Arnold Kling  

Correcting James Kwak

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This post about Freddie Mac and Fannie Mae does not reach a fundamentally unsound conclusion. However, along the way, I think he gets a number of things wrong.

First, a minor correction. He writes,


Although they had been private, profit-seeking companies for forty years

Freddie Mac was still a government agency when I started there in 1986. They were under the Federal Home Loan Bank Board and their shares were held by savings and under non-tradable status. The shares became publicly tradable a couple of years later.

Next,


If thirty-year fixed-rate assets are bad, that means no one would buy thirty-year U.S. Treasury bonds, yet people do (at 4.53 percent). A bank could originate a thirty-year fixed-rate mortgage and just buy an interest rate swap to hedge the interest rate risk.

Yes, there are 30-year Treasuries. But the volume is miniscule compared to the volume of 30-year fixed-rate mortgages. Without Freddie and Fannie willing to hold 30-year fixed-rate mortgages in portfolio, the market would not be as deep. I think that those who worry that the 30-year fixed-rate would be more expensive without Freddie and Fannie have a point.

Next,


So let's think about what might happen if Fannie and Freddie didn't exist. People would still want thirty-year fixed-rate mortgages, so some bank would try to originate them. That bank might just hedge the interest rate risk with interest rate swaps and hold onto the credit risk. This is what banks did during the postwar boom.

Um, no. Banks and thrifts retained the interest rate risk during the postwar boom. And those that did so (mostly the thrifts) were insolvent when rates moved against them in the 1970's. As for interest-rate swaps, (a) they did not exist back then, (b) they are not sufficient to hedge the interest-rate risk, which includes prepayment risk, and (c) they only transfer the risk--it does not disappear into thin air.

The way I look at it, 30-year fixed-rate mortgages give borrowers are very valuable option. If rates go down, the borrower prepays and refinances at the lower rate. If rates go up, the borrower keeps the mortgage and somebody else takes a loss. If the "somebody else" is not the original lender because the lender has executed a swap, then the counterparty to the swap becomes the "somebody else." And chances are that "somebody else" will be the taxpayers, once push comes to shove.

Taking bailouts as a given, the 30-year fixed-rate mortgage is a time bomb that is bound to blow up in the taxpayers' face. If by some miracle the regulators locate the interest-rate risk and force those who take that risk to hold sufficient capital to make a bailout unlikely, my guess is that the 30-year fixed-rate mortgage would cost a lot more, and eventually fewer borrowers would go that route.


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COMMENTS (11 to date)
volatility bounded writes:

Kling is a breath of fresh air. It's absolutely true that if fannie and freddie were shut down, the cost of long-term mortgages would increase, and homeowners would switch to shorter term or variable rate mortgages.

The government might pass rules to force institutional demand for long term mortgages though. It has been pushing pension funds and insurance companies into long bonds in order to avoid volatility from a regulatory and accounting perspective. This has led to the recent wave of liability driven investment strategy that's been sweeping across those institutions, and pitched by various big banks and money management firms.

Kwak and his boss Simon Johnson are also out to lunch on bankruptcy for banks. They do no analysis of bankruptcy law, and throw up their hands and say bankruptcy can't deal with big banks. The problem with Lehman Brothers is that there was no advance planning; no well advised company files bankruptcy that way. Let Kwak and Johnson explain why bankruptcy can deal with massive bankruptcies in the energy sector, which has markets bigger than the financial markets. As if they are competent to do so. Heh, heh.

Nick Rowe writes:

Yep.

It bugs me when people say that US 30-year "fixed rate" mortgages are fixed rate. They aren't fixed rate at all. They are "open" mortgages, because they have the option to re-finance at a lower rate.

Canadian open mortgages exist, but usually only for a year or two. And you pay a considerable premium for an open mortgage over a closed mortgage. Except for people planning to sell their house soon, open mortgages fail the test of the market. People aren't willing to pay enough for that option to persuade someone else to supply it.

But what I don't understand is why there isn't a demand from pension funds to buy 30-year truly fixed rate (i.e. closed) mortgages. Pension funds (I think) buy 30 year fixed government bonds. Why wouldn't they also buy 30 year fixed (i.e. really fixed) mortgages?

volatility bounded writes:

Nick the pension funds and insurance companies tend to buy long term treasuries because they aren't callable, and juice the yield with leverage and/or with CDS overlays on other debt.

I'd guess they could also invest in long term mortgages that are callable, if they hedged the borrower's call option with interest rate swaps.

Dan Weber writes:

When Professor Kling testified before Congress a year or two ago, didn't he recommend to them a return to the 30-year mortgage? Is that just the least-bad among many alternatives?

