Nick Rowe writes US fixed rate mortgages aren’t fixed rate mortgages; they are weird, stupid, and dangerous. It’s a good discussion, especially in the comments.
For the bond nerds in the audience, Nick thinks they are stupid because they are callable (can be prepayed) which creates negative convexity, which is dangerous with a fixed rate.
It’s interesting, one of the reasons investors desired subprime was that it was believed to be more stable on the prepayment front; everyone was looking at interest rate risk instead of credit risk, and while the former was fine the second exploded (a situation relevant to Fannie as well, as John Hempton points out). I’ll have more to say on this when we start to dig into housing reform, but I just want to point this out for now.
I do want to post this paragraph from Arnold Kling:
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 not sure what he means by “the market ought to decide” what a mortgage looks like. A fully deregulated mortgage market? I’m fairly certain every modern nation has some sort of regulation on mortgages, and those nations that are modernizing are looking around for first-world solutions to emulate and guide them. (Another reason I take the financial reform movement seriously is that the developing world will have to live with it too. Here are notes on Mexico looking to the Danish mortgage market to modernize itself from Risk.net and Global Banking and Financial Policy Review.) This is because developed mortgage markets require developed capital markets, which also go with a system of regulation.
Mortgages in the State of Nature
We do have a case study of what deregulated lending looks like: the subprime market. It’s worth remembering that subprime lending was not on the books of any of the relevant consumer laws in the country. Alan Greenspan refused to enforce consumer protection laws, most importantly in 1994 The Home Ownership and Equity Protection Act, which bans “extending credit without regard to payment ability of consumer” and put strict rules on prepayment penalties, negative amortization, and balloon payments. Ned Gramlich urged Greenspan to have the Fed start regulating subprime, which he could do with Citigroup (NYSE:C), and HSBC (HBC) started buying out subprime lenders. So did the GAO and a HUD-Treasury task force. Greenspan wouldn’t. (Since it is off the shelf, this is from Our Lot p. 67-68.)
Leading conservative and libertarian think tanks were also touting the idea that subprime was the future of a deregulated mortgage market, replacing the need for consumer protection and lending laws. My favorite (h/t James Kwak) is this 2000 Cato publication, Should CRA Stand for “Community Redundancy Act”?, which informs the reader that the CRA isn’t responsible for the increases in homeownership, or much of anything, since financial statistical technology and subprime are taking its place (how talking points change!).
So how did subprime work out? I walk through the experience of a subprime homeowner here as well as the “fake homeownership” part of it here, but in general in a consistently refinanced short term loan most of the equity growth goes to banks, in terms of refinancing fees and prepayment penalties (click to enlarge):
That’s how often they recycle: something like 75% are refinanced 30 months into the life. It is a vehicle that is very difficult to build equity in. Julie Gordon, from the Center for Responsible Lending, likes to say “I’m in favor of home ownership, not home buyership” when it comes to discussing these subprime loans, and I think that is accurate. Even if you weren’t mislead, which many, many people were (Broke USA opens with a representative, and heartbreaking, episode of a man being lied to about how his payments would go), this is a terrible product.
I think further deregulation would see something similar to what we see in the credit card market, where everyone’s mortgage looks like whatever the laws of North Dakota say, and that the poorest homeowners (or “inept”, if you prefer) cross-subsidize the richest. Like subprime, the whole thing would be characterized by interest rate jumps and penalties and a whole bad-faith expectation that someone can actually pay it off. (I compare the logic of a credit-card to the logic of a subprime loan here.)
And I think that is accurate of mortgage markets in an unregulated market. The idea of home ownership for a broad class of people as a mechanism for building equity and wealth, without government intervention, doesn’t exist. It didn’t really exist before the New Deal (but please send me sources if you think I’m wrong about that), and it would look much more like subsidized renting, with the banks eating all the government subsidies. The mortgage would look, from a financial point of view, nasty, brutish and short in an unregulated market. Is that the future with more deregulation? I’m very open to all of your opinions on the matter.