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In defense of the 30-year mortgage

When writers are forced to discuss the complicated world of housing reform, as they have had to do after President Obama’s recent housing speech, they usually rush to one of two meta-conversations.

The first is whether or not we emphasize homeownership too much, and whether we should encourage more people to rent.

The second is whether or not the 30-year fixed-rate mortgage, which President Obama and many approaches to Fannie/Freddie reform want to preserve, is a luxury, and a subsidy not worth preserving after the crisis.

Given the complexity of the debate, I don’t blame anyone for going meta. The Center for American Progress put out a document that charts out the minor differences between 26 (!) different plans to reform Fannie Mae and Freddie Mac (the GSEs). But readers should know that GSE reform does impact them even if they are a renter, and be aware of the strong arguments for why a 30-year fixed-rate mortgage is worth preserving.

Fannie and Freddie aren’t just for homeowners

Let’s get the first conversation out of the way: The GSEs play a major role in providing financing for mortgages for multifamily units that go to fund apartments and other rentals. As Andrew Jakabovics and John Griffith of Enterprise Community Partners note in an informative editorial, the GSEs’ credit guarantees were especially crucial “to keep money flowing to the multifamily rental market during economic downturns.” Pre-crisis, the GSEs accounted for almost 30 percent of new multifamily mortgages; during the crisis it’s been closer to 60 percent, and hit 85 percent in 2009. Without the GSEs, the huge run-up in rental rates during the crisis would have been much more vicious.

FHFA, in a recent series of studies, found that, without the government guarantee, this market would have little value, and that private investors wouldn’t sweep in to pick up the slack. If the credit guarantee was to be dismantled, FHFA estimates that rents would increase between 0.2 and 2.1 percent, and new rental housing supply would decrease anywhere between 4 and 27 percent.

Sorry renters, you have to pay attention. If you live indoors, and even if you cannot afford to live indoors, you have a stake in this debate.

Why back up private mortgages?

Before going further, let’s break down some of the jargon. Before the crisis, the GSEs were private firms that would create mortgage-backed securities and retain the credit risk. They had an implied backstop from the government. Since the backstop was only implied, this insurance was never explicitly priced. Meanwhile, private-label mortgage-backed securities (PLS), which took over housing in the 2000s and are associated with subprime loans, did not have this credit risk guarantee. They were thought to be safe as a result of stream of private financial engineering techniques.

The approach being considered in the Senate, as well as by Obama, has two parts. First, it would create something like an exchange for creating, standardizing and regulating new mortgage-backed securities, and create an agency, the Federal Mortgage Insurance Company (FMIC), modeled on the FDIC, for this purpose. This would sell catastrophic risk insurance on those securities for an actuarially fair price, thus making it the government guarantee explicit and priced. Investors would still take the first 10 percent of losses in this case. The House bill, PATH, would have a weaker exchange and no guarantee, leaving the entirety of housing to the PLS market. (A good, accessible summary is here.)

There are three broad reasons to support the credit guarantee included in the Senate plan. The first is that the PLS market is a mess, and unlikely to recover soon. There are record number of defaults, but also conflicts-of-interest, bad servicing and endless lawsuits. Even if it does recover, there’s little reason to believe the PLS market can cover the entire demand for U.S. mortgages by itself.

The second is that providing macroeconomic stability is a legitimate and important function of the government. After the crash, the government had to step in, prevent a banking crisis and run the entire mortgage market after private capital disappeared. As such, the government holds the tail risk of the mortgage market imploding already; why not make this insurance explicit, while also regulating and pricing it?

We need 30-year mortgages

And the third reason is to preserve the 30-year fixed rate mortgage. But wait, why should we preserve that? As David Min, a law professor at University of California, Irvine, has argued, there are several broad reasons to continue this mortgage.

The 30-year fixed rate mortgage provides certainty over costs for homeowners. There’s cost certainty in relation to interest rates, but also when you compare the 30-year mortgage to other mortgages, which require consistent refinancing. Prime mortgages with a fixed rate have a lower overall foreclosure rate than adjustable-rate mortgages.

This stability is mirrored in macroeconomic stability. Before the Great Depression, mortgages were usually short-term, with variable rates of interest, had bullet or balloon payments, and needed to be consistently refinanced. This is also what you would think of when you think of the subprime loans of the 2000s that characterized the PLS market. And these loans tend to facilitate pro-cyclicality in the housing market, with more dramatic swings with short-term interest rates.

Meanwhile, the 30-year fixed-rate mortgage puts interest rate risk on those who can best handle it. The broad financial universe of lenders puts large resources into analyzing and responding to interest rate risk, resources individual households can’t deploy. You see this in the data; foreclosures for adjustable-rate mortgages are significantly higher than fixed-rate mortgages, even when both are prime. The 30-year fixed rate mortgage is just good business sense.

A lot of people cite the availability of loans for wealthy homeowners in the high-end “jumbo” (loans too big for the GSEs) market as sufficient proof that there’s no need for a government role in housing. But there’s no reason to believe that this will scale to the size of the United States’ housing market or even outside the very wealthy. As Georgetown University law professor Adam Levitin has testified, the jumbo market is small, perhaps 10-15 percent of all origination. It also piggybacks on the GSEs by locking in rates through their markets and hedges their risks through GSE instruments.

The market gods will not save you

It would be nice to imagine that the “free market” will just take care of this issue. But remember that the housing market is created through a huge web of government policy. The PLS market, that choice of those who claim the free market, was created through a wholesale revision of law in the 1980s, from tax law to replacing state laws with the ratings agencies. Without those changes, PLS wouldn’t even exist. The question is not whether government should play a role. It’s what role government should play.

This is, in broad strokes, the argument for keeping the government’s mortgage guarantees, and preserving the 30-year mortgage. If you think it’s appropriate for the government to charge a fair fee for catastrophic insurance, and to nudge interest rate risk onto lenders, while working to ensure the stability of the macroeconomy and accessible mortgage credit, then the Senate bill has something for you. If you think that handing over the entirety of the housing market to the mortgage industry of the 2000s is the right approach, then the House bill is more your style.