Government Must Jettison the 30-Year Mortgage
Those who seek a continued government role in housing finance frequently contend that the 30-year fixed-rate mortgage will not be available without a government guarantee. On its face, this is not true, since anyone can go to the Internet and find lenders offering jumbo fixed-rate thirty-year loans which, by definition, have no government backing.
It is true that a 30-year fixed-rate mortgage is somewhat more expensive than a government-backed 30-year, since the lender is taking a longer-term risk on interest rates, but the lower cost of the government mortgage simply means that the taxpayers - as well as all other mortgage borrowers who are not taking thirty-year fixed-rate mortgages - are providing a subsidy (in the form of government guarantees and eventual taxpayer bailouts) to the person who wants a government-backed mortgage with these terms.
Given two spectacular failures of U.S. housing finance tied to the thirty year fixed rate mortgage in the last 20 years, 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. In fact:
• 30-year fixed mortgages have caused a roller coaster of mortgage origination volumes (that is, new refinanced mortgages) depending on whether the home owner could or could not extract money from the existing loan by obtaining a new lower mortgage rate. When rates are lower, borrowers treat their homes like ATMs and withdraw equity through serial refinancings. When rates go up, mortgage originators try to increase volume with loosened underwriting in an effort to maintain market share.
• The 30-year loan amortizes slowly; keeping the homeowner's equity low and debt level high for the early portion of the loan when the risk of default is the highest.
• Rampant refinances cause the resetting of a substantial portion of all outstanding mortgages at the then current nominal market value. The volume of mortgage origination grew from $1 trillion in 2000 to $4 trillion in 2004. If the millions of borrowers who took cash out in 2003-2007 had to sell their homes to access their equity, the resulting over-supply of homes for sale would have caused a collapse in prices. Owning a home became akin to owning stock on margin. When prices fell, millions of homeowners experienced a margin call.
• This same roller coaster origination volume caused excessive loan prepayments which translated into volatile mortgage-backed securities values and a need for hedging to offset potential losses from these fluctuations. Fannie and Freddie's respective 2004 and 2003 scandals related to hedging their massive portfolios of 30-year fixed rate mortgages. Later in 2008, the two GSEs suffered a liquidity crisis as the rate they had had to pay on short term debt to finance their $1.6 trillion portfolios spiraled upward, thus necessitating a taxpayer bailout.
• Wall Street traders enjoyed all this churning since they made money on each trade.
• This same volatility caused sizable and rapid fluctuations in the market value of mortgage servicing rights.
• Delinquency rates were kept deceptively low as seasoned loans were constantly being replaced with unseasoned ones. These misleading pricing signals instilled a false sense of confidence in investors.
• Deceptively low delinquency rates depress the accumulation of loan loss reserves which are tied to loan charge-off rates.
• Last but not least, all of this led to the two largest bailouts ever experienced by the taxpayers.
Thus, the freely pre-payable 30-year fixed rate loan is neither a stabilizing factor nor free.
No proponent of government guarantees has ever explained why the taxpayers and other mortgage borrowers should be subsidizing this particular type of mortgage. For homeowners who want a thirty-year fixed-rate loan, it is available at a slightly higher cost without the risk of a taxpayer bailout.
What would happen if the private housing finance market operated without a government guarantee? Treasury Secretary Geithner recently testified that under any of the three options recently outlined in his report to Congress, mortgage rates might go up a moderate amount. Under a privatized housing finance market operating without a government guarantee, borrowers would have a variety of solidly underwritten loan choices - including both prepayable and loans prepayable upon payment of modest fees during the first few years. What the interest rates would actually be depends, of course, on monetary and fiscal policy in the United States.
In the list below, I use the 6 percent jumbo fixed-rate mortgage as a benchmark to estimate the range of probable rates for a series of mortgages with different characteristics that would be available in a nongovernment market. The administration has proposed that Fannie and Freddie be stripped of their unfair pricing advantages over the private market. Once this is done, the difference between a Fannie rate subsidized by the government and a market rate will be quite modest.
Some borrowers would select a thirty-year fixed-rate freely prepayable loan at an interest rate of 6 percent, with others selecting a different option based on their needs and cost. These options offer a lower rate for a shorter maturity and/or a lower rate if borrowers choose a loan with a prepayment fee:
6.00% 30-year fixed-rate term with no prepayment fee
5.625% 30-year fixed-rate term with a 3%-2%-1% prepayment fee
5.375% 30-year amortization with fifteen-year fixed-rate term and a 3%-2%-1% prepayment fee
5.375% 15-year fixed-rate term with no prepayment fee
5.125% 15-year fixed-rate term with a 3%-2%-1% prepayment fee
5.00% 7-year ARM with 30-year amortization underwritten at fully indexed 7-year rate with no prepayment fee
4.75% 7-year ARM with 30-year amortization underwritten at fully indexed 7-year rate with a 3%-2%-1% prepayment fee
Given the demonstrated instability caused by the widespread availability of the freely prepayable mortgage, proponents cannot possibly justify putting the taxpayers at risk a third time.