Ever since Fannie Mae and Freddie Mac collapsed and were bailed out by the U.S. government in 2008, in one of the largest government bailouts in history, the future of the 30-year fixed mortgage has been in doubt. Both President Obama and the Republicans have expressed support for the idea of eliminating Fannie and Freddie and privatizing the U.S. mortgage guarantee process.
But it hasn’t happened yet, and it’s been nearly 5 years. The reason why is that killing the 30 year mortgage, which an editorial in Bloomberg espoused yesterday, is extremely unpopular politically. Consumers love fixed-rate mortgages because they provide certainty in terms of the monthly payment, lessening risks that are posted by adjustable rate mortgages.
Interestingly enough, adjustable rate mortgages are the rule in Europe, where the government never developed the role in the mortgage process or the investment in the idea of homeownership that the U.S. government did. Here in the U.S., the government has for more than the past half century played a central role in the mortgage process, either outright owning or guaranteeing many fixed rate mortgages.
From a risk point of view, assuming the interest rate risk on a 15 or 30 year basis is something that few, if any, financial institutions are willing to take on given what happened in the financial crisis and what has happened with interest rates over the past few decades.
That’s because if interest rates increase — and they, will eventually — a financial institution would be stuck paying out higher interest rates on savings accounts, certificates of deposit and IRAs, while receiving a very small return on interest on fixed rate long term mortgage commitments made years ago. In contrast, an adjustable rate mortgage will eventually increase to market rates, which poses much less risk for banks and other lenders.
That leaves the U.S. government as the default lender of last resort for fixed rate mortgages. Today, the U.S. government owns or guarantees 90 percent of all new mortgages, which is a major increase from the 50 percent it owned or guaranteed in the mid-1990s. Given the boom and bust nature of U.S. real estate markets, that means it’s all too likely that at some point the U.S. government will be left holding the bag when the real estate market goes bust again and large numbers of homeowners default.
That’s not as likely with rates so low, because the underwriting environment is so conservative currently and payments are affordable. However, as underwriting standards loosen and rates go higher, the table will be set for another housing market disaster. After all, the most recent real estate market boom/bust wasn’t the first, just the latest in a long line of U.S. real estate market ups and downs.
So when the next bust happens, the U.S. government, as the guarantor of last resort will be on the hook for all those defaults, obligated to pay — wait for it — billions of dollars to banks for the homeowners who are unable to make those payments. And since the U.S. government is us, the taxpayers, we could be left footing the bill for another expensive bailout.
The solution, many say, is to abolish fixed rate mortgages altogether and leave adjustable rate loans as the only option for consumers. This would take the long-term interest rate risk out of the picture for both the government and financial institutions. Unfortunately, that leaves consumers holding the bag and assuming the vast majority of risk surrounding interest rates.
Well, that’s hardly fair. Why should consumers bear most of the risk from an unpredictable, speculative real estate market? We saw the impact of a variety of adjustable rate loans during the real estate bust. Lax underwriting standards, outright fraud on the part of some unscrupulous mortgage brokers and appraisers and exotic loans left homeowners at the mercy of sky high payments and many lost their homes or were stuck making unsustainable payment that they could barely afford.
The Bloomberg editorial mentions some creative solutions that could help fill the gap if the 30 and 15-year fix rate mortgage is abolished. These intriguing options include:
- Pegging monthly mortgage and interest payments to neighborhood home values
- Allowing borrowers to pay more up front for the ability to make lower payments later if home prices go down
If the 30-year mortgage is indeed toast, we need to see more innovative ideas like those above so that homeowners aren’t forced to bear all the risk from unpredictable real estate markets. It’s certainly not fair to expect the government or financial institutions to do so and there is no reason why consumers should have to either.