it again and take money out. The only difference is that in the US this is usually done with two different loans. One is your primary mortgage and the second is the home equity line.

That may be the same sort of thing, though I'm not quite sure. Is the value of the house involved in calculating the second loan?

Anyway, with my mortgage it's all combined into one produce that consists of debt payments and an account. In that scheme I must always pay of the principle at a particular rate. In can pay faster, and if I do so I can later take money out of the savings account to reverse that process. But, I can't decrease the minimum rate that the debt is paid off.

There are other products that behave like current account overdrafts. You buy a house and get given a current account that's overdrawn to the price of the house. Those are a little different, I think the minimum rate of payment can be changed. Those normally charge higher interest.

Anyway, it's interesting to hear about how other systems work.

Boonton writes:

Yes, that's right. The benefit of this I should mention, is that in Britain when an individual earns interest it is taxed. So, if a person has a savings account and a mortgage they pay more tax than necessary.

OK but you're not really earning tax free interest income, you're reducing your interest expense. Generally in the US you're also taxed on interest income unless you earn interest in certain retirement accounts.

That may be the same sort of thing, though I'm not quite sure. Is the value of the house involved in calculating the second loan?

Yes, they typically take the value of the house, minus the balance of your mortgage and the balance is what's available for a home equity line. It's a '2nd mortgage' which means that if you go into foreclosure the entire first mortgage gets paid off first before the 2nd one sees any cash. Given the relatively bad position the bank has with a home equity line (but this is better than a credit card which is backed by nothing but your good name), its in their interest to not let you borrow too much.

You can, of course, have a home equity line without a mortgage. One of the chief selling points in the US is interest on real estate backed debt is tax deductible but not interest on other types of debt. If you're smart, you use a home equity line to finance a new car or major purchases rather than a car loan or credit cards you can score double. You get a lower rate because the debt is more secure and you can deduct the interest on your taxes. Of course you can also get yourself into trouble using the line as a ATM to buy a lot of silly things you wouldn't have normally purchased...

ThomasL writes:

@Dr. Kling

IIRC, the standard mortgage in the '20s was a 5y balloon note. That was what seemed to come about naturally in the free market (correct me if I'm wrong on that, I think the market was pretty free), while the 30y fixed-rate came about only after the USG became heavily involved with Fannie Mae, etc. under the New Deal.

My question is, do you think the 5y balloon would still be more or less what an open market would tend toward? Or to an ARM with a ~5y initial fixed rate? Or perhaps a kind of graduated ARM where the interest rate check-pointed every N years? To something else?

I'm starting to go Moldbuggian and skeptical of all the maturity mismatching. I wonder how one could reasonable arrive at maturity-matched mortgage finance.

Boonton writes:

My question is, do you think the 5y balloon would still be more or less what an open market would tend toward?

I don't think so. A 5 yr mortgage is, on the other side, a 5 yr investment. I suspect in the 1920's there were fewer sources of funds that were willing to 'lock themselves up' for longer than 5 years and few people or institutions that you'd want to trust for much longer than 5 years. Today there are large pools of pension and retirement funds that are willing to forgo cash for long periods of time. That means a bank should be able to find more ways to borrow more than 5 years at a time. If the bank doesn't have to worry about turning over its debt every 5 years neither should the mortgagee.

So I'd suspect a perfect open market would still even out with mortgages of terms longer than 5 years. 30 years? Maybe or maybe not.

Steve Sailer writes:

Dear Arnold:

Thanks. Most insightful.

Mercer writes:

"soooo strange to me to attempt to achieve the goal of having more home ownership by making more credit available to people. It would seem to be better to attempt to make homes cheaper. Of course it is in the interest of local governments to make homes more expensive in their area and this they attempt to do."

I agree. I don't think it would easy to change zoning laws but I wish economists and others who comment on housing in the media would point out how zoning is making it difficult for young people to afford houses and that putting so much of our wealth into real estate is not good for the economy.

Current writes:

This business of 5yr balloon notes...

Notice, in Britain the government hasn't interfered with this. The standard British procedure is a 25 year ARM mortgages linked loosely to the central bank base rate. That is the outcome of a reasonably free market in mortgages within a central banking system.

The same sort of arrangements are in place in other European countries. I've heard this story before that "without fannie and freddie we would have to remortgage every X years" and I don't believe it. No-one else does now in the countries that have no similar institutions.

As I understand it the reason that only short dated mortgages were given before the New Deal was branch banking laws. Banks were so small they could afford much risk.

Boonton,

but you're not really earning tax free interest income, you're reducing your interest expense.

Yes, that's right. The problem is that in Britain we have no "tax day" and no tax forms to fill in. For normal employees all tax is taken by employers on behalf of government, so it's all unsophisticated. There is no system where you can declare that you earn £X of interest and pay £Y or interest and then cancel X & Y. So, before offset mortgages many people were in an conundrum.... If they paid off their mortgages early then they saved money, but they couldn't withdraw later. On the other hand, if they paid into a savings account they could withdraw later, but the interest rate would be much lower than what they would have saved by paying off their mortgage. Offset mortgages solved this problem.

