The dismantling of the economy’s legal infrastructure V-2: An aside on the financial economics of the 30 year mortgage

Consider the practical questions of how the risks of financing 30 year fixed rate mortgages can be managed. There are two principal sources of risk: credit risk and interest rate risk; and two possible sources of funding: savings deposits and capital markets financing.

Credit risk is the risk that borrowers fail to make their payments. Even the best managed portfolio will have some regular level of default as borrowers are affected by illness and idiosyncratic hazards. Loan origination practices play a crucial role in credit risk, because if the borrowers are not carefully vetted, their likelihood of default will be higher. In addition, because of the regularity of economic cycles and the resulting fluctuations in employment, credit risk also has both a strong cyclical factor and includes the risk of extreme recessions/depressions. Finally, credit risk is also significantly affected by the loan products being offered: loan products that attract a more risky type of borrower can have dramatic effects on credit risk.

Interest rate risk exists because the funding of mortgage lending is typically shorter term than the mortgage loans themselves. That is, interest rate risk exists because of maturity mismatch between assets and liabilities. At any given moment in time the interest rate being paid on a 30 year fixed rate loan is greater than the interest rate being paid on savings accounts or on the capital market instruments used for funding. Interest rate risk exists because the interest rate on the 30 year fixed rate loan stays fixed for 30 years,[1] whereas the interest rates paid on savings accounts and the instruments used for funding are shifting over time. If the revenue being paid into the bank or funding vehicle from the portfolio of 30 year loans falls below the interest rate expense the bank or funding vehicle must pay to fund that portfolio, then losses will force the bank or funding vehicle into bankruptcy. In short, interest rate risk is the risk that the mortgage lender ends up in a nonviable situation where the lender can no longer afford to pay the interest rate necessary to continue to fund the mortgage portfolio. As a result, when maturity mismatch increases, so does interest rate risk: a portfolio of 12 year loans is safer than a portfolio of 30 year loans with the same funding.

It is important to understand that the greater the maturity mismatch between assets and liabilities, the harder it is to manage not only interest rate risk, but also credit risk. Over a 30 year period the likelihood that an extreme, unexpected recession will occur is much higher than over a 12 year period, and the very slow rate of repayment of 30 year loans means that repositioning the portfolio is much more difficult than it is for 12 year loans. In short, short term financing of a 5 year loan portfolio is easier to manage than short term financing of a 12 year loan portfolio, which in turn is easier to manage than short term financing of a 30 year loan portfolio. This fact explains the structure of mortgage lending prior to the Depression, where the safety of commercial banks was considered a paramount goal, and savings and loan associations were less regulated, but attentive to the risks of mortgage lending.

Once one understands the risks of 30 year fixed rate mortgages, the question becomes how it is possible for the private sector to finance them. Let’s go over the options.

First, consider the case of the very short term funding provided by savings and commercial banks. One solution is for the banks to only lend a fraction of their balance sheets to mortgages, say 10 or 20 percent. In this situation, the banking system as a whole can almost certainly manage its way around the risks. On the other hand, there will be very little availability of these mortgages compared to what we are accustomed to today. In order to reduce demand to this level, one would have to assume that 30 year fixed rate mortgages are actually very expensive – at which point other mortgage options are likely to become popular. Arguably this was more or less the situation before the 1930s: there was a purely private bank-funded solution to the mortgage problem, but mortgages were much less favorable to consumers than the 30 year fixed rate mortgage to which we are all accustomed.

