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Tuesday, June 22, 2010

"US Fixed Rate Mortgages ... are Weird, Stupid, and Dangerous"

More on 30 year fixed rate mortgages. Nick Rowe disagrees with Richard Green:

US fixed rate mortgages aren't fixed rate mortgages; they are weird, stupid, and dangerous, by Nick Rowe: Americans aren't really insular, like the English. But they live in a very big country, and that can have the same effect. If there's something peculiar about the US, Americans sometimes won't realise how peculiar it is. US mortgages are peculiar. "Weird" is a better term.
Patrick Lawler, as described by James Hagerty, has tried to explain to Americans that their 30-year fixed rate mortgages aren't 30-year fixed rate mortgages, and that they are weird, stupid, and dangerous. He failed, perhaps because he ran out of time.  Richard Green didn't get his point (H/T Mark Thoma). So I'm going to try.
First off, American 30-year fixed rate mortgages aren't 30-year and aren't fixed rate. The term is variable, and the rate is variable. That's because they are "open" mortgages, rather than "closed" mortgages. A 30-year 6% closed mortgage really does have a fixed term and a fixed rate. You know exactly how much you will be paying per month for the next 30 years. An open mortgage means you have the option to pay off or refinance that mortgage at any time over the next 30 years. And you will of course exercise that option at any time when the market interest rate for the remaining term falls below the rate you are currently paying. And exercise it again, if the market rate falls again. So the actual term is whatever you want it to be, and the interest rate you actually pay will vary, if market rates for the remaining term ever fall below the initial rate, as they almost certainly will (as I shall explain).
The option to renew sounds good. It's like a one-way bet. Heads, and interest rates fall, you exercise the option and win the bet. Tails, and interest rates rise, you stay locked in and the bet's off.
If the option were free, of course you would want an open mortgage. You can't lose. But, of course, there must be someone taking the other side of the bet. The lender won't sell you that option for free. You have to pay for it, and you pay for it in higher interest rates.
The longer the remaining term to maturity of the mortgage, the greater the chance that market rates will fall, the more that option is worth, and the higher the interest rate premium you would pay to buy that option. If you only have a couple of months left on the mortgage, interest rates won't move very far in that short time, so an open mortgage will have only a slightly higher interest rate than a closed mortgage. So even if interest rates on closed mortgages have no trend up or down as the remaining term to maturity shortens over time, interest rates on open mortgages will tend to trend down as the remaining term to maturity shortens. So the option to refinance will probably be exercised again and again.
I can understand the argument in favour of 30-year fixed rate mortgages, if they are truly 30-year and fixed rate. Which means a closed mortgage. A risk-averse person borrowing to buy a house knows exactly what he will be paying until the mortgage is paid off. But why would such a risk-averse person ever want to buy an option that interest rates will fall?
That's what's so weird about open mortgages. It's not just weird, it's stupid. It's like an insurance company bundling lottery tickets with its insurance. "Sorry, but you can't buy fire insurance unless you buy a lottery ticket at the same time". Actually, it's even stupider than that, because at least the lottery and fires are independent probabilities. The reason you didn't chose a variable rate mortgage is presumably because you wanted to insure against interest rate risk. So why buy a one-way bet on interest rate risk at the same time?? It's really stupid.
It's equally weird and stupid from the lender's point of view. Lenders aren't always risk-neutral; they care about interest rate risk and liquidity risk. If you are about to retire, and want a safe income for the next 30 years, or if you are a pension plan looking for an asset that provides a safe return to match your fixed payouts to retiring clients, a 30-year fixed rate mortgage looks like a good investment, if it were truly 30-year and truly fixed. Why would you ever at the same time want to write an option on interest rates? Why would you ever agree to write a one way bet that you lose if interest rates fall? Falling interest rates are the one thing that retirees and pension plans want to insure against, not bet that they won't happen! It's really stupid.
It's equally stupid from the liquidity risk point of view. The job of banks is to convert illiquid assets into liquid liabilities. It's not an easy job. But it's an even harder job if you don't know how liquid your assets are. You know in advance when a closed mortgage will be paid off, assuming no default. With an open mortgage you have no idea when it will be paid off, even assuming no default. Plus, banks borrow short and lend long. A fall in interest rates is good for banks, because the value of their long assets rises more than the value of their short liabilities. But a fall in interest rates is just the time when people will pay off their open mortgages, so banks get lots of liquidity when they least need it. It's really stupid.
Stupid, and also I think dangerous. But this is the bit I don't understand too well. As I understand it, one of the main reasons behind the securitisation of mortgages in the US was because of the interest rate risk and liquidity risk I have talked about above. Banks didn't want to hold risky open mortgages on their books. So they securitised them and sold them off. Then the default risk turned out to be higher than the buyers of those securities thought it would be. And because the mortgages were sliced and bundled, it was impossible in practice for the lender to renegotiate terms with a borrower in difficulties. (Plus, there's the other weird and stupid feature of US mortgages [edit: in many states] that they are non-recourse, so the borrower can just hand in the keys and walk away, but that's a whole other subject). And then everything went pear-shaped when house prices fell.
Understandably, Americans don't like foreigners interfering in their internal affairs. But dammit, the US is big, rich, powerful and important, not some piddling little country that doesn't really matter to the rest of the world. When the US financial system catches a cold, other countries will at least sneeze. US 30-year fixed rate mortgages are not 30-year and not fixed rate. They are are weird, stupid, and dangerous. They need to know that.

Arnold Kling:

30-Year Fixed-Rate Mortgage Debate, by Arnold Kling: Richard Green likes them. Nick Rowe does not. I can understand Green's antipathy toward the most common forms of adjustable-rate mortgages in the United States. However, I think that a mortgage that amortizes over 30 years, with an interest-rate adjustment every five years, and no teaser rate would be better than any of the common mortgages here. The five-year fixed term would suit many people, since many people move in less than ten years.
In any case, regardless of what Green or Rowe or I believe is the right mortgage, I think that the market ought to decide. It is my hypothesis that, in the absence of government support (including loading the tail risk onto taxpayers), the thirty-year fixed-rate mortgage with no penalty for either prepayment or default would be priced too expensively to attract borrowers.

I'm trying to meet a deadline, so I'll have leave comments to you.

    Posted by on Tuesday, June 22, 2010 at 09:10 AM in Economics, Housing | Permalink  Comments (110)


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