Last May, I had a post asking "Should We End the 30-Year Fixed-Rate Mortgage?
" That post featured the graph above illustrating how the significant interest rate risk of 30-year mortgages contributed to the 3,000 bank failures during the S&L crisis. Because S&L's were borrowing deposits at short-term, variable interest rates and lending mortgage money long at 30-year fixed rates, many banks became insolvent by the early 1980s when rising interest rates resulted in S&L's paying short-term rates on deposits as high as 10-15% to finance 30-year fixed rate mortgage assets at rates as low as 5-7%. When a bank is paying 15% variable-rates on deposits and receiving only 5% on fixed-rate assets, that's a sure prescription for bank failure.
"The fact is that federal involvement in housing has been a constant since the 1930s. A market without government support would almost certainly involve the demise (for most of middle-class America) of that populist favorite, the low-cost 30-year fixed-rate mortgage.
For a homeowner, a mortgage with a 30-year fixed rate (especially one that he can pay off early without a penalty) is a wonderful thing. For lenders and investors, however, it is a financial Frankenstein’s monster, an unnatural product filled with the potential for losses. Absorbing some of the risk of those losses is a large part of what the government does in the housing market.
The problem with 30-year fixed rate mortgages is “interest-rate risk, the danger that interest rates will rise sharply after the mortgage has been made, thereby burdening the bank with money-losing loans. (Interest-rate risk was the root cause of the savings and loan crisis - see chart above.) The longer a mortgage lasts, the more difficult it is to manage both of these risks. And 30 years is an awfully long time.
Wouldn’t a better solution be for banks and other financial institutions to offer mortgage products that they actually want to keep on their own books? Maybe these would take the form of 15-year mortgages with a rate that would be adjusted after five years so that the banks wouldn’t have to worry about long-term interest-rate risk. This might not even mean the disappearance of 30-year fixed-rate mortgages — the private market has historically provided them to consumers whose mortgages are too big to qualify for a Fannie and Freddie guarantee. But these are usually issued only to the wealthiest, most credit-worthy consumers.
And therein lies the rub. Almost certainly, any 30-year product would be offered on a more limited basis and at a higher price than it is today. How much higher, it’s hard to say. In the pre-crisis days, Fannie used to argue that its guarantee enabled consumers to pay one quarter to one half of a percentage point less in annual interest on their mortgages; today, mortgages without a government guarantee would cost at least several percentage points more according to PIMCO’s Williams Gross. If his numbers are right, then mortgages — and 30-year mortgages in particular — would be far more expensive, and the pool of American homebuyers would shrink.
This may well be the right long-term answer. After all, other countries manage fine without the widespread availability of 30-year fixed-rate mortgages. But is there an American politician alive who would accept responsibility for depressing the housing market further?"
HT: Paul Kedrosky on Twitter