Americans aren't really insular, like the English. But they live in a very big country, and that can have the same effect. If there's something peculiar about the US, Americans sometimes won't realise how peculiar it is. US mortgages are peculiar. "Weird" is a better term.
Patrick Lawler, as described by James Hagerty, has tried to explain to Americans that their 30-year fixed rate mortgages aren't 30-year fixed rate mortgages, and that they are weird, stupid, and dangerous. He failed, perhaps because he ran out of time. Richard Green didn't get his point (H/T Mark Thoma). So I'm going to try.
First off, American 30-year fixed rate mortgages aren't 30-year and aren't fixed rate. The term is variable, and the rate is variable. That's because they are "open" mortgages, rather than "closed" mortgages. A 30-year 6% closed mortgage really does have a fixed term and a fixed rate. You know exactly how much you will be paying per month for the next 30 years. An open mortgage means you have the option to pay off or refinance that mortgage at any time over the next 30 years. And you will of course exercise that option at any time when the market interest rate for the remaining term falls below the rate you are currently paying. And exercise it again, if the market rate falls again. So the actual term is whatever you want it to be, and the interest rate you actually pay will vary, if market rates for the remaining term ever fall below the initial rate, as they almost certainly will (as I shall explain).
The option to renew sounds good. It's like a one-way bet. Heads, and interest rates fall, you exercise the option and win the bet. Tails, and interest rates rise, you stay locked in and the bet's off.
If the option were free, of course you would want an open mortgage. You can't lose. But, of course, there must be someone taking the other side of the bet. The lender won't sell you that option for free. You have to pay for it, and you pay for it in higher interest rates.
The longer the remaining term to maturity of the mortgage, the greater the chance that market rates will fall, the more that option is worth, and the higher the interest rate premium you would pay to buy that option. If you only have a couple of months left on the mortgage, interest rates won't move very far in that short time, so an open mortgage will have only a slightly higher interest rate than a closed mortgage. So even if interest rates on closed mortgages have no trend up or down as the remaining term to maturity shortens over time, interest rates on open mortgages will tend to trend down as the remaining term to maturity shortens. So the option to refinance will probably be exercised again and again.
I can understand the argument in favour of 30-year fixed rate mortgages, if they are truly 30-year and fixed rate. Which means a closed mortgage. A risk-averse person borrowing to buy a house knows exactly what he will be paying until the mortgage is paid off. But why would such a risk-averse person ever want to buy an option that interest rates will fall?
That's what's so weird about open mortgages. It's not just weird, it's stupid. It's like an insurance company bundling lottery tickets with its insurance. "Sorry, but you can't buy fire insurance unless you buy a lottery ticket at the same time". Actually, it's even stupider than that, because at least the lottery and fires are independent probabilities. The reason you didn't chose a variable rate mortgage is presumably because you wanted to insure against interest rate risk. So why buy a one-way bet on interest rate risk at the same time?? It's really stupid.
It's equally weird and stupid from the lender's point of view. Lenders aren't always risk-neutral; they care about interest rate risk and liquidity risk. If you are about to retire, and want a safe income for the next 30 years, or if you are a pension plan looking for an asset that provides a safe return to match your fixed payouts to retiring clients, a 30-year fixed rate mortgage looks like a good investment, if it were truly 30-year and truly fixed. Why would you ever at the same time want to write an option on interest rates? Why would you ever agree to write a one way bet that you lose if interest rates fall? Falling interest rates are the one thing that retirees and pension plans want to insure against, not bet that they won't happen! It's really stupid.
It's equally stupid from the liquidity risk point of view. The job of banks is to convert illiquid assets into liquid liabilities. It's not an easy job. But it's an even harder job if you don't know how liquid your assets are. You know in advance when a closed mortgage will be paid off, assuming no default. With an open mortgage you have no idea when it will be paid off, even assuming no default. Plus, banks borrow short and lend long. A fall in interest rates is good for banks, because the value of their long assets rises more than the value of their short liabilities. But a fall in interest rates is just the time when people will pay off their open mortgages, so banks get lots of liquidity when they least need it. It's really stupid.
Stupid, and also I think dangerous. But this is the bit I don't understand too well. As I understand it, one of the main reasons behind the securitisation of mortgages in the US was because of the interest rate risk and liquidity risk I have talked about above. Banks didn't want to hold risky open mortgages on their books. So they securitised them and sold them off. Then the default risk turned out to be higher than the buyers of those securities thought it would be. And because the mortgages were sliced and bundled, it was impossible in practice for the lender to renegotiate terms with a borrower in difficulties. (Plus, there's the other weird and stupid feature of US mortgages [edit: in many states] that they are non-recourse, so the borrower can just hand in the keys and walk away, but that's a whole other subject). And then everything went pear-shaped when house prices fell.
Understandably, Americans don't like foreigners interfering in their internal affairs. But dammit, the US is big, rich, powerful and important, not some piddling little country that doesn't really matter to the rest of the world. When the US financial system catches a cold, other countries will at least sneeze. US 30-year fixed rate mortgages are not 30-year and not fixed rate. They are are weird, stupid, and dangerous. They need to know that.
Update: See Arnold Kling's response. I tend to agree that there must be some sort of weird government policy that leads the market to create such weird mortgages.
Worthwhile Canadian Initiative 
Nick
The problem is that people move. If they have a mortgage with a 20 year duration and long term rates come down by 2% they will have to pay 40% of the notional amount of the mortgage to terminate. So if they are going to have 30 yr mortgages (which I’m not saying they do), then they probably need the embedded option.
I largely agree, but keep in mind that some businesses and producers might choose to take both futures and options positions on the same underlying. The futures to lock-in the price, and the option to provide a way to get the upside (or downside) potential if the market turns that way. For businesses and producers, I think it has less to do with risk aversion than with cash flows and debt/leverage.
