Monday, June 14, 2010

Frontal Assault on the 30-Year Fixed Rate Mortgage

A few weeks ago, I had a CD post "Should We End the 30-Year Fixed-Rate Mortgage?", as a follow-up to a discussion Arnold Kling started.  Now the WSJ has a related article today "Radical Ideas From a Federal Housing Bureaucrat," about Patrick Lawler, chief economist of the Federal Housing Finance Agency and his "frontal assault on the most sacred element in U.S. housing-policy dogma: the 30-year fixed-rate mortgage loan, providing the right to refinance at any time, with no prepayment penalty." Here's more from the article:

"Americans are very attached to their 30-year fixed-rate freely prepayable mortgages. They like not having to fuss about the possibility of 28% interest rates in 2032, even though most of us will move or die long before then. They love to refinance every time rates drop and then brag to their neighbors about how much they are saving per month. What they don’t stop to realize often enough is that they are paying a very large price for that privilege– twice.

1. Mortgage rates are higher than they otherwise would be. That’s because lenders and mortgage investors must build in protection for the risk that we will prepay and stick them with a lower yield than they were anticipating. Mr. Lawler estimates that Americans pay at least an extra 0.25 to 0.50 percentage point in rates because of this option to prepay without penalty. They also pay another premium-–sometimes a percentage point or two–for having a long-term fixed rate. Over 30 years, that translates into some real money, but no one ever mentions that when bragging to the neighbor.

2. Our nation has created the likes of Fannie, Freddie and the FHA to facilitate these oddball 30-year fixed-rate loans, which aren’t normally provided by the private market. For a long while, that seemed like a free lunch. Fannie and Freddie, we were told, were far better able to handle those complex risks than we dumb consumers ever could. But since the government had to rescue Fannie and Freddie in 2008, the taxpayers’ tab for this indigestible lunch has swollen to $145 billion, and it’s still rising. So that’s the second time we’ll pay for our irrational love of American-style mortgages – only this time, we all pay, not just mortgage borrowers.

Meanwhile, other wealthy nations–notably Canada–do without our kind of mortgages and yet somehow manage to have homeownership rates similar to ours. They do not pretend that there are risk-free ways to buy houses on credit."

MP: Actually, the homeownership rate in Canada (69 percent) is higher than in the U.S. (67.2 percent).

HT: Sprewell

23 Comments:

At 6/14/2010 1:12 PM, Anonymous Anonymous said...

I'm not giving up my 30 year fixed rate mortgage at an obscenely low rate, but since I plan on dying with this house, I'm fine with them pulling up the ladder behind me.

 
At 6/14/2010 1:30 PM, Anonymous Anonymous said...

MARKETS IN EVERYTHING: 30 year fixed rate mortgages with no prepayment penalty.

Some home buyers are willing to pay a premium in interest for fixed rate mortgages with no prepayment penalty to hedge against the risk of rising interest rates. Some lenders are willing to make 30 loans at a fixed rate with no prepayment penalty in order to earn a premium on interest. Some investors are even willing to purchase those loans in the secondary market.

I don't see the the problem. It's free enterprise in action.

 
At 6/14/2010 2:03 PM, Anonymous morganovich said...

anon-

i agree with you but with one caveat: when groups like freddy and fannie use the backing of the US government to perform credit rating arbitrage and subsidize these sorts of loans at the expense of the taxpayer, then you have a serious problem (of course, the same can be said of any sort of loan, it's just that these carry longer loss strings)

prepayment and refinancing actually make mortgages one of the most difficult financial instruments to properly value and, as we have seen, they have high correlation around these behaviors, so aggregating and securitizing do not alleviate the valuation issue through a portfolio effect.

 
At 6/14/2010 2:04 PM, Blogger John said...

I have an idea, why don't we let the free market decide what kind of mortgages are available, what rates are, what terms and conditions are --- people decide which they like. The ones people like and work for them will prosper and the ones that don't will go away.

Gee, a novel idea free markets decide.

 
At 6/14/2010 2:20 PM, Anonymous Lyle said...

Way back when in the eara of high interest rates(1978) I recall a year prepayment penalty on a 30 year fixed rate mortgage, the penalty applied if you prepayed with money borrowed from anyone else. (9.5% interest btw). You were able to prepay up to 20% per year with no penalty. So at least at that time you had 30 year fixed with prepayment penalties (not that anyone in their right mind would have prepayed at that rate for the 3 year period that followed, when rates hit 12 to 13 percent) Clearly they were worried about interest rates going down. Now I can see a clause that in exchange for a 30 year fixed you agree not to re-finance for some period except for a pre-payment penalty. I.E. if you inherit enough money to pay off the mortgage you can pre-pay with no penalty, but otherwise there is a pre-payment penalty.
The problem is that 30 years and our perpatetic society are somewhat incompatible.

