Can Homeowners Arbitrage the Mortgage Subsidy?

There's something very attractive about being given the opportunity to buy something which you know the seller is losing money on. That's why a standard round of haggling in any bazaar will involve the seller explaining that he's losing money already at this price: in some kind of economic theory-land the buyer shouldn't care about such things, but in reality we always do.

Some people love to spot these things and effectively arbitrage them. Do gas stations make all their money from selling overpriced sodas and lose money on the gasoline? Then if you don't buy the soda, you're essentially taking free money from the gas station. Will a hotel lose money on its special offer if you don't order room service or other optional extras? Same deal. And in the financial world, there's a certain type of person who will take low-interest-rate-for-life balance-transfer offers from credit card companies, borrow a large lump sum on the card, invest that sum in a CD, and pocket the spread.

Sometimes, you can make real money from this kind of thing. And when the sums of money become mortgage-large, and the government is subsidising mortgages, then there might be a trade here. Or that's what Arnold Kling thinks, anyway:

My wife and I have owned our house free and clear for about twenty years. But I think we probably should take out a conforming mortgage and invest the proceeds in a municipal bond that matures in 2011. It looks as though on an after-tax basis we would come out pretty close to break-even over those two years. At that point, we can re-assess. If it looks like I am wrong about the outlook for interest rates and inflation, and rates are still at five percent or less and likely to remain so, then we will unwind our position (use the proceeds of the bond to pay off the mortgage). On the other hand, if I am right and interest rates are headed up in 2011, we can take the proceeds from the maturing bond and invest them in some nice high-yielding instrument. If nothing else, this strategy can give me some income with which to pay off the taxes that the government is going to make me pay to cover the cost of the subsidized mortgages that Freddie and Fannie are issuing today.

Kling's big idea is that the government is effectively subsidizing mortgages -- this is true -- and that therefore he, as a homeowner, should be able to get his hands on some of that subsidy. But it doesn't really work like that.

For one thing, let's actually do the math here. Say that Kling takes out a $100,000 mortgage on his house and invests it in a Maryland municipal bond. According to the Maryland muni-bond yield curve, munis maturing in 2011 yield on average 1.692%. But some bonds trade at higher yields than that: today, a hospital bond with a coupon of 4.25% sold at 102.789 cents on the dollar to yield 3%. If Kling put $100,000 into that bond at that price, he'd receive four coupon payments of $2,067, as well as $97,287 at maturity.

Meanwhile, let's say he takes out a 30-year mortgage in order to lock in today's artificially low interest rates for the maximum amount of time: the headline Chase rates are an interest rate of 5.125% and an APR of 5.225%. Plug those numbers into an upfront cost calculator, and you'll see that Chase is charging $1,120.35 in up-front fees, not including application fees, appraisal fees, or fees for obtaining credit reports. Call it just under $2,000 all-in. The mortgage itself will have a principal amount of $98,879.65, and get paid off at $544.49 per month.

Over the next two years, Kling will spend $13,068 in mortgage payments; add in the up-front fees, and the cost of having that mortgage for two years is about $15,000. At the same time, he's getting $8,268 in coupon payments on his municipal bond, which means that over the course of those two years, he's basically got a negative carry of $6,732.

Plugging Kling's mortgage numbers into an amortization calculator, we can see that when the bond matures, the balance on the mortgage will be $95,955. He can pay that off in full with the proceeds from the maturing muni bond, and still have $1,332 left over. But that still means that he's $5,400 in the hole -- which is way more money than he'll ever get in mortgage-interest tax relief or anything else he might be counting on in order to get "close to break-even". And in the meantime, of course, he has to consider the opportunity cost of making all those mortgage payments without anything like sufficient coupon income to cover them: think of all the other things he could do with that money. And we're not even starting to add up the amount of personal time and hassle that Kling's going to have to go through in order to set this whole scheme up; nor are we making any allowances for credit risk on that muni bond.

So what are the chances of any remotely sensible person trying to take Kling's advice and put on a freeload-off-the-government trade by locking in low mortgage rates? About zero, I think. There are many things to worry about when it comes to government intervention in the housing market, but this isn't one of them.

Comments

[bc818:]

Agreed. The opportunity cost generally kills these kinds of arbitrage opportunites. Same as your credit card example. Imagine something goes terrbily wrong and you're one day late paying the credit card. then, imagine the fees, fines and penalties that would ensue as you try to unwind the position.

However, in your analysis you neglect the tax consequences. The mortgage interest is tax deductible and he doesnt have to pay tax on the muni, so there's signifcant tax savings there--although probably still not enough to make this practical.

Feb 26 01:18 PM

[SW Richmond:]

WARNING: SARCASM FOLLOWS. DON'T TRY THIS AT HOME.


Kling's scenario is way too whimpy. The way he could be a big winner is this: Take out a HELOC for 100% of the home's current price (find a nice appraiser who needs work for some "help"), use the cash, and any other cash he might have, to buy precious metals. Put the PM's in a secure location in the "Bank of Gaea". Wait two years for home prices to fall another 40%; never make a mortgage payment, use cash flow / mortgage payment money to buy a couple of Hummers. When (if) they get around to foreclosing, demand a government-backed Obama cramdown. Pay off the renegotiated note at sixty cents with 1/3 of the PM's (which will have at least doubled by then), keep the home and the rest of the PM's and laugh your ass off at your neighbors for being honest, hard-working suckers who helped buy your house.

Feb 26 01:38 PM

[rufusmcbufus:]

Oh, Richmond, you are very naughty indeed....but gosh that plan is truly breathtaking.