I meant: “which I’m not saying they need to“. I know that they “do” have them.
K. When you move, you take the mortgage with you to your new house. Or it stays with the house, if the new owner is a good credit risk. Or you can pay it off, if you are unexpectedly flush with cash. You have to pay a penalty for early repayment, of course, equal to the difference between your old fixed rate and current market rates. But that “penalty” is not really a penalty, or a risk. All it means is that you insured yourself against interest rates rising over the term of the mortgage, and they didn’t rise, they fell, so your insurance wasn’t needed ex post. Like when I take out fire insurance on my house, and then my house doesn’t burn down. I don’t say “Dammit, my house didn’t burn down, so I lost that money I paid when I bet my house would burn down, so can I have my insurance premium back please?”
You don’t need to write an option on interest rates to deal with people moving. In Canada, lenders offer portable and/or assumable mortgages – meaning you can transfer the mortgage from one property to another or change the borrower (no doubt subject to the lender agreeing).
The standard US mortgage is such a terrible deal for lenders, one wonders why they ever started doing it in the first place.
I’m sorry Nick but you were doing just fine in your description of the pre-payment option until you got to the part about if being weird, stupid and dangerous.
You’ve given no argument for why a portfolio of fixed rate bond and option weird, stupid or dangerous. Yes it’s a different portfolio then the one without the option but you have given no explanation as to why it’s worse.
Patrick: good question. My guess is some legal restriction on closed mortgages, so the market isn’t allowed to provide it. Or political pressure on Fanny and Freddy. Like the US legal system doesn’t (in most states, I think) enforce recourse mortgages.
Adam: I thought I did give an argument. Not a formal math proof, but an argument nevertheless. I can understand a market in insurance. I can understand a market in lottery tickets. But I can’t understand a market in which lottery tickets are bundled with insurance. So it’s impossible to buy insurance unless you buy a lottery ticket at the same time. Presumably because of some legal restriction, so you cannot alienate your right to pay off a mortgage. And until someone comes up with a good explanation that explains not just why the two products are sometimes bundled, but why they are always bundled, I’m going to say it looks stupid, and it probably is stupid.
Phil: I don’t understand your first paragraph, on risk neutrality. It went over my head. Good corrections and points in the rest. I don’t understand why Canadian closed mortgages have those small “openings”. But they are small. Maybe just a gimmick?
Apologies, Nick, as I obviously made a hash of my explanation. A danger whenever public commentary overlaps my professional area. On the material points of your post, I agree with you.
“I can’t understand a market in which lottery tickets are bundled with insurance” is not an argument for it being weird, stupid or dangerous.
“Risk neutrality refers to probability measures, not people”
No Phil, risk neutrality can be used, correctly, to describe either. Most commonly it refers to people.
“simply means that when calculating an expectation (average outcome) with respect to the measure, the market price will be recovered.”
and this is just wrong.
It is not really correct to say that there are no closed loans in the US. One of the primary features of subprime lending was the inclusion of prepayment penalties, which are indeed absent from ‘prime,’ ie Freddie and Fannie approved, mortgages. This was used by lenders to make the loans more explicitly bets on the collatoral rather than the credit worthiness of the borrower.
Interestingly there are almost no assumable mortgages in the US, which went out of fashion in the Eighties when Volcker was throttling inflation and the rest of the economy with 22% interest rates.
From your brief description it seems that mortgages in Canada are much less focused on the collatoral than the US structure, since mortgages are never portable here.
Here by the way is Mike Konzcal on the way pre-payment penalties fed into the sub-prime market in the US. Plus, I still don’t get the danger part, it was, after all, the sub-prime prepayment mortgages that blew up first.
Lenders don’t operate in a monopoly, so they have to offer incentives to borrowers so that they don’t take their business elsewhere.
Securitization is a separate issue. It becomes a problem if not properly regulated and rated, but otherwise is not that complicated or stupid.
Aren’t you suffering from a social construction of interest rate risk? A closed, fixed rate 6% mortgage exposes you to the risk of interest rates declining. If nominal interest rates unexpectedly decline because of reduced inflation expectations, the real cost of your debt increases. Take someone who took a 15% closed FRM in 1982 expecting large nominal increases in income and home prices that didn’t come to fruition, and finds they cannot meet their projected budget. Isn’t this a form of “interest rate risk?” Why can’t you call a closed, fixed mortgage an unusual and dangerous bundling of purchased insurance on overall interest rate volatility with written insurance on interest rate declines? Why should consumers take the debt-deflation risk (or debt-disinflation risk) when banks and other financial intermediaries might be better equipped to handle almost all kinds of interest rate risks? Because wages will be sticky downward?
Maybe you think that the risk of interest rates declining is unimportant, because if someone can make their first payment, they can make all future payments even if inflation expectations decline (i.e. because mortgage payment terms are inherently front-loaded in a world with inflation). Well, there would still be deflation risk. But also, a household might budget a big expense for year five (a big vacation) when they expect lower real mortgage payments, which they then would have to forfeit thanks to interest rate risk. Why is it more dangerous to offer a loan with full interest rate volatility insurance than a loan with partial interest rate volatility insurance?
OGT: Very interesting post by Mike Konzcal you link to there. The comment by “q” on that post is also interesting, and reflects more my way of thinking. US prepayment penalties seem very different from Canadian and UK, I think. A fixed amount, rather than the difference between the old and new interest rates. The latter means nobody has any incentive to re-finance when interest rates fall, and will only pay off a mortgage early if there’s some significant unexpected change in their personal circumstances. And in the US it was the mortgages with prepayment penalties that had the higher rates, presumably because they were offered to borrowers with higher credit risk. So if their credit risk later improved, or if banks lowered standards, they sometimes paid the penalty to refinance at a lower rate, on a prime, open mortgage. Here, of course, closed mortgages have the lower interest rates.
