Is the 30-year fixed rate mortgage a risky product?

Is the 30-year fixed rate mortgage is just too risky of a product? Banks don’t like it because it creates asset-liability mismatch. It’s become a risky product for taxpayers because the mortgage underwriting process has become too easy and the risky loans are backed by the government, and the Ponzi type borrowers have taken advantage of the situation.

The 30-year fixed-rate mortgage is government-sponsored product. In fact, it was the first affordability product, but it had underwriting requirements that reduce the risk to the lender and added stability to the banking system. The three simple underwriting requirements made this loan the bedrock of our housing market for over 60 years:

  • A 20% down payment requirement
  • A through credit check with co-signing if necessary
  • A mortgage payment that was realistic percentage of our income.

As these standards get relaxed, the system becomes less stable, and with the government backing all the loans, that means potentially trillions of dollars of exposure and potential taxpayer losses.

Kill the 30-Year Mortgage

After a devastating cycle of bubble and bust, the U.S. housing sector is on the road to recovery. New homes are being built at the fastest rate in years and prices are increasing across the country. Foreclosures are down and the number of “underwater” mortgages has declined by almost 12 percent since the peak at the end of 2011. Even Fannie Mae and Freddie Mac, the mortgage-finance companies in conservatorship since 2008, are reporting record profits.

What’s wrong with this picture? None of this would be possible without massive government support. Today, the government owns or guarantees about 90 percent of new mortgages, up from about 50 percent in the mid-1990s. It isn’t sustainable, let alone fiscally acceptable, for the U.S. to have such a domineering presence in what should be a private-sector function.

The housing recovery now under way creates a perfect opportunity to plan for the future of U.S. mortgage markets. Several recent innovations in mortgage finance by economists and academics are worth considering.

Just a little editorializing on my part, most economist and academics don’t have the street-sense to really know what is wrong with mortgage market. Failure of financial innovation in the mortgage market is the root cause of the housing bubble. It is not possible to innovate in mortgage finance without destabilizing the market. In short, financial innovation is NOT the answer.

First, it helps to understand the origins of today’s situation. Before the New Deal, people bought houses by borrowing for a few years at a time. They only paid interest until the loans matured, at which point they would make a large payment or refinance. That worked well enough until house prices collapsed during the Great Depression. Lenders refused to refinance, hoping to get paid in full. Many borrowers defaulted; about 10 percent of homes ended up in foreclosure.

It’s also a good time to note that the stock market crash was due in part to stocks purchased on margin which was another form of easy credit.  Controls and practices were adopted by the exchanges like daily settlements and margin calls to reduce leverage the risk in the future.  This is an example of easy credit that created a bubble that was followed by a collapse.  Will the Qualified Mortgage rules do something similar to housing or will they be useless rules?

Downward Spiral

To prevent another downward spiral, the U.S. came up with the self-amortizing, long-term, fixed-rate mortgage.

And it worked. It was the last “innovation” to sweep mortgage finance in the 1950s. It was an improvement over the previous system because it introduced amortization which made loan balances decline.

It enticed lenders into offering these products by promising to buy mortgages that conformed to certain underwriting standards. That’s where Fannie Mae and Freddie Mac come in: They bundle loans into securities, then sell them to private investors. For a fee, the government absorbs the risk of borrower default.

As long as house prices were relatively stable, the new system worked. But once prices soared, only to collapse a few years later, scores of homeowners defaulted. A cascade of foreclosures further depressed prices as more houses were dumped onto the market. Economists say this was responsible for 20 percent to 30 percent of the decline in home prices from 2007 through 2009. It was the Great Depression all over again.

Exactly, it was credit bubble all over again.  For 60 years the 30-year fix rate mortgage worked with little trouble.  The housing bubble was caused by an alliance of cheap credit, easy credit, low down payments, and affordability products.  Affordability products weren’t fixed mortgages. They were interest-only loans, adjustable-rate mortgages (ARMs), and negative-amortization loans (Option ARMs).  These products reduced the monthly payment to an amount much lower than the 30 year fixed mortgages payments.  Borrowers could afford larger loan amounts which put the lenders at greater risk when these borrowers defaulted. With low down payment requirements, the loanowners have little incentive to stay with the home when home values drop below the principal balance of the mortgages.