Feb 26 02:05 PM

[Jon Smirl:]

The real benefit here is getting a tax deduction from interest while offsetting it with tax free income. Forget about the two year bond, just buy a 30 year one that matches the life of the mortgage. Of course doing this transaction is prohibited by IRS rules, but it is very hard to prove. It also doesn't work if your tax bracket is lower than the differential between the two interest rates.

Feb 26 02:13 PM

[and:]

if kling can find a way to lease out the property, he may be able to profit from it. without rental income, the property won't make any profit anyhow...

Feb 26 02:25 PM

[Patrick22:]

I think that you are correct that the mortgage fees (especially title insurance) will make the transaction unprofitable. However, I think your analysis is off and your homeowner is not doing the correct comparison. However, if one is buying a house, the fees are being paid anyway and you have a situation where you could max the mortgage and take the cash and invest it in pre-refunded munis.

Your analysis is off because you neglect the tax benefit. However, the tax benefit is probably offset in large degree by the standard deduction. The numbers should be run. Especially if the homeowner pays property taxes and other itemized deductions that already exceed the standard deduction.

The other major problem is that you are trading guaranteed debt payments costs for a risky investment income. I don't know about the Hospital Bond, but it is not a 100% situation (it might be taxable, which is why the yield is that much higher) if its yield is 3X other comparable bonds.

The proper comparison is with Maryland pre-refunded munis coming due in 2011. These are risk-free (or as risk free as an American can get), like the debt.

A 30-yr mortgage would be dumb to use with a two-year muni. Better to get a 3/1 and use the lower interest rate. Or as someone suggested, get a 30-yr bond to match the mortgage. However, I don't believe there are 30-yr pre-funded munis, so you would be taking on risk.

Feb 26 02:55 PM

[Alex Filonov:]

Looks like everybody and his dog is buying precious metals. Looks like good time to short.

On Feb 26 01:38 PM SW Richmond wrote:

> WARNING: SARCASM FOLLOWS. DON'T TRY THIS AT HOME.
>
>
> Kling's scenario is way too whimpy. The way he could be a big winner
> is this: Take out a HELOC for 100% of the home's current price (find
> a nice appraiser who needs work for some "help"), use the cash, and
> any other cash he might have, to buy precious metals. Put the PM's
> in a secure location in the "Bank of Gaea". Wait two years for home
> prices to fall another 40%; never make a mortgage payment, use cash
> flow / mortgage payment money to buy a couple of Hummers. When (if)
> they get around to foreclosing, demand a government-backed Obama
> cramdown. Pay off the renegotiated note at sixty cents with 1/3
> of the PM's (which will have at least doubled by then), keep the
> home and the rest of the PM's and laugh your ass off at your neighbors
> for being honest, hard-working suckers who helped buy your house.

Feb 26 03:39 PM

[retred:]

Felix, you're not too good at this, are you?
You made several conceptual and math errors in your analysis.

1. The mortgage payment $544.49 is for a $100K loan, not $98,

2. The muni bond interest is not taxed, neither federal or state or county income tax rates if the investor lives in Maryland.

3. The mortgage interest, the bond premium, the refi costs and investment expenses are tax deductible.

4 At your rates, and initial mortgage of $100K, I see 2 years' mortgage interest paid of $10,107. I deduct $2000 expenses (either in year 1 for points,fees or amortized until accelated at payoff). A deductibe bond premium of $2713.33 is straight-lined over 2 years to maturity). Total deductible expenses for this trade are $14,820.50. Your cost of carry included principal, which is incorrect on an income basis. It is cashflow, but repayment of debt is not an expense.

5. Assuming the trader makes $300-$500K and lives in Montgomery County, MD, he pays 35% federal tax rate, 5.5% MD tax and 3.2% county tax, and deducting the state income tax from his federal income, he pays an effective income tax of 40.66%. His tax savings would be $6025.

6. The cost of the trade now is:
$8,269 tax free muni interest + $6025 tax savings - $14,820 expenses = $(526). So you're right, there is no arbitrage over 2 years. The real upside is that 2 years from now, his municipal bond will mature, he will have $98K cash in hand with a tax-deductible fixed-rate of 5.125% for 28 years. At that time, maybe he can buy US Treasury bonds with a 10% yield, and lock in 5% carry for 28 years. If he doesn't like his prospects in 2 years, he can pay off the mortgage and is out $525 over 2 years. A cheap option.

The real cost of this is that the government is spending huge amounts of money to create mortgage allocations (from banks and GSEs) to help prop up home prices. He takes some of that to refi a paid-for house. He doesn't pay $6025 in taxes he would have paid. He buys municipal bonds, which don't help the economy create jobs. Other people have to be taxed to pick up the slack.

BTW, I did this trade about 6 months ago, drawing down a HELOC to buy munis to wait and see what's available. It's been a sickening ride with my leveraged muni fund, but I'm OK now after tax-free dividends.

Also, Felix, you made a math error in your "The Truth About Mortgages" article too -- mortgage balance for 20% down loan example.

Feb 26 03:55 PM

[SW Richmond:]

Trade up and down if you want to, that's not my game.

On Feb 26 03:39 PM Alex Filonov wrote:

> Looks like everybody and his dog is buying precious metals. Looks
> like good time to short.
>
> On Feb 26 01:38 PM SW Richmond wrote:

Feb 26 05:08 PM

[Patrick22:]

Nice work Retred.

This arbitrage was actually widely talked about in 2006, when muni yields had moved up and were over the mortgage rate x 72%.

One thing Retred, the premium on a muni bond is not deductible. It is a return of principle. You cannot claim a capital loss.

Feb 26 08:16 PM