Original posted in the Wall Street Journal by James Hagerty:
One benefit of our financial crisis is that it gives us a chance to rethink the way Americans finance their purchase of homes. Congress and the Obama administration are starting to think about how to reform federal institutions–such as Fannie Mae, the Federal Housing Administration and the Federal Home Loan Banks–that were created during the Great Depression and somehow managed to stay with us into a new century.
But we may be starting that debate with a false premise: That we need to preserve at all costs the 30-year fixed-rate mortgage with an option for the borrower to prepay at any time. That is the assumption of a new set of mortgage-reform proposals released today by the Center for American Progress.
Questioning the sanctity of the 30-year fixed home loan is tantamount to proposing that the White House should be repainted pink. For Realtors, mortgage lenders and home builders, the fixed rate is nearly as sacred as the tax deduction on mortgage interest (an even more dubious American policy, but let’s leave that for another day).
Yet there are good reasons to wonder whether the 30-year fixed-rate mortgage deserves to be enshrined and protected in public policy.
For one thing, it’s very awkward for lenders. Banks don’t get 30-year deposits at fixed rates and so aren’t in a position to count on being able to match the rates on their assets and liabilities if they are making and holding 30-year loans. The S&L crises of the 1980s resulted partly from a mismatch between low rates on loans and soaring rates for deposits.
One response, of course, was to rely more heavily on the use of mortgage-backed securities to provide funding for home mortgages. Banks and other firms could make the loans and then sell them to investors, who could worry about when (and whether) they would be paid back. That works, but only if properly regulated, as we learned when defaults began to soar in 2006.
With the 30-year fixed mortgage, the homeowner can count on paying the same rate of interest every month, even if the general level of rates jumps. But the risk of interest-rate fluctuations doesn’t go away; it just ends up with other people. Much of it ended up with Fannie Mae, Freddie Mac and other buyers of mortgage securities (who later passed on some of their losses to the U.S. taxpayer, typically a homeowner with a fixed-rate mortgage).
Holders of mortgage securities tend to hedge against the risks of rate gyrations by purchasing interest-rate swaps and other derivatives. All of this hedging, involving trillions of dollars sloshing around the globe, makes financial markets more volatile. It also leads to Byzantine accounting rules for the valuation of those derivatives. Those complex rules make it harder to understand what’s really going on at Fannie, Freddie and other buyers of mortgage securities. (Fannie and Freddie got into big trouble with regulators in 2003 and 2004 by trying to work around the accounting rules.)
Homeowners also pay for the security of fixed rates. In a normal market (unlike today’s government-dominated one), the fixed rate is well above the adjustable rate on offer. In a February 2004 speech, Alan Greenspan, then Federal Reserve chairman, noted that “many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade” as rates declined. That raised such an uproar among the fixed-rate priesthood that Mr. Greenspan soon felt compelled to add that he didn’t mean to suggest that everyone should have an adjustable-rate mortgage.
What about the argument that we need 30-year fixed-rate mortgages to ensure that more American households can hope to own a home?
Outside of the U.S. and Denmark, 30-year fixed-rate mortgages are generally unavailable. Variable rates are the norm, and people live quite well with them. The U.S. homeownership rate is around 68%. That is within a percentage point or two of the homeownership rates in Canada and in the European Union as a whole, where variable rates rule.
Yes, the risk of rising rates is real. Interest rates soared in the late 1970s and early 1980s as the Fed fought inflation. That could happen again.
But buying a home is never going to be risk-free. Buyers should be prepared for unexpected costs. It isn’t clear that the government needs to create subsidies to ensure that long-term fixed-rate loans will always be available to American home buyers. (If home buyers are treated like adults, they might even act like adults.) If demand for fixed-rate loans is strong enough, the market eventually will provide them – for a premium price to cover the interest-rate risk being shed by the homeowner.
If, however, we do decide that 30-year fixed rates are a national priority, we might want to look to the Danish model. The Danes have a system under which long-term fixed-rate mortgages are financed through the bond market without the need for government-backed entities like Fannie and Freddie. By all accounts, it has worked quite well for more than two centuries.