I didn’t know that US mortgages were never portable!! That maybe explains why people insist on open mortgages, in case they ever want to move house. But why aren’t they portable? Is it because they are (in many states) non-recourse? That might relate back to your comment that Canadian mortgages seem less focused on collateral. In the event of default, you get the house, and can still go after the borrower (some exceptions in Alberta).
What’s a “assumable” mortgage? Is that where I sell my house, and the new buyer assumes the mortgage? I wonder why they went out of fashion. But if they aren’t assumable, and also not portable, that would definitely explain why Americans insist on open mortgages. Otherwise what do you do with the mortgage if you sell your house? You can’t take it with you, and you can’t sell it with the house!
The whole thing is more intertwined than I initially thought. Good comment.
asp: “Lenders don’t operate in a monopoly, so they have to offer incentives to borrowers so that they don’t take their business elsewhere.”
Agreed. But why don’t they compete on lower rates, rather than on providing open mortgages? Insurance companies don’t compete by offing free lottery tickets with every insurance policy.
dlr: good question. But there’s an answer.
First, it puzzles me that mortgages, and all loans, aren’t indexed to inflation. But let’s leave that aside.
The “risk” that matters, and hence the correct way to define “risk”, is variance in your consumption stream, not your wealth at a point in time. For example, suppose I am about to retire and know I will live for exactly 30 years, and want to have constant known consumption for each of those 30 years. I buy a 30 year annuity. If interest rates rise or fall, the Present Value of my annuity will fall or rise. So an annuity is very risky in the Present Value sense, whereas leaving my money on deposit at a variable interest rate is perfectly safe. But I don’t care about the present value. I care about having a risk-free rate of consumption for 30 years. And the 30 year annuity gives me that exactly, with perfect safety. Leaving my retirement funds on deposit, at a variable interest rate, exposes me to risk on my stream of consumption.
It’s exactly the same, only with minus signs, for someone who wants to use a (they hope) constant stream of wages over the next 30 years to pay down a mortgage and consume the remainder.
adjacent: what’s a “term variable annuity” (unless it’s a life annuity)? And why would anyone buy and sell one (unless it’s a life annuity)?
Don’t forget that mortgage interest deductibility factors into higher interest rates and/or prices as well.
The US has a very distorted housing market.
Nick, I don’t buy your response to dlr. Mortgages probably should be indexed to inflation, but in practice, they are not. The important risk for the borrower is not present value risk but deflation (or disinflation) risk. I’m presuming that most borrowers are in their working years, and their nominal income depends on the price level. Granted, a call option on interest rates doesn’t fully protect the borrower (because real rates can rise, and because the effects of deflationary forces on an individual borrower are not a linear and predictable function of the expected inflation component), but it sure helps. As someone whose income has been reduced, but not enough to prevent my qualifying for a new mortgage, I can personally attest to the risk-reducing effect of the prepayment option on borrowers. I think that if I’d had a choice, I would have chosen to purchase the prepayment option even if it weren’t bundled with my mortgage, and ex post that clearly would have been the right decision (even leaving aside the necessity for a prepayment option due to the possibility of relocation, given the non-assumability and non-portability of the mortgage).
I believe it comes down to an irrational fear of rising rates and an emotional need for certainty.
30-year fixed-coupon mortgages with payoff privileges used to be the norm both in Canada and the United States. I’ve spoken to friends (Canadians) who fondly remember this time. They think that a 25-year fixed mortgage is the height of certainty and security. They dread that uncontrollable or rising payments could force them out of their house.
The Canadian mortgage market took its present shape in the 1970’s. The Canada Interest Act was amended to say that six months interest was the maximum penalty chargeable for breaking a mortgage, and rates started to rise into double digits. People started to refinance their mortgages at the earliest opportunity to try to get the rate down. Banks eventually started to offer the 1-5 year terms we see now in order to accommodate this. The fixed 25-year mortgage became a thing of the past. These rate terms also helped the banks because they could easily match their mortgage assets to their deposit liabilities. 5-year mortgages balanced off 5-year GIC’s.
Thanks Nick. On assumable, you’re right in guessing the meaning. When rates went sky it was common for sellers with lower rates to allow buyers to assume the mortgage in exchange for a higher selling price. Now that was a nice option! So lenders, who didn’t want to keep getting paid 12% when the going rate was 18%, from someone they didn’t underwite no less, started adding transfer clauses. Pretty much every mortgage I’ve ever seen in the US the balance is payable on transfer of the deed unless the transfer is approved by the lender.
The US brand of federalism certainly may play a part in non-portability, not only do states have different restrictions on recourse, they also have different foreclusore proceedures, and other regulations. Texas, for example, bans prepayment penalties and cash out refi’s. In addition, remember national banks are a relatively recent development here, so one assumes a regional Boston bank wouldn’t want to have an Arizona house over 2,000 miles away from their nearest branch as collatoral.
A few points on this:
-Nick, you asked why Canadian closed mortgages have these small and limited ‘open’ options (such as you can pay off a certain amount once a year, double-up payments, etc). The key is that the cost of the open prepayment (US mortgage) is very high repayment risk over the life of the 30-year fixed. For Canadian closed mortgages – typically fixed for no more than five years – the small ‘options’ make the additional risk of the closed mortgage small, both to the borrower and the lender. Basically, the term is short enough, and the options limited enough, that banks can price them reasonably finely – but not perfectly. And the borrower can accelerate their mortgage more or less at will – but not all at once, and not many actually do. (And the unwinding cost is smaller, due to shorter term, and really only arises when someone sells early. Plus portable.
-Why do these mortgages exist in the U.S.? Basically, only Fannie and Freddie can write 30-year open due to the risk. And they require them to be this way. (I believe there is also a legal requirement but can’t 100% state this).