 
At 6/14/2010 4:38 PM, Blogger Ron H. said...

Anon @ 1:12 - "I don't see the the problem. It's free enterprise in action."

morganovich - "i agree with you but with one caveat: when groups like freddy and fannie use the backing of the US government..."

John - "I have an idea, why don't we let the free market decide what kind of mortgages are available..."

The solution, then, is obvious: Eliminate Fannie, Freddie, and FHA. With no risk to taxpayers, lenders and borrowers could price mortgages correctly.

 
At 6/14/2010 5:07 PM, Anonymous Anonymous said...

The solution, then, is obvious: Eliminate Fannie, Freddie, and FHA. With no risk to taxpayers, lenders and borrowers could price mortgages correctly.

For all you libertarian pinheads, there is no, repeat no, mortgage market without the gubmint. Government-related entities backed 96.5% of all home loans during Q12010.

 
At 6/14/2010 6:21 PM, Anonymous sprewell said...

Anon 5:07, there would always be a market for housing without the government, it's just that rates would be higher to adequately reward lenders for the risk they're taking and loan periods would be smaller as in most other countries. However, when Freddie and Fannie "back" those loans (they don't provide the loan, they merely insure it), they allow a lot of people who shouldn't be buying houses or who should be paying higher rates to pay lower rates, as the govt is then taking on that risk. That works fine until those people can't pay, then guess who has to pay the difference? That's right, taxpayers, who have to bail out your beloved Freddie and Fannie. If getting rid of Fannie, Freddie, and the FHA means there are less mortgages, that's a good thing.

 
At 6/14/2010 6:24 PM, Blogger Mark J. Perry said...

Sprewell: Thanks very much for the link, I had not seen it, so thanks for the tip!

 
At 6/14/2010 6:50 PM, Anonymous sprewell said...

No problem, Mark, I enjoy your blog very much. :) Btw, you might want to link to the original WSJ post, I don't see it linked in your post.

 
At 6/14/2010 6:52 PM, Blogger Mark J. Perry said...

Sorry for not providing the link to the WSJ article, it's been update now.

 
At 6/14/2010 8:08 PM, Blogger Ron H. said...

"For all you libertarian pinheads, there is no, repeat no, mortgage market without the gubmint. Government-related entities backed 96.5% of all home loans during Q12010."

That is my complaint exactly. Do you think 96.5% government backing is a good thing? I can't imagine how any sentient being can rationalize taxpayers being forced to assume risks that private lenders aren't willing to take, but give it a try, if you'd like.

 
At 6/14/2010 8:47 PM, Anonymous Lyle said...

Given that both parties have supported home ownership since and including Hoover, the question is what was the motivation of the political class? Now its clear from other comments that Hoover was a progressive as contrasted with Coolidge who sincerly believed that the government that does the least is the best (see Last Call a History of Prohibition).
My thought subject to some research into history by someone is that the thought was that if you own a home the basic slogan of the left "Workers of the World Unite you have nothing to loose but your chains" did not apply. Recall that in the 1930 there was a quite significant communist feeling in the US, and with the number of foreclosures pending at the time, it was decided to defer them to protect the banks that had come thru the bank holiday.

Its clear what the mortgage market would look like without Fannine Fredie and FHA, min 20% down, 5 years with a balloon payment, but adding a new wrinkle the ability to buy a swap on the next mortgage to ensure the interest rate.

 
At 6/14/2010 8:59 PM, Blogger juandos said...

"For all you libertarian pinheads, there is no, repeat no, mortgage market without the gubmint"...

Again I think we see why liberals should be kept away from YOUR money...

What did people live in before Freddie and Fannie came along to rip off the productive so politicos could pander to the parasitic?

BTW how about this good news: Fannie-Freddie Fix at $160 Billion With $1 Trillion Worst Case?

 
At 6/14/2010 10:14 PM, Anonymous Anonymous said...

Another big part of the problem is how ingrained the use of the secondary market is in mentality of modern bankers. The money is too good for them to be ideological and look for sustainable housing options. Banks who have a large portfolio of Freddie and Fannie loans make a killing on servicing fees without even having to worry about the risk; if the secondary market buys the loan then it's their problem if it goes bad. If customers want to refinance constantly it's not a big deal because they get to recollect their fees.

