Should We End the 30-Year Fixed-Rate Mortgage?
The United States is one of the only countries in the world with 30-year fixed rates for mortgages, and Arnold Kling suggests that this is "an artifact of government intervention, and that without it we would have a simpler, safer mortgage finance system." For example, Canadian mortgages carry a fixed interest rate for a maximum of five years, and rates are then re-negotiated for the next five years, similar to a five-year adjustable rate. That type of five-year mortgage is much more typical around the world than the U.S. system of fixed-rates for 30 years.
The reason the 30-year fixed-rate mortgage has to be a creation of government intervention, and not the market, is that it is a one-sided loan arrangement that bestows huge benefits on the borrower, but with almost no compensating benefits for the lender/bank/thrift, i.e. it's "pro-borrower and anti-lender."
As Arnold points out, there is an extremely valuable pre-payment option on a 30-year fixed-rate mortgage that favors the borrower, who can re-finance the mortgage whenever it is to his/her advantage over the 30 years, i.e. when rates fall enough to justify the refinancing costs. Lenders have no such option to renegotiate the rate when it's to their advantage - when interest rates rise. Or to be more accurate, the pre-payment option favors the borrower when it is under-priced, which is the case in the U.S., likely as a result of government influence.
Looking again to Canada, refinancing mortgages is allowed, but there are very stiff prepayment penalties equivalent to about three months of mortgage interest (about $1,500 for every $100,000 mortgage amount), which discourages the kind of refinancing that frequently takes place in the United States and contributed to our real estate bubble and financial crisis. In other words, the pre-payment option under the Canadian system is probably much closer to a market-driven price than in the U.S.
The chart above shows the potential danger to banks of 30-year fixed-rate mortgages, and illustrates how they contributed to the S&L crisis. Because S&'L's were "borrowing short and lending long," or financing 30-year fixed-rate mortgages with short-term deposits at interest rates approximated by the 1-year T-bill rate, S&Ls were "upside down" by the early 1980s. They were paying more on short-term deposits (e.g. 10-15%) than they were earning on their 30-year fixed-rate loans (e.g. 4-8%).
Simply put, 30-year fixed-rate mortgages were a major factor in 3,000 bank failures during the S&L crisis, and this helps support Arnold's position that they have to be an artifact of government intervention because banks wouldn't willingly expose themselves to such a huge level of interest rate risk with 30-year fixed-rate mortgages with under-priced pre-payment options. All it took was a period of rising interest rates in the 1970s and 1980s to force thousands of thrifts into insolvency, largely because their assets were so heavily concentrated in 30-year fixed-rate mortgages.
Q1: Now that 30-year mortgage rates are below 5% and close to historical low levels, are we in danger of setting up another S&L-type crisis sometime over the next several decades? It wouldn't take much of an increase in inflation and short-term interest rates before many banks/thrifts could see their interest margins squeezed, and short-term rates could conceivably even rise above 5% sometime in the next 30 years, which could put the banks "upside down" again and lead to failures.
Q2: Shouldn't financial reform include putting an end to the pro-borrower, anti-lender 30-year fixed-rates mortgages in the U.S.?