-When I learned this stuff, ‘points’ (up-front fees, like a front-end fee) were one way that US banks priced this risk in. Basically, you bought down your interest rate by paying higher points up-front; the pay-off structure of the option had different characteristics basically depending on whether you were likely to refinance. (As a sunk cost, it actually didn’t effect borrower behaviour post facto – or at least much).
I work on emerging markets lending, esp mortgages. The general argument/line of discussion for years was that the U.S. could afford the expensive luxury of long-term open fixed mortgages due to deep capital markets – the explosion of the industry and Fannie/Freddie make this argument questionable.
But long-term fixed open are particularly weird, stupid and dangerous in most other markets with shorter yield curves/shallower capital markets. (There’s an interesting corollary to this story, which is the proliferation of longer-term fixed, open mortgages IN FOREIGN CURRENCIES in much of Eastern Europe – these are not even weird, just stupid and dangerous).
The curve for e.g. Russian rubles goes out no more than ~10 years (and at that term, is available basically only to the government). How can you price a fixed-rate mortgage longer than that? (Hint: you can only do so by being willfully stupid, generally with someone else’s money – typically the government’s). And Russia has deeper capital markets in their own currency than most.
The other thing, Fannie in particular for years had a very active international program, basically promoting mortgages. Parts of it were good – Fannie knows, or used to at any rate, mortgage underwriting extremely well. Parts of it were absurd: in particular, the assumption that all mortgage markets would all develop to perfection over time, and ultimately resemble the U.S. market. It amounted to a religion: first, originate fixed rate mortgages; second, securitise them. I believe Fannie stopped doing active proselytisation after they got hit with their first big restatement/accounting scandal (2004?).
By the way: time to renew your analysis/data on CMHC. I still think CMHC is doing better than most think.
Now, I have a question that I would most like a “real” economist’s answer to: the nature of inflation risk for ‘individuals’ as a whole.
My argument for floating rate mortgages includes the following:
-Floating rate loans are basically (over medium term) inflation plus some extra.
-For the class of individuals in an economy, inflation is basically the growth in their income.
-Hence, overall, for the class of individuals, it is collectively nonsense to hedge inflation risk – their income IS inflation for most intents and purposes (over time).
-Hence, for both lenders and borrowers (as classes), the risks they need to consider and insure against are temporary ups and downs in the floating rate (that in the short term may be out of line with inflation, which we could call basis risk for a major difference between inflation and the short-term lending rate), deflation risk (let’s leave that to the central bank). This is pretty easily hedged against with caps on increases, rolling fixed rates, any number of modest add-ons. Five year fixing is probably enough to avoid the vast majority of ‘interest shock’ risk.
-Individuals still need to deal with the risk of their own wages growing substantially slower than inflation – which I would just call credit risk.
Thoughts?
The reason for the embedded call option is to allow mobility. If borrowers could prepay upon the transfer of a deed (but not because of falling interest rates), the mortgage would not inhibit mobility but would still be more attractive to investors. As mobility is more predictable across a pool than interest rates, this embedded risk could probably be priced reasonably well.
But from a credit perspective, the prepayable fixed has been safer than other mortgage types. According to the most recent MBAA data, “[t]he seasonally adjusted delinquency rate increased for all loan types with the exception of FHA loans. On a seasonally adjusted basis, the delinquency rate stood at 6.17 percent for prime fixed loans, 13.52 percent for prime ARM loans, 25.69 percent for subprime fixed loans, 29.09 percent for subprime ARM loans, 13.15 percent for FHA loans, and 7.96 percent for VA loans.”
“And you will of course exercise that option at any time when the market interest rate for the remaining term falls below the rate you are currently paying.”
It’s not that bad because there are points and/or fees when you refinance (even if there’s no explicit repayment fee, which sometimes there is). So, the gain from the lower interest rate will usually have to be fairly substantial to make it worth it to pay new points and/or fees plus the cost of your time and trouble. As a result, people aren’t refinancing their mortgages every month, or every day, or every hour, so the price of these mortgages does not get extremely high relative to floating.
“The reason you didn’t chose a variable rate mortgage is presumably because you wanted to insure against interest rate risk. So why buy a one-way bet on interest rate risk at the same time?? It’s really stupid.”
But it’s not that easy to avoid. You might say why not unbundle. Just sell the insurance without the option. But you take away the option and you have a 30 year mortgage that can not be refinanced or paid off even if you sell the house. So what if you get a promotion and transfer after four years and have to sell the house and move? What if you lose your job and have to move for a new one? What if you get a divorce? What if you have children and now need a bigger house? What if your income permanently drops and you now need to buy a less expensive house?
The problem is it’s too risky and/or problematic and/or complicated to ask many people to lock in to a 30 year mortgage that they can never payoff until 30 years, no matter how soon they might sell the house and move. True, if you have to move due to a transfer or promotion, you can sell your $200,000 home, put the funds in a government money market account, move to the new state, and then use the $200,000 to buy a new house for $240,000 plus perhaps a new small mortgage. Or, if the new house is $170,000, then they could invest the extra $30,000. There are ways to funge all this money, but now you are asking people to have a lot more expertise in finance and to spend a lot more time.
There’s a real cost in time, complication, unpleasantness, and stress to many people in constantly asking them to learn all these things and deal with all this complication and risk. This stuff just piles up as you move more and more laissez faire in a world that’s not 1810 anymore, and makes people spend more and more time learning finance and other areas of expertise and analyzing risks, and less and less time producing wealth or enjoying time with their families. These costs can get to be enormous even though they are assumed away and ignored in freshwater models.
So, you’re not going to find any really smooth solution here.
And, a crucial concept to keep in mind is that it can be extremely efficient to shift risks from individuals to large groups that can greatly diversify away a lot of the risk, and that can pool risk in a very large entity to make it far less harmful per person. So, often it makes great sense to have an individual shift risk to a large organization, and in return pay a fee, or premium. Because given that the large organization is much less at risk from the thing in question than the individual, they can be more than compensated with a premium that is still a great deal for the individual.