 
At 6/14/2010 10:46 PM, Blogger Ron H. said...

Anon @ 10:14 said... - "Another big part of the problem is how ingrained the use of the secondary market is in mentality of modern bankers. The money is too good for them..."

You are absolutely right. This is perfectly rational behavior on their part. You and I would likely do the same. If someone offered to assume our risk, we wouldn't hesitate to take advantage of the generous offer.

 
At 6/15/2010 8:27 AM, Anonymous Anonymous said...

Do you think 96.5% government backing is a good thing?

The invisible hand of the laissez-faire market scurried away like a rat with Billy the Exterminator on the job.

When the credit (mortgage) bubble popped, the private sector ate Billy's warfarin and is dead.

There is no mortgage market without the gubmint. You actually think that Carpe Diem (apparently a mouthpiece for the National Association of Realtors [[NAR]) is going to post year over year increases in sales in California, Arizona, Nevada or Florida starting in July. I will guarantee you that it will not happen. Don't be surprised if sales are off 30% year over year. The residential real estate market has already started the second leg down and it will only accelerate without further gubmint intervention.

 
At 6/15/2010 8:33 AM, Blogger juandos said...

"Don't be surprised if sales are off 30% year over year. The residential real estate market has already started the second leg down and it will only accelerate without further gubmint intervention"...

So just like the fools who foisted that overly expensive TARP crapola on us with their illogical logic, "to big to fail" you to are now bragging you don't understand how markets work...

'If' housing falls by 30% its obvious that means housing priced as it is now is at least 30% to expensive for what it is in this market today...

 
At 6/15/2010 10:13 AM, Anonymous Anonymous said...

juandos, why would care if existing house sales fall 30% (just for Carpe Diem, 4.2 million SAAR in July)? You are a renter. Just to be clear, I don't have any issues with 33% of households being renters. What ratio do you think is right? I just surmise that the net externalities of homeownership are positive. Of course, you could move to the not invisible hand of Eurosclerosis, where historically homeownership rates are lower.

What are yammering about The Tarp? It was just some cash to bolster short term solvency ratios (err, prevent martial law), coupled with some FASB changes. The steep yield curve for the next 10 years should solve the long term insolvency issue with the financial sector.

 
At 6/15/2010 5:40 PM, Blogger Ron H. said...

Anon @ 8:27

Wow! I liked your exciting story about the death of the private sector. You really added some drama. However, if you are going to invoke a hero like Billy, don't just use that boring Wiki description, give us some real action.

In this exciting clip, fresh from his single-handed destruction of the private housing market, Billy gives a graphic demonstration of what our parasitic gubmint has in store for the rest of the economy.

"The residential real estate market has already started the second leg down and it will only accelerate without further gubmint intervention."

Gee, can even government help at this point? When everyone has eaten every scrap of credit they possibly can, will even a 0% Fed rate force more down their throat? What about a negative rate?

What can cause people to buy houses when they already have too many?

Perhaps The Hand will return to help reallocate resources correctly.

 
At 6/16/2010 3:49 AM, Blogger jeppen said...

In Sweden, most house mortgages are 3 month fixed, the rate of which is somewhat negotiatable and currently listed at 1.88% at my bank. Many choose to fix rates for part of their loans on 2 or 5 year, but longer durations is very uncommon.

We cannot refinance without paying essentially the difference of rates times the remaining time. Also, the loans follow the borrower, not the house. You can't just give the house to the bank and say "sorry, I can't pay". You're stuck with the loan until you have paid regardless of what you do with the house.

The Swedish government intervention in this is that the law says that these loans must be paid preferentially before other loans if someone defaults.

BTW, the more I hear about the US, the more I realize that it is not the free market economy I once thought it was. I feel Sweden is actually more free-market, more streamlined and less burdened with ad-hoc government interventions in most areas.

 
At 6/16/2010 12:00 PM, Anonymous Lyle said...

Jeppen what you describe in terms of a mortgage is called a recourse mortgage in the US, about 30 states have this that after the property is sold you are responsible for the difference between the amount realized and the amount owed. Just recently I have read that lenders are waking up to this and begining to go after the deficiency, in the past they thought there was no more blood in the turnip so they did not try.
Note that the only way to beat a default judgement is bankruptcy.

 
At 6/18/2010 11:57 AM, Anonymous M. Ortgage said...

30 year fixed rate mortgage may be would not be good. As I am not going to follow that.

 

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