The Risky Mortgage Business: The Problem with the 30-Year Fixed-Rate Mortgage
January 7, 2013
In the United States, the standard mortgage product has a fixed rate for 30 years with prepayment allowed at any time. This enables more people to borrow but at the expense of the lender. In addition, the standard mortgage is a level-payment, amortizing mortgage. In other words, a borrower pays the same amount each month and that is sufficient to pay off the principal at the end of the 30 years, says Arnold Kling, a member of the Financial Markets Working Group at the Mercatus Center of George Mason University.
These policies create many problems for lenders. For example, there are hardly any lenders with a financial outlook that fixes their obligations for 30 years. Instead, they invest mortgages to earn a return for a few months to a few years.
Moreover, mortgage assets have a financial duration of much less than 30 years. The duration is typically estimated to be around seven to eight years but is affected by prepayments that take place when houses are sold or refinanced.
However, the condition of the market can affect the duration of the mortgage, which hurts the lender. For example, if market interest rates rise, the duration will lengthen because prepayments will slow down. But if interest rates go down, the duration will shorten and borrowers will rush to refinance at lower rates.
As a result, lenders must keep rebalancing their portfolios to offset risk. But the risk is simply placed onto taxpayers because policymakers fear letting large financial institutions fail. Because the government protects these financial institutions, there is less regulation, which allows lenders to make risker decisions that often end up hurting the taxpayer.
The Savings and Loan (S&L) industry provides an example of what can happen today with current lending practices.
- The S&L industry had little regulation, which allowed it to load up on interest-rate risk.
- As a result, it could issue 30-year mortgages funded by deposits that could quickly be liquidated.
- However, the S&L faced a collapsed and cost taxpayers over $100 billion dollars.
Currently, the government is keeping interest rates low to protect institutions like Freddie Mac, Fannie Mae and the Federal Reserve. If interest rates go up, there could be severe operating losses. The government needs to impose stricter capital requirements to ensure that the burden of interest-rate risk is placed not on taxpayers, but rather private investors.
Source: Arnold Kling, "The Risky Mortgage Business: The Problem with the 30-Year Fixed-Rate Mortgage," The American, December 11, 2012.
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