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.