With 30 year mortgages risk is shifted from individuals (for which interest rate risk can be really dangerous) to big companies (for which interest rate risk is a lot less dangerous) and to the government (for which interest rate risk is even far less dangerous – the government sometimes makes a great insurer because of its massive size, its massive life, its lack of an incentive to mislead for profit where asymmetric information is large, potentially gigantic economies of scale without having a for-profit monopoly, and other reasons).
Nonetheless, I think 30 year mortgages can be improved, perhaps with a larger and ubiquitous prepayment penalty to diminish socially expensive mortgage hopping which can have high transactions, time, and trouble costs, but do little, nothing, or negative to add to social utility. The prepayment penalty is less risky than a variable rate mortgage because it’s capped at a fixed amount, while there’s no limit to how high interest rates can go.
Richard:
Canada and the United States have almost identical home ownership rates, yet here it’s the individual who bears the interest rate risk/reward. Same in the UK. In both countries a 25-year mortgage with a normal amortization curve consists of 5-25 individual mortgage terms with its own interest rate, set at the market’s going rate.
You actually haven’t proved anything about US 30-year fixed rate mortgages because other countries have achieved similar results without making US choices.
The “risk” that matters, and hence the correct way to define “risk”, is variance in your consumption stream, not your wealth at a point in time. For example, suppose I am about to retire and know I will live for exactly 30 years, and want to have constant known consumption for each of those 30 years. I buy a 30 year annuity. If interest rates rise or fall, the Present Value of my annuity will fall or rise. So an annuity is very risky in the Present Value sense, whereas leaving my money on deposit at a variable interest rate is perfectly safe. But I don’t care about the present value. I care about having a risk-free rate of consumption for 30 years. And the 30 year annuity gives me that exactly, with perfect safety. Leaving my retirement funds on deposit, at a variable interest rate, exposes me to risk on my stream of consumption.
If I didn’t know better, I’d say you were falling for the money illusion. We care about variance in your real consumption stream, right? You don’t want to take out a fixed annuity, see inflation rise unexpectedly, and be content with the smoothness of your nominal consumption (fixed, flat, annuity payments) while your real consumption sinks like an anchor. If you’re talking about an inflation-indexed annuity (which I don’t think you are), on the other hand, it is the wrong analog to a closed fixed rate mortgage (which is the whole point).
A consumer with a hypothetical budget for smooth, real consumption who experiences unexpected disinflation will suffer a negative nominal surprise in incomes and asset values. If they have taken on a closed FRM (presumably without owning off-setting fixed income instruments) their nominal payment obligations will remain unchanged and thus their expected real income will decline, reducing expected consumption in future periods relative to the smooth budget. Isn’t this a consumption path risk?
@Richard Green: you are stating that the reason for the embedded call option is to allow for mobility. If this is the risk that is being mitigated, why not fix the rate for a shorter period of time? What’s bizarre is the mismatch between the openness and the 30-year fixed rate.
Two points on the relative default rates between fixed/ARM:
-Some increased default is to be expected – the question is the trade-off between costs (including externalities).
-Most importantly: I have looked at some of these comparative figures, and for the most part, the data are NOT comparable. The securitizers may have SAID ‘prime’, but this does not mean they can be compared well – see the case brought by the SF Home Loan Bank about fraudulent reps and warranties. There is, ultimately, no common standard for prime.
-Keep in mind: the ONLY party securitizing fixed rate in any quantity was Fannie and Freddie. Almost literally the only game in town – anyone originating them was originating them for F&F.
If one really wanted to compare defaults on ARMs vs fixed, probably the only way to start would be ARMs from Freddie/Fannie (relatively few) to their fixed rate, and to be very careful about comparing like to like.
For a quick test to determine why there is something suspect about this data: can you think of any reason why, in a period when rates FELL, that the ARMs should have performed worse? All things being equal, rates on the ARMs should have fallen below their original payment levels, and hence defaults fallen. If this did not happen, there must have been some underlying other issue that was causing them to default – indicating that this comparison is probably not valid.
Wow! Lots of very good comments coming in. I’m not sure I can do them justice.
Christopher: mortgage interest deductibility should cause house prices to be higher, and cause people to pay down their mortgages more slowly. It’s a big distortion. Not sure it would affect mortgage rates that much (very elastic supply?).
Andy: I think you have a valid point there. It works as long as falling interest rates are correlated with disinflation. It wouldn’t have worked in (say) 1982. But outright indexation would presumably be better. And even floating rate mortgages would presumably be better, since then the bet works symmetrically, unlike open mortgages, where it only works in one direction.
Determinant: that’s a very important bit of information. I hadn’t known that. So Canadian “closed” mortgages aren’t really as closed as they look, if there’s a maximum 6 month penalty for prepayment. And that killed off the 25 year closed mortgage in Canada, understandably.
OGT: I think I can understand why lenders wouldn’t want to make open mortgages assumable. It’s a one-way bet for the seller of the house. But if it were a closed mortgage, I can’t see why they would care (as long as the new buyer’s credit was OK), and the borrower would like the feature, and be prepared to pay for it.
GA: I don’t have anything to add to your very useful first comment. On your second comment, I tend to agree. Variable rate mortgages ought to give better indexation to inflation, and for that reason ought to be seen as less risky than fixed rate mortgages, both for lenders and borrowers. I think there are two arguments going the other way:
1. If inflation rises, and nominal interest rates rise by the same amount, the borrower is no worse off in real terms. But a variable rate mortgage becomes more “front-end-loaded”. The effective average term to maturity falls. Take an interest-only mortgage for simplicity. With full indexation, you would only pay the real interest rate each year. But if inflation rises from 0% to 10%, and interest rates rise from 5% to 15%, your real payment has gone up in the first year, even though the remaining balance of the loan has fallen by 10% in real terms.
