Wednesday, March 16, 2011

End Gov't. Subsidy of 30-Year Fixed-Rate Mortgages

From AEI's Ed Pinto, writing in today's Real Clear Markets:

"Given two spectacular failures of U.S. housing finance tied to the 30-year fixed-rate mortgage in the last 20 years (MP: The S&L crisis and the recent housing/financial meltdown), and the attendant cost to taxpayers of two massive bailouts, the housing industry should be required to show why it needs government support again.

History has shown--and simple economics would anticipate--that a government subsidy for a freely prepayable 30-year fixed-rate mortgage is not good policy. This subsidy causes most borrowers to choose the 30-year fixed-rate loan, since in general it offers a fixed low monthly payment with a government-subsidized free prepayment option. Supporters point to the apparent stability it provides to borrowers. This stability is akin to the eye of a hurricane."

MP: Ed points out that the 30-year fixed-rate mortgage would likely be offered by private lenders in a mortgage market that was not distorted by government policies and intervention. But those 30-year  mortgages would be priced accordingly, likely with higher interest rates than any other mortgage product, especially for mortgages with no pre-payment penalty.  For example, here's a schedule of mortgage options that might be offered today, based on true market rates:

1. 6.00% 30-year fixed-rate term with no prepayment fee
2.  5.625% 30-yr. fixed-rate term with a 3%-2%-1% prepayment fee
3. 5.375% 30-yr. amortization with 15-yr. fixed-rate term and 3%-2%-1% prepayment fee
4.  5.375% 15-year fixed-rate term with no prepayment fee
5. 5.125% 15-year fixed-rate term with a 3%-2%-1% prepayment fee
6. 5.00% 7-year ARM with 30-year amortization underwritten at fully indexed 7-year rate with no prepayment fee
7. 4.75% 7-year ARM with 30-year amortization underwritten at fully indexed 7-year rate with a 3%-2%-1% prepayment fee

Bottom Line: It's not that the 30-year fixed-rate mortgage is inherently bad, but it's the government support and subsidy of those mortgages that has distorted mortgage and housing markets, and contributed to two serious banking and financial crises. We shouldn't end the 30-year fixed-rate mortgage, but we should end the government support and subsidy of those mortgages.


At 3/17/2011 9:44 AM, Blogger Eric H said...

When the chairman at the helm of the fiat printing press declares he can change interest rates in 15 minutes, why would anyone in their right mind sign up for a variable rate? When the variable rate is also distorted by the government, what is the difference?

At 3/17/2011 10:21 AM, Blogger Buddy R Pacifico said...

The rates quoted roughly align with commercial rates with a 25-30% equity position required. When commercial loans have a government component then the equity required drops to 10%. The traditonal minimum 20% down payment needs to return for home mortgages.

At 3/17/2011 8:39 PM, Blogger Hydra said...

Why is a prepayment fee necessary in a time of rising rates? The bank re lends the money at a higher rate, and hopefully more margin.

At 3/17/2011 8:55 PM, Blogger Hydra said...

I got my 30 year fixed at 4.5% from a bank. How is the bank subsidized to provide it?

It replaces two small 15 year notes. This improves my cash flow, and reduces the risk of default, should I lose my job. The bank gets closing fees, and more interest.

Who is the loser here?

At 3/17/2011 9:15 PM, Blogger Mark J. Perry said...

The loser could be the lender, if/when short-term interest rates rise above 4.5% over the next 30 years. That's what caused 3,000 banks to fail during the S&L crisis - borrowing short and lender longer, a recipe for bank failures in a period of rising interest rates.

At 3/18/2011 9:42 AM, Blogger Hydra said...

But most thirty year loans don't last thirty years, thanks to no pre-payment penalty, people are more free to move. People only stay in a home 7 years or something, and even if they do, they often refinance.

In times of rising rates, doesn;t this work to the banks advantage?

In times of falling rates, the bank plans on some revenue stream, then if rates fall and the mortgage is refinanced, the banks plans go south. In that case a prepayment penalty means the borrower has to share their gains (lower rate) with the lender, who lets him off the hook.

I see your point though. If the bank is "borrowing" from its depositors, and short term rates go up, the bank is in a world of hurt.

But then, that is their business: to assess such risks, and maintain sufficient reserves and margin.

Isn't it the case that 30 year rates ARE higher than ARMs? If the rates are not high enough, Why hold the buyer responsible for overzealous competition by the banks?

At 3/20/2011 11:22 AM, Blogger Stan said...

Interest earned is taxable. Interest paid used to be deductible. Had a nice, fair balance. But then the govt decided screw us by treating interest differently if we paid it rather than received it. Fortunately for taxpayers, we were able to save part of the deduction -- the only interest we could deduct was for mortgages.

How is getting screwed out of part of our interest deduction magically transformed into a govt subsidy?


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