The biggest challenge going forward is separating the choice to buy a house from the decision to make a leveraged bet on housing prices. Right now, when a borrower puts down $50,000 to buy a $500,000 house, she doubles her equity if the value of the house goes up to $550,000. The lender, however, has no claim to any of that appreciation. Alternatively, if the price declines to $400,000, the borrower is suddenly in the hole. She has a strong incentive to default, leaving the lender in the lurch.

If the borrower puts down a 10% down payment they will think very hard before defaulting.  It’s the loanowner that puts down 3% that will mostly likely default.   Large down payment adds stability by reducing price swings by added a higher entry barrier and filtering buyers with better saving discipline.

Outside the U.S., floating-rate mortgages, where monthly payments rise and fall with the short-term interest rate, help borrowers deal with some of this volatility. Interest rates generally move in line with the health of the economy, so these mortgages are more flexible for both borrowers and investors. This approach effectively allows borrowers to refinance even if they are underwater, yet it does nothing to reduce the risk of default and foreclosure associated with negative equity.

The U.S. must figure out a way to better manage these risks if it is to turn housing back over to the private sector. Fortunately, economists have lots of ideas. The common theme is that mortgage principal should be keyed to economic conditions, and monthly payments should rise and fall proportionately. These features ensure that borrowers have a stake in repaying their loans, while also making it easier for them to do so when times get tough.

Unless you look at housing as speculation investment vehicle and not shelter, most buyers want to keep their housing costs a known quantity.  If you want to reduce risk then government should only guarantee mortgage that have terms 30 years or less and charge very high mortgage insurance.  Shorter terms loan greatly speed up the repayment of principal loan balance and would carry less expensive mortgage insurance. And the most common sense approach will require a 20% down payment. It’s biggest factor keeping the borrower from defaulting, and the bank is protected with an equity cushion in case of default.

Continuous Workouts

These new mortgages would also damp the swings in spending that come from the wealth effect. Robert Shiller, the Yale University economics professor and co-founder of the widely used Case-Shiller index of home prices, and colleagues have modeled a few versions of a product called a “continuous workout mortgage.” In essence, the Shiller loans would allow borrowers to pay higher interest rates upfront in exchange for the right to lower principal and monthly payments when house prices go down.

These loans might be right for some people, but we prefer another idea: Mortgages with principal and monthly payments that move with an index of neighborhood home prices. As prices rose, so would monthly payments. Conversely, if prices fell, monthly payments would, too. These might be more attractive to borrowers since they wouldn’t have to pay higher rates upfront. Instead, they would compensate lenders by passing on the gains from house-price appreciation.

I don’t know ever increasing housing costs is a good thing, especially when it’s your largest living expense. A constant mortgage payment allows borrowers lower their housing costs with rising wages. In my parents generation they would use the extra money to pay the loan faster or save for retirement.  These academics want to make housing the center piece of your retirement savings. Unfortunately, these proposals would just enrich Banksters that are already taking tax money.

Borrowers would still have an incentive to maintain their property because they would keep (or lose) any change in the value of their house relative to the prices of their neighbors’ homes. Investors’ demand for these products would probably be strong, given their demonstrated eagerness to gain exposure to single-family house prices by buying them outright.

The government and the private sector have an interest in this sort of financial innovation. Right now, investors have little appetite for mortgages that lack government guarantees, partly because they were badly burned by misrepresentations the last time around. But if the U.S. ever hopes to reduce Fannie’s and Freddie’s dominance in the marketplace, as its regulator, the Federal Housing Finance Agency, recommends, the country needs to accept that the 30-year fixed loan — a financial product from our grandparents’ generation — has outlived its usefulness. We can create a better housing market by encouraging the development of more resilient mortgages that don’t depend on federal default insurance.

The only thing that has out lived it’s usefulness is the Too-Big-Too-Fail banks that proposing this nonsense. You want private market to come back? Stop the printing the money which suppresses mortgage rates. Allow mortgage interest rates to increase over time.  Investors down want to loan money at 3% they want 7% or 8% which is a very good return for the risk of the mortgage pool.  The 20% down payment requirement protected the investor/lenders in case of default and adds stability to prices.  Well developed underwriting requirement ensures the borrower could actually pay for the loan.

This is just a proposal from the beard scratchers in the academic world and banksters that want to make you pay more on your home, as always.  Policies that caused housing to collapse like cheap credit, easy credit, low down payments, and no underwriting requirement came from the Federal Reserve (academics mostly) and Crony Capitalist (Wall Street and GSE’s).   If you dust off the loan standards from around 1975 the housing market you will see they work fine and over 10 to 15 years we can return to the traditional housing market.