2. If inflation targeting is credible, and the target remains the same, all interest rate fluctuations should be real, not nominal, at least ex ante, in expected terms. And that seems to be close to the world we live in nowadays, at least in Canada. So there’s no expected inflation for variable rate mortgages to insure against.
Richard Green: Welcome! Sorry to disagree with you so strongly!
But you can have mobility with closed mortgages as well. Mortgages can be portable (you transfer it to the new house you buy), assumable (the new buyer of your house assumes your mortgage, or you can even pay it off if you pay the interest rate differential.
But why has the “prepayable fixed” (i.e. “open”) mortgage been a better credit risk? There must be some reason why borrowers with worse credit ratings are pushed into the mortgages with prepayment penalties, and yet actually pay higher interest rates than those who borrow in the “prime” market for open mortgages. I don’t think you are comparing like with like.
Richard Serlin: As I said to the other Richard, there are 3 options for someone with a closed mortgage who wants to move house. Maybe it’s complicated. And both open and closed mortgages exist in Canada, so they “meet the test of the market”, but open mortgages are only readily available for one year terms (presumably often bought by people planning to sell), and don’t meet the “test of the market” for longer terms. Canadians seem to manage to own and move houses, even with mostly closed mortgages.
Determinant: Yep. Which Richard are you addressing? Or maybe both!
dlr: “If I didn’t know better, I’d say you were falling for the money illusion.”
Yep! I was implicitly assuming zero inflation. I should have made that explicit. Point taken. See my comment above, in reply to GA, on variable rates as an inflation indexation device.
Before the 30s, mortgages were generally 5 year ballon loans. Imagine trying to find refinancing under deflation with plunging asset values, in no small part due to this. The 30 year amortization was introduced to stabilize this although deflation would still present a risk. A mortgage is really a confluence of a lender, a borrower, and a property. The size of the US mitigates against portability since lenders are often geographically limited. Inflation in the 70s ended assumability. Yes, 30 year fixed aren’t really, but that is a good thing. It would be trying to eliminate risks that cannot be eliminated. Not only moving, but bankruptcy, death, and destruction. Not only interest rates, but inflation (deflation not so much). Rather than encouraging lending, borrows would view it as an anathema. How far would rates fall before walking away would be preferred. Creation of large rocks in the path of the economy would add rigidity. Most first time buyers are stretched to meet the payment which means they need fixed payments at least for a time. That option is valuable because interest rates do usually fall in recessions and is the primary way the Fed stimulates. Think of it like a first approximation to a five year fixed adjustable but having become accustomed to fixed most see no advantage to changing, not to mention the variability of terms on adjustables make them difficult to compare. There are, or were, 1, 2, 5, 7, 10 years, sometimes changing in 5 or 10 and sometimes not at all after that, using multiple indexes (some using the libor, can you imagine that after the crisis), caps in change and caps overall, with various teaser rates, and a notable propensity for calculation errors by both borrowers and lenders. All this makes adjustables more expensive than vanilla 30 years, so that option is free. Much of this is for historical reasons, but history is hard to change.
Non-recourse entered in the 30s as well to avoid interstate flight as a result. It takes two to make a bad loan, but the lender, having the money, deserves a higher level of accountability, especially at times like these that are the result of lender irresponsibility.
And most corporate debt is callable as well. Only treasuries are not.
Nick:
Lord mentions some key points when you talk about American and Canadian mortgages. An American looks at a Canadian mortgage and sees a “Balloon Mortgage”, one where the bulk or whole of the principal is due at the end of the loan, usually 5 years or so. He shudders at the insecurity of renewing a mortgage.
A Canadian looks at an American mortgage and sees interest rates that are too high, too rigid and lacking in options on interest rate planning. Up here you get a menu of interest rate terms (which is NOT the same as amortization*) when you take out a mortgage. You can go really low on the yield curve and take a variable rate, or go higher up with a 5 year rate. You can switch back and forth. Your choice. Studies have consistently shown that 99% of the time, the shorter your term, the less you pay in interest. For a 25 year amortization, 50 6-month terms has always been cheaper by tens of thousands of dollars than 5 5-year terms. Basic economics because you are paying a rate that is lower when the yield curve is normal, which has been 99% of the time since WWII.
*In Canada the amortization is the period over which the loan will be retired, usually 25 years. The term is the period for which the interest rate is fixed, anywhere from 6 months to 5 years. You can pay off as much as you want when the term expires without paying a penalty.
In theory a variable rate mortgage works for deflation protection, but I have an intuitive feeling (which I think many will share) that it’s actually a lot riskier than a prepayable fixed rate mortgage. For one thing, as you point out, the interest rate flexibility wouldn’t have protected you from disinflation in 1982, and if you got the mortgage in the late 1970’s, you would be totally screwed by a variable rate mortgage resetting upward just as the disinflation was about to start. Also, there is much to be said for having the security of constant payments in the case where the inflation rate remains roughly constant. It would be very tough to actually model all the various risks, but my feeling is that it’s still much safer to pay for the option than to take a variable rate (and still worth paying for the option if it’s not bundled). Of course, an inflation adjustment might be even better.
And I second the point Lord made about corporate debt. It’s normal for debt to be callable. If you think callable mortgages are a puzzle, then you really have a much bigger puzzle to deal with.
Nick: to be clear, I disagree with a key part of your argument. It’s the 30-year fixed rate that is weird and dangerous; making it open is stupid, but flows from it being weird and dangerous. You’re focussing too much, I think, on the closed/open issue.
To state the big difference baldly: some floating element is normal and almost the worldwide standard; markets with very long fixed rates are the exception (US and Denmark usually cited, and Danish ones are weird and closed – but to be fair they seem to work). Those markets using floating rate mortgages do not have noticeably worse performance in virtually any element of home ownership/mortgage finance, or at least ones traced to this issue.
