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 
K: Thanks, you make a good point about the practice for corporate debt/bonds. This is the point I was trying to make above, that in corporate lending, the practice is make whole (what I’ve called unwinding costs). When the note is floating rate, there are no unwinding costs – and the remainder is spread, possibly plus a small penalty to cover fixed costs. Same point – it’s unrelated to interest rates.
For the floating rate (truly open) mortgage borrower, same principle; the fixed rate faces unwinding/make whole (with, in Canada, caps on the amount of the unwinding costs – but the more effective part of the cap is the limit of closed to, generally, five year). Hence usually the only reason to refinance a floating-rate is to either benefit from a spread change (usually limited for ‘prime’ borrowers, so only makes sense when you have truly moved credit classes), or to fix for whatever reason, such as to limit exposure to increasing rates.
For an example, about four years ago I fixed a mortgage on a rental property – at the time it seemed like rates could go no further down (I was very wrong on this), and the upside of even lower rates was limited. For unrelated reasons, sold the property later, and had to pay some unwinding costs – but was able to reduce them by paying off a partial balance before, doubling up some payments, etc. Final cost was, I think, less than 2% of the balance outstanding (probably 1%).
While annoyed, this was significantly less than other fees and costs, esp real estate agent fees.
If everyone is so worried about the consumer, why not focus on the high estate agent fees? (Oh wait, competition agency in Canada is doing this).
My cynical side believes strongly that the reasons underlying the structure of the industry in the states has very, very little to do with consumer protection, and much to do with the incentives (rents) of real estate industry, mortgage brokers, servicing companies, etc. They all collect fees at any change, and these are much more significant than unwinding costs.
I can’t easily keep up with all these very good comments. But the discussion doesn’t really need me.
K: Nothing to apologise for. You are very civil.
Your two paragraphs on whether a fixed long-term mortgage acts as a hedge are very good. I’m with you on your great 30 year fire insurance analogy. This is where I think I disagree:
“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.”
I think I see it differently. We are born with a short position in housing, since we will need somewhere to live. (I did a post on this a few months back http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/07/we-are-born-with-a-short-position-in-housing.html ). And the only way to cover this short position is to buy a house. So assume I am born and have no assets, except a stream of future income from wages. And no liabilities, except a stream of future liabilities of needing somewhere to live. (Assuming no inflation) if I get a 100% fixed interest 30 year mortgage and buy a house I have hedged/covered? my short position in housing perfectly, by selling a portion of my stream of future wages forward to cover my stream of future rental liabilities.
I’m not sure I’ve got my head around this properly.
Jon: you may be right. I have heard people (who? I can’t remember) say that banks really don’t like holding those open mortgages, because they never know when the damned things will be paid off. But this may be only a very small part of the story of the financial crisis. I maybe overcooked it on “dangerous”. I stick with weird and stupid.
adjacent/q: I’m glad to see you here. I liked your comment on the other site. Feel free to re-post it here, since it’s relevant.
Scott: Thanks! Wish I understood all the details better though. But again, that’s what comments are for, and why blogs are so great.
The FDIC seems to think that the mismatch played a role in the S&L crisis:
Click to access 211_234.pdf
“By law and regulation, MSB assets were permitted to be invested
primarily in fixed-rate mortgages and long-term bonds, but as short-term interest
rates rose to historically high levels between 1979 and 1982, the market value of these assets
plunged. At the same time, MSB liabilities were composed almost exclusively of shortterm
deposits paying rates of interest subject to deposit interest-rate ceilingsand as
market rates rose, even small savers began to think like investors. … Yields on assets rose much more slowly, and net interest margins shrank and became negative. Operating losses were so great that capital levels