So what are the alternatives for savings and commercial banks to fund 30 year fixed rate mortgages at low rates and with general availability. Without some form of government support, there is little reason to believe that it is possible for the private sector to manage the risks of this extreme maturity mismatch when mortgages account for a significant fraction of bank balance sheets. To address credit risk, there needs to be a government backstop for the lenders in the event of a severe recession. In the 1930s when the 30 year mortgage was first introduced, Federal Housing Administration insurance was created to provide this backstop.[2] In 2009-2011 there was a “backdoor bailout” by a vast broadening of Federal Housing Administration insurance and a program of Federal Reserve-financed refinancing of mortgages.[3] Interest rate risk can be addressed by either financial repression that stymies the market forces raising short term interest rates and forces consumers to incur negative real returns on their savings and thus to bear the costs of funding mortgages, or a government backstop that supports the bank mortgage lenders through the period where they are upsidedown on their net interest rate revenue.

Elements of a policy of financial repression were attempted in the 1960s and 1970s, but there was no genuine commitment to stymying market forces[4] (as there was in Nazi Germany, the classic case of financial repression) and as a result by the early 1980s the realization of interest rate risk had left vast swathes of the savings and loan industry bankrupt. Famously, the government instead of providing the necessary backstop promptly attempted through deregulation to allow the bankrupt savings and loans to earn their way to solvency – and succeeded only in making the problem worse. By the time the savings and loan industry was finally bailed out by the government in 1989, the cost of the bailout had increased dramatically.

An alternate solution to private sector funding of 30 year mortgages is to finance them using capital market instruments. In particular if funding is both longer-term than the mortgage portfolio and callable (that is, the borrower can choose to pay it before maturity), then interest rate risk cannot drive the funding vehicle into bankruptcy. The reason long-term funding must be callable in order to address interest rate risk is that the typical 30 year mortgage permits prepayment and is therefore refinanced when interest rates decline. In order for maturity matching to work, the funding instrument must also be pre-payable. Even if interest rate risk is addressed by maturity matching, credit risk remains and can cause the funding vehicle to go bankrupt, putting losses to the capital markets investors. Thus, because the 30 year lending horizon is inherently risky and because the embedded call option also has a price, capital markets investors are likely to demand relatively high rates for this product, which will in turn mean that for the vehicle to be financially viable 30 year mortgages will have to have relatively high rates. Certainly, in an environment where government subsidization of 30 year mortgages is the norm and is expected, it will be impossible for a purely private funding vehicle that eschews maturity mismatch to compete. (While this type of funding did exist for a short time in the US in the early ‘00s, the market for private label mortgage backed securities (PLMBS) collapsed entirely and had to be bailed out alongside the banks that participated in it.[5] It is no longer a meaningful player in the US mortgage market.)

A standard mechanism for reducing the cost of funding on capital markets is to have a capitalized corporation provide a guarantee to the debt security instead of having it issued by a bankruptcy-remote funding vehicle. A corporate guarantee on the debt ensures that the shareholders of the corporation will bear any losses before the investors do. Under these circumstances the mortgage backed security will bear an interest rate comparable to that of the debt issues of the corporate guarantor. This is a standard means of funding mortgages and is comparable to the system of “covered bond” finance in Europe.

Whether an entirely private corporation will be willing to take on the risks of providing such a guarantee to a securitization of 30 year fixed rate mortgages is I believe unknown. (If you know of an example, please let me know.) The PLMBS that were issued in the US in the early naughties did not have such a guarantee. By contrast, government guarantee of the securitization of 30 year fixed rate mortgages is definitely a viable model, as illustrated by Ginnie Mae, which still issues MBS today.

There is another hybrid model of capital market funding of 30 year mortgages: that of Fannie Mae and Freddie Mac, which were private, but “government-sponsored” corporations (“GSEs”) from 1970 to 2008. These GSEs provided a corporate guarantee of all of their securitizations which put their shareholders at risk, and their longevity is indicative of the fact this model is at least potentially viable. Even though the GSEs had shareholder funds at risk, they were highly regulated and received government support of their debt in the form, for example, of legal preferences for GSE debt over general corporate debt as an asset that may be held by banks and the Federal Reserve (and other regulated entities). Timothy Howard makes the case in The Mortgage Wars for the success of this model.