As for the closed/open, I think there’s a bit of terminology that may be useful to readers. (probably dead obvious to others)
The red herring of ‘what if you need to move and prepay?’ keeps coming up, but a comparison to commercial finance might help. In a standard commercial (business) loan, the rate may be fixed or floating. Floating rate loans can generally be prepaid early; there may be a penalty for prepayment, but generally not onerous. This prepayment fee is basically to reimburse the bank for some of the up-front (fixed) costs of making the loan and a bit of foregone income, but it’s mostly unrelated to the prevailing interest rates. (Borrower might be able to renegotiate the loan spread by threatening to prepay, the prepayment fee might decline in time, and other variations possible).
In a fixed rate loan, there will usually be ‘unwinding costs’ in addition to the prepayment penalty. This departs from the assumption that the bank is fixing its costs on the liability side by getting matching funding (or equivalent using derivatives). If you prepay, the bank has to carry that fixed-rate liability or ‘unwind’ the derivatives related (or some equivalent). The unwinding cost is directly related to the prevailing interest rates – it’s the cost of reimbursing the bank for paying that higher, fixed interest rate on its borrowings over the life of the original contract when it can only make a new loan today at lower rates. (If rates have gone up, unwinding costs will be zero).
At any rate, this is why the shorter-term floating or modest-term fixed rate (hybrid) allows for small or modest prepayments. If it’s floating, there’s no unwinding cost. So if you need to move, you can – portability/assumability is a minor feature in this.
Someone will object that in complete markets there are a zillion options, puts, swaps, swaptions that can help manage this – which is true, but avoids the fact that markets are not complete and transaction cost or counterparty-risk free, and it’s not easy or costless to manage this stuff carefully – complexity and risk goes up with the term of the contracts.
Likewise, US commenters often raise the hoary spectre of the depression, when borrowers with ‘balloon’ payments (e.g. five year mortgages with a bullet/balloon at end pending) that could not roll over because banks refused were foreclosed on en masse. (In a nice illustration of the fallacy of composition/herd mentality, the banks went bust too).
In other markets, they just required the lender to rollover at the new market rate. Banks end up taking liquidity risk – but, if you trust the Bagehot principle, with some certainty that they refinance their book. Since the mortgage will reset at market rates, the likelihood the mortgage will fall significantly below outstanding principle (par) should be small.
“I wouldn’t recommend sex, drugs or insanity for everyone, but they’ve always worked for me.”
I would add 30 Yr Fixed Rate Mortgages as well to my list.
I believe the other reason for non-recourse was to clear court calendars. The bankruptcies were too widespread to be handled. Recourse after all, is of little practical use; normal times don’t need it, abnormal times make it irrelevant.
Nick,
Ok so it’s possible the complication is not that bad if you do things like making the mortgage portable.
I really should have used more “might”s and “may”s and “I think”s here because this is something I really haven’t thought about. As an adjunct professor of personal finance for many years in the US, I’ve thought about what is the best mortgage type for an individual to take given his circumstances and the options that are given, but not which options are best for society.
But in Canada with these closed long term mortgages, what if an individual sells his home, moves somewhere else for work, and then just rents because he doesn’t think he will live there for long. The mortgage company no longer has its collateral. Do they force you to repay the mortgage and the difference in interest rates? Sounds risky if you’re mobile. Maybe these mortgages are so popular in Canada because the country is a lot less mobile than the US?
Nick: A term variable annuity is a term life annuity. I was thinking of something else — the “variable” doesn’t matter here — but note that life annuities have embedded prepayment options that vary with the prevailing interest rate. The buyer locks in an effective interest rate for several decades at origination but makes payments spread out over time. If interest rates go up during the term it might make sense for the holder to exercise and then “refinance” (ie buy a new annuity). (I think I have that the right way.) So something that looks simple and is popular can be very complicated.
You also referred to the comments by the poster “q” on Konszcal’s post. I’m the same person BTW. I would post here under “q” but most sites have policies about changing their name and I posted here once as “adjacent” before.
I think most of my good ideas are in the comment on the other site so I would copy it here if that’s appropriate.
Easy Prof. Serlin.
A Canadian can easily move house one of four ways:
1) Move the mortgage along with the individual. Canadian banks are all national in scope and have branches everywhere. They will loan you money in any part of Canada.
2) Since moving normally requires a large amount of planning, a person will normally have converted their mortgage term into an “Open” term. Remember, amortization is not the same thing as the term in Canada. I hate to be a broken record but if we’re not clear than we’re going to talk at cross-purposes. “Term” is the period for which the rate is non-negotiable. An open mortgage can be paid off at any time without penalty.
A variation on this theme is to hold the mortgage until its term expires and it comes up for renewal, then pay off the balance. There is no penalty for this. Since terms are for 6 months to five years they are on average less than five years. If you listen to any financial planner in the country, you’ll probably have a six-month fixed-rate term. Easy to bail out of. A person who knows they are going to move will likely arrange a short term for the convenience. Their banker would also likely persuade them to do so, for everybody’s sake. See my next point.
3) A “closed” mortgage isn’t truly closed. A “closed” mortgage means that penalties will be levied for paying off the mortgage and breaking it. According to the Canada Interest Act, this may be no more than three months interest or an interest rate differential. This:
http://www.vernonrealestate.com/blog-refinancing-penalty.html
contains a succinct example of what happens.
Banking law and interest is a federal matter in Canada. The Government of Canada has always taken an interest (no pun intended) in making sure that residential and farm borrowers (who vote) can bail out of unfavourable mortgages. Because the statutory penalty cap is very small in comparison to 30-year mortgages, they have become extinct. 6-month to 5-year terms mean the penalty is still a deterrent. They also match (not coincidentally) the terms offered on bank GIC’s.