Arnold Kling writes:

I recommend a return to mortgages with significant down payments. I am not a fan of interest-only mortgages and other innovations of the recent period. But the 30-year term is not necessary. A five-year rollover works well in Canada. Why not here?

Mark Cassell writes:

Great points. Perhaps pre-payment penalties could be introduced. German mortgages typically include stiff penalties but of course home ownership rates are much lower in Germany. In suggesting replacing a 30 year fixed to a 5 year roll over, isn't there some concern about the instability this would cause? One of the features of the Great Depression was that many families went into foreclosure because they were unable to refinance their non-amortizing 5-7 year mortgages. Moreover, the lack of financing wasn't because families couldn't afford a new mortgage but because lenders lacked the capital to lend. The dynamic added to the overall instability at the time. Wouldn't that still be a concern?

MtgGeek writes:

I don't understand the fixation on the interest rate risk in 30yr mortgages. It's true that you can't PERFECTLY hedge the IR risk, but you can get a close enough approximation to make it negligible from a solvency perspective. If you want to reduce the risk in the derivatives market, make everything exchange-traded with daily margining.

The problem with the GSEs is the pricing of the default risk - they considerably under-priced that risk, leading to their bailout. Their problems had nothing to do with interest-rate risk. The re-pricing of 30yr mortgage rates that would accompany elimination of the GSEs would come from a market-based pricing of default risk (a good thing, in my view).

Noah Yetter writes:

"Prepayment risk" isn't really RISK per se is it? It's not like a mortgage loan being paid back early causes the lender to actually lose money, they just don't end up making as much as they expected they were going to. I get that economically these are somewhat interchangeable but financially there's a difference. There's certainly a difference in magnitude between this "risk" of prepayment and say, the risk of non-payment and subsequent foreclosure.

mark writes:

So, as far as I can tell, Kwak only cited two numbers -- and you're saying he got both of them wrong. Facepalm.

David Min writes:

Great piece, interesting comments. A few thoughts.

1) Nick Rowe, my understanding is that most of the pension funds and other fixed income investors who currently finance our mortgage system (along with foreign central banks, although I believe since the conservatorship of F/F, that has declined) are looking for safe and liquid assets (i.e. AAA-rated bonds with liquid secondary markets). Sure, you could find pension funds (and more likely hedge funds and PE funds, not to mention REITs) who would probably be willing to directly invest in mortgages. But that's a fundamentally different type of investment than a Treasury equivalent (which is what agency securities are, and what AAA-rated PLS were supposed to be). Assuming you believe the credit risk of the US govt is 0 (a perhaps debatable proposition now, i realize), then you're basically just dealing with interest rate risk for agency stuff. Actual mortgage debt carries a bunch of other risks, including credit risk, liquidity risk, and prepayment risk, among others. It also needs to be underwritten, and given the huge problems with PLS in the past decade, I'm pretty sure investors are going to want to do extensive due diligence on mortgage debt in the absence of a govt wrap (as they did in the Redwood Trust deal), which makes it hard to understand how this can achieve scale.

2) On Canada, a few points.
a) Canada's vaunted 5 year mortgage still has a 25 year amortization schedule. So there's still rate risk there. It's just that it's held by the borrower, not a financial intermediary. This past crisis, to state the obvious, was due to credit risk (due to both shoddy underwriting and 30% home price drops), and not rate risk, so it doesn't really speak to the 5 vs. 30 year argument.
b) On prepayment vs. open mortgages, there's at least one study (Kiff?) that finds the difference to be negligible. The prepayment penalties in Canada are roughly equivalent to the extra origination costs (points, fees, etc.) in the US so it's mostly a wash. Of course, you could increase the prepayment penalties, but the point is that that's far less of a difference than people think.
c) also on prepayment, one issue in the US is that mortgages are not portable (I think a few portable mortgages were offered in the credit bubble, not sure of their performance). I believe this is primarily the result of convention, but there may be some legal reasons as well (varying bankruptcy laws across states, etc.) So we couldn't have a truly closed mortgage anyways, since we can extinguish our mortgage debt by selling the house.

3) MtgGeek, I don't agree with you on hedging 30 year rate risk. Even if you're right that you can currently hedge 30 year rate risk (which I suspect would be pretty expensive), that's a completely different proposition from saying that the markets can hedge $12 trillion (or whatever fraction of that you think will or should be 30-year) in 30 year rate risk (and if somehow you were able to do this, talk about too big to fail!). The same issue arises for 5 year or 7 year mortgages, to a lesser extent.

David Min writes:

Also, on Kwak's misstatement on the postwar era. Bank/thrifts didn't NEED to buy interest rate swaps (which as Kling points out, they didn't) because there was no rate risk under the Bretton Woods accord.

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