The 30-year fixed-rate mortgage, the most common way U.S. buyers finance a home purchase, isn’t the ideal instrument its supporters claim it to be.
First, its dominance requires permanent government subsidies. Second, it amortizes slowly, exposing homebuyers to years of unnecessary default risk. Third, it was responsible for two taxpayer bailouts in the last 20 years.
Most important, these mortgages may be behind a new bubble.
The combination of a federal funds rate of almost 0 percent since late 2008 and injections of money into the economy through quantitative easing by the Federal Reserve has kept borrowing rates artificially low. Federally insured banks, thrifts and credit unions hold $1.7 trillion in Fannie Mae-, Freddie Mac-and Ginnie Mae-guaranteed securities, while an additional $2.2 trillion are held by local, state and federal governments and agencies. Both categories have increased by about 30 percent since 2007. As a result the government, banks and other financial institutions backed by the Federal Deposit Insurance Corp. now hold 52 percent of outstanding agency securities. Most are backed by 30-year fixed-rate mortgages.
Federal policy has, in effect, created a closed system whereby the government subsidizes the rate on 30-year mortgages, guarantees the credit risk and then puts itself on the hook for most of the interest-rate risk. Although government protects holders from credit or default risk, these investors are exposed to potentially sizable losses due to changes in the price of the security if interest rates go up.
Concentration of Risk
This system simultaneously drives down mortgage rates on guaranteed loans and permits lenders to back them with minimal capital. This encourages banks and other deposit-taking institutions to hold more mortgage securities than would normally be justifiable, a recipe for both bubbles and bailouts.
Rather than diversifying risk, these government policies promote a concentration of risk. A single national event, specifically an abrupt increase in interest rates, would adversely affect prices for this entire asset class. Banks may attempt to hedge this risk, but hedging gains and losses can be uneven, particularly in the case of volatile markets or when many participants are forced to sell at the same time. For example, Fannie and Freddie have had a combined $17 billion in hedging-related losses during the first three quarters of 2011.
How might this bubble burst?
Most of these government securities are backed by 30-year fixed-rate mortgages yielding the lowest rates seen in generations. For example, the average security yields about 4.5 percent, down from about 7 percent as recently as 2000.
Because of the government guarantees, banks that hold these securities qualify for favorable capital treatment under risk-based-capital rules. Securities of Ginnie Mae, a government-owned entity that subsidizes affordable housing, carry a risk weight of 0 percent, meaning a bank doesn’t have to hold any capital against them. Fannie and Freddie securities carry a risk weight of 20 percent, meaning 1.6 percent capital is required rather than the normal of about 8 percent. These same capital rules allowed European banks to load up on the 0 percent risk-weighted debt of Greece and other countries on the periphery of the euro area.
Depository institutions make money on these long-maturity investments by using short-term funding. Because these securities are backed by the government, they are considered highly liquid. But being highly liquid doesn’t protect against wide price swings, and securities tied to 30-year mortgages are notorious for price volatility. If mortgage-loan rates went up only by a moderate amount, say from 4 percent to 5.5 percent, the value of the securities held by banks and other financial institutions would go down by about 6 percent, or $100 billion based on the size of their holdings. A larger increase in mortgage rates -- to say 9 percent -- may put us on the verge of another financial meltdown.
Not First Time
This wouldn’t be the first financial crisis in which the 30-year fixed-rate mortgage played a large role. Twice in the last 20 years we have seen spectacular failures of U.S. housing finance, each at enormous cost to taxpayers. Both the savings and loan crisis and the Fannie-Freddie bailouts can be traced to congressional support for, and subsidization of, the 30-year fixed-rate mortgage.
The S&Ls invested in 30-year mortgages that they funded with short-term deposits. By 1981, when deposit rates soared as high as 15 percent, the thrift industry found itself insolvent due to portfolios stuffed with 9 percent mortgages.
Fannie and Freddie were set up to support the 30-year fixed-rate mortgage market, buying the loans from lenders, packaging them into securities and selling some of them to investors -- all with an implicit federal guarantee that helped to lower mortgage rates. In 2008, both were taken over by the government, costing taxpayers more than $160 billion and counting.
Freddie, and Fannie to a lesser extent, suffered a classic liquidity squeeze. In the late summer of 2008 as debt markets became concerned about the two companies’ solvency, yields on their debt relative to U.S. Treasuries ballooned. That imperiled their ability refinance hundreds of billions in debt used to back its huge mortgage portfolio.
The solution is to wean the housing market from its dependence on subsidized 30-year fixed-rate mortgages, starting with winding down Fannie and Freddie over a period of five to seven years. A private market focused on prime quality mortgages would offer borrowers a wider variety of loan choices. These loans would have varying amortization terms, prepayment options and periods of protection against changes in interest rates. In flush times, lenders should be required to build capital to better cover credit risk. Finally, risk weights should be increased to reflect price volatility inherent in securities backed by long-term mortgages.
The 30-year mortgage has a place in the U.S. housing market, but all things in moderation. Congress needs to ask the housing industry why we should continue subsidizing a product with this kind of track record.
(Edward Pinto, the former executive vice president and chief credit officer of Fannie Mae, is a fellow at the American Enterprise Institute. The opinions expressed are his own.)
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