4) Many corporations who move their people around will have arrangements to buy their employees homes and sell it themselves. Banks do this with their managers. Managers can and do move across the country. The bank will buy the managers house. I have family friends who have done this.
also, just to point out what hasn’t come to surface anywhere, if you actually look at where the losses are coming from in Fannie and Freddie’s books, the vast majority come from two sources:
— private label securities, which are mostly securitizations of subprime mortgages. as i understand it these were purchased to meet certain social / governmental goals. i hope the government has learned its lesson with these and doesn’t allow any sort of government guarantee or funding on securitizations of subprime loans.
— prime mortgages for the bubble years, mostly 2006 and 2007, mostly in nevada, florida, and california, which exposed the entities to considerable losses as the price of collateral plummeted.
ie during this crisis, interest rate policy was not responsible for losses.
Great post. I hope that once we abolish Fannie and Freddie it brings to an end this unhappy chapter in our financial history.
Nick write:
So your position is that MBS arose because ‘open mortgages’ were too risky? Support for that claim? Why now? Why not years ago?
Consider an alternative explanation: certain very large investors (pension funds, insurance companies) were required to hold a certain amount of AAA securities. The Basel accords stepped it up as well by focusing on risk weighting.
In 1979 60 corporations had AAA ratings. Now there are 4, right before the bubble burst, only 7.
The push behind structure investment vehicles arose from the regulatory pressure to hold AAA graded debt, which JP Morgan cleverly concocted.
Nonetheless… sure the housing market took a big tumbled, but the victims have mostly been banks hold loans directly. Losses due to MBS have been small in absolute terms, but crippling to a handful of firms who made very leveraged bets.
AIG tumbled not because of actual losses in MBS but because the derivatives contracts they wrote permitted their counter-parties to demand collateral for losses in mark-to-market value not realized losses. AIG only incurred actual losses after the government ceased control bought out the contracts at par. Reckless stupidity to an extreme.
The GSEs have bled capital, but that appears to be a case of fraud. Sub-prime borrowers were classified as prime but loan terms reflect the lie, and in some cases these loans were repackaged and sold as MBS with the lie intact.
Nick: In response to my comment about market risk that is realized when people move you wrote:
“When you move, you take the mortgage with you to your new house. Or it stays with the house, if the new owner is a good credit risk. Or you can pay it off, if you are unexpectedly flush with cash. You have to pay a penalty for early repayment, of course, equal to the difference between your old fixed rate and current market rates. But that “penalty” is not really a penalty, or a risk. All it means is that you insured yourself against interest rates rising over the term of the mortgage, and they didn’t rise, they fell, so your insurance wasn’t needed ex post. Like when I take out fire insurance on my house, and then my house doesn’t burn down. I don’t say ‘Dammit, my house didn’t burn down, so I lost that money I paid when I bet my house would burn down, so can I have my insurance premium back please?’ ”
Imagine you had a very high risk of fire and you bought 30 year fire insurance at a very high fixed premium (I know, no such thing – but we have to imagine it to complete the analogy to 30yr fixed mortgages). Imagine then that your risk of fire was massively reduced and you then came to the insurance company to terminate your insurance. They aren’t just going to let you cancel it for nothing. If they are sane, they are going to make you pay the PV of 30 years of premium difference. Maybe you will say “Dammit, I should have got an ‘open rate’ insurance policy” (or maybe “dammit, I’m burning down my house”). One big difference in reality is term: a real insurance contract is one year and so the cancelation cost is negligible. But there is another important real difference: The fire insurance hedged a very real problem, the potential loss of your house. If the contract was a good match for the risk, then the mark-to-market loss on the insurance contract would be equal to your mark-to-market gain on the expected loss of your house so you shouldn’t be upset at all no matter what happens. The fixed rate mortgage unfortunately serves no such purpose: It “hedges” an exposure that you never had in the first place.
However, I disagree with those commenters who suggest that a mortgage should be used to hedge your future income/consumption stream. A more reasonable assumption is that your desired hedge/asset allocation versus your income/consumption stream has been achieved before you buy the house. Then you add the house and mortgage into the asset mix. The goal of mortgage configuration is then only to hedge the house since the rest is already optimal. Then the real question is: what is the correlation of house prices to interest rates. The answer, to first order, has to be that houses stay relatively fixed relative to other non-money assets, and so, they grow in nominal value at somewhere between the rate of inflation and the rate of nominal growth. So from that perspective, a floating rate loan with a notional amount somewhat less than the value of the house seems like a pretty good bet. (The only caveat being that floating rate mortgage rates dont go negative. So you still need some kind of additional hedge for the negative nominal growth scenario. Maybe one should receive fixed a bit – e.g. buy some bonds).
On a separate note… I think I (and many others) sometimes come across harsh and possibly arrogant when I post. In my case it stems from the fact that I get excited to post something on the rare occasion when I see that you have written something that I think is wrong about something I think I know something about. So the context of all my posts is “Hey look! Nick made a mistake”. That seems horribly ungrateful in the face of the almost daily enjoyment and education I get from your thought-provoking posts. All of which is to say, thanks for the education, and if ever I come across pompous or impolite (which I promise to try to avoid), I truly apologize.
In the interests of fairness and evenhandedness, you really do next need to do a follow-up post “Canadian mortgage interest rate calculations are weird.” Really, mortgage calculated half-yearly, not in advance?
It’s neither stupid nor dangerous, but it is weird.
Some commenters have said that most corporate debt is callable, just like US mortgages. Effectively this is not really true. Most bonds are callable at “make whole + spread”, which means that the call price is determined by valuing the bond on the treasury curve plus a (typically small) spread. The call is therefore only a credit spread option; the option does not get in-the-money just because rates go down. Only a small fraction of (typically junk) bonds are callable at a fixed price.
@adjacent/q
Exactly what social / governmental goals were the private label securities being purchased to meet?