NCPA - National Center for Policy Analysis

New Bubble May Be Building in 30-Year Mortgages

December 30, 2011

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.  While it is most certainly useful in mortgage financing and would certainly have a place in a completely free market, the concentration of investment in this one type of mortgage is dangerous and could have disastrous effects.  This can be seen in three separate factors that cause the 30-year fixed-rate mortgages to be a great deal less safe than it is advertised to be, says Edward J. Pinto of the American Enterprise Institute.

  • Its dominance requires permanent government subsidies.
  • It amortizes slowly, exposing homebuyers to years of unnecessary default risk.
  • It was responsible for two taxpayer bailouts in the last 20 years.

This first point, brought to the forefront by the government's absorption of Fannie and Freddie in 2008, underlines the danger of concentration in only a single type of security.  Government policies have encouraged a disproportionate share of investment in 30-year fixed-rate mortgages to the point that they easily dominate the market.  This causes a lack of diversified risk and leaves the sector vulnerable to shocks.

  • The combination of a federal funds rate of almost zero percent since late 2008 and injections of money into the economy by the Federal Reserve has kept borrowing rates artificially low.
  • These low rates artificially boost the value of the mortgages, and because the securities are backed by federal insurance, the technical risk allotted to them is nonexistent.
  • These two facts together encourage significant concentration of investment.

Disproportionate investment, beyond what the market would recommend, is a large contributor to eventual bubbles.  In the same way that European banks were able to accrue large amounts of Greek sovereign debt with little capital reserves to back it up (because it was ostensibly risk-free), American banks are able to invest in these mortgage giants and circumvent reserve requirements.

Were government policies to change suddenly and affect interest rates, volatility within the mortgage securities market would be substantial.

  • If mortgage-loan rates went up only from 4 percent to 5.5 percent, the value of these securities would go down by about 6 percent.
  • Given current investment levels, this would result in a $100 billion loss.
  • A larger sudden interest rate hike would necessarily cause larger losses.

These scenarios are not unrealistic, and they emphasize the importance of a reversal in federal policies that artificially support the concentration of risk in a volatile security.

Source: Edward J. Pinto, "New Bubble May Be Building in 30-Year Mortgages," American Enterprise Institute, December 23, 2011.

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