Under the GSE structure, government support allows the corporations to raise both short and long-term funds cheaply, regulatory requirements set the level of capitalization and monitors that the vehicle is meeting goals for the provision of low-cost mortgage finance, and the private capital at risk creates incentives for careful management of interest rate and credit risk. The corporate guarantee is the key element that makes the GSE structure work: it is in the interests of GSE to carefully supervise the quality of the mortgages it securitizes; in economics jargon incentives are aligned. Thus, the GSEs set the mortgage standards in the US mortgage market for decades – the word “subprime” originally meant that a mortgage was below GSE standards. They reviewed loans carefully and were able to weed out from a plethora of newly introduced loan characteristics those that were consistent with quality mortgages and those that were not. As a result, the securitization market that collapsed in 2007 was the private-label securitization market, not the GSE market.

Howard (2014) makes the case that through the 1990s and into the early naughties Fannie Mae had exceptionally high quality risk management. This is, however, also the pitfall of this GSE model. As Howard’s account itself indicates risk management was such a difficult task that a change in management at the end of 2004 was sufficient to destabilize a very effective mortgage funding mechanism. (On the other hand, one does need to be careful about allowing sceptics of government support to prove their point by sabotaging the GSEs, as Howard argues OFHEO, Fannie Mae’s regulator did. I, unfortunately, have no capacity to weigh these claims on their merits.)

Overall, the conclusion one draws from this discussion is important: there is virtually no reason to believe in the feasibility of the 30 year fixed rate mortgage as a financial product in the absence of some form of government support.

My next post will study what happened when the government, instead of recognizing that if it wanted to support the 30 year loan as a financial product, it would have to underwrite many of its risks, chose to distort financial regulation in order to promote cheap finance for housing.

[1] Because the norm with 30 year fixed rate mortgages is to permit payoff without a prepayment penalty, when 30 year interest rates fall, the interest rate being earned on the portfolio tends to fall quickly as borrowers choose to refinance their loans. There is no counterbalancing effect when 30 year interest rates rise. This makes the interest rate risk problem even more severe, and is known as prepayment risk.

[2] Note that in the 1930s the focus of concern was credit risk, not interest rate risk, because the gold standard had precluded interest rate risk for the preceding generation or two and the immediate problem was deflation and low interest rates.

[3] Owners of shares in Fannie Mae and Freddie Mac make the case that one should add the conversion and use of the GSEs as instrumentalities of the government to this list (Howard 2014: 250-53; http://www.housingwire.com/articles/print/29008-paying-fannie-and-freddie-investors-was-never-part-of-the-plan).

[4] The permissive attitude to the growth of Eurodollar accounts and money market mutual funds precluded a successful policy of financial repression.

[5] Howard (2014: 131) explains the flaws of PLMBS. Because there is no corporate guarantee, there is no incentive for credit standards to be enforced. Thus, when mortgage lenders generate new risky characteristics for loans and rating agencies make risk judgments without adequate or applicable historical data, there is nothing to stop these loans from being securitized and sold on to investors. In this environment relaxed underwriting can bring in new buyers who would not have qualified in the past.

2 thoughts on “The dismantling of the economy’s legal infrastructure V-2: An aside on the financial economics of the 30 year mortgage”

  1. In Canada, there is a “term” for the mortgage – typically five years or less – over which the negotiated interest rate applies, and an “amortization period” – typically 25 years – over which the combined payments of interest and principal are calculated so as to repay the mortgage. At the end of the “term”, the mortgage agreement typically allows the borrower and lender to either negotiate a new “term” while staying within the remaining years of the amortization period, or to part ways, with the borrower transferring the remaining principal and amortization period to a new lender under a new term. In practice, borrowers and lenders see the end of each term as allowing the borrower to renegotiate the entire mortgage or take his business elsewhere. I suspect that the number of residential mortgages in Canada with rates fixed for more than 5 years would be very very low.

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