Yes, they typically take the value of the house, minus the balance of your mortgage and the balance is what's available for a home equity line. It's a '2nd mortgage' which means that if you go into foreclosure the entire first mortgage gets paid off first before the 2nd one sees any cash.

I see, that's quite different. A British offset is part of the first mortgage. It's not related to the value of the property at all, it's only related to the amount of debt taken out.

Boonton writes:

Current

I think you have a good selling point for the offset there. In the US one issue that often comes up is the fact that you don't really get credit for paying extra on your mortgage. Say for 6 years you make one extra payment per year. That reduces the time it will take to pay off your mortgage but if at the end of year 6 you loose your job and you start missing payments you have no credit for those '6 extra' payments that you can tap. You're just as behind as someone who never made any extra payments.

As a result one school of thought says sink extra payments into a savings account and don't use it against the mortgage until you can make one giant payment that ends it early. The offset, though, sounds like it solves that problem.

richard writes:

Arnold,

In the Netherlands, a 30 year mortgage is not very common, but can easily be gotten:

http://www.abnamro.nl/nl/prive/hypotheken/tarieven_popup.html

The rate is
- 5,70%, with govt guarantee (if house is cheaper than 350.000 euro)
- 6,00%, financing up to 75% of the value of the house
- 6,10%, financing up to 100% of the value of the house
- 6,30%, financing up to 125% of the value of the house

You also see that a down payment is not necessary (but it makes it a bit cheaper). On the other hand, a non-recourse loan is not available in the Netherlands. If you don't pay your mortgage on time, the bank will go after your car and sell all your stuff and also confiscate your monthly paycheck.

jmg writes:

As someone that works in the mortgage industry, if we required all buyers to have 20% down or to have the income necessary to pay back principal in 5 years (is that really what you intended to say?!), we'd make VERY few loans. You're right, though, that borrowers tend to know very little about the home loan business (of to the bank's advantage). You're absolutely right about government intervention being terrible for the market, though.

Dave writes:

Floccina hit the nail on the head. The goverment tries to solve many affordability "problems" by subsidizing them, thus making them more costly in total, although perhaps not to the consumer.

anon trader writes:

also, for what it's worth, long term fixed rate mortgages of terms upwards of 30 years are quite common in the Japanese market(in addition to their presence in the nordic markets -- I also believe that they exist in Italy but haven't looked lately). mortgages of a 40 year duration are most common in the current Japanese market place.

Also, why would a borrower prefer a mortgage of a short duration in the face of upward sloping yield curves and low interest rates? In the marketplace ARM popularity has varied inversely with the 10-year us bond yield.

Charlie writes:

A couple years ago I tried researching what the mortgage market was "in the past". 99% of the US "history" goes back no farther than the 1930's.

So having to do loads of research myself, what I found is that commercial banks did few residential mortgages at all. Home loans were generally handled by mutual societies - either insurance companies or B&L's (the pension and retirement funds of their time). An insurance company would generally loan for short terms (5, 7, 10 years max) with 50% down minimum and the loans didn't self-amortize. B&L's would loan for longer terms with 20% down minimum and would self-amortize but generally required some sort of savings plan.

You have to remember than at this time the U.S. was a non-inflationary environment; so houses weren't looked at as investments - appreciation was gladly accepted but not expected. Once the 5-year term was up, people either paid the principal back, paid a portion of it back and took a new mortgage for the balance, or sold the house. Of course, if a borrower's savings went up in smoke because of a bank failure, getting affordable terms on a re-fi were impossible, thus foreclosure. The banking law changes in the 30's along with the FHA and other GSE's essentially primed the pump for commercial banks to jump in to what had before been not lucrative enough to bother with, and they all but replaced insurance companies as lenders.

Once interest rates dip below say 6%, it's not so lucrative for banks to hold mortgages (as the S&L crisis demonstrated) so they offload them. Note that lending at 5% isn't even in the interest of current-day pension and retirement funds as they are targeting 8%+ annual returns; indeed these funds were the driving force behind the GSE's getting out of their traditional "safe" mortgages and expanding into sub-prime mortgages.

Mercer writes:

"Once interest rates dip below say 6%, it's not so lucrative for banks to hold mortgages (as the S&L crisis demonstrated) so they offload them."

I thought the S&L crisis occurred when interest rates rose. This is also what Arnold says in his last paragraph. Why do you say a fall in interest rates hurt mortgage lenders?

Foobarista writes:

Commercial mortgages tend to be more of the balloon variety - the 5-10 year term with 25 year amort is common. They are often fixed over the five years. Also, these notes are often assumable (which used to be common in residential, but doesn't seem to be anymore).

In practice, what happens is the note gets refied every five years as the property owner generally doesn't want a lot of cash tied up in the property. But most commercial mortgages require at least 20% and more likely 30% in the property.

Also, interest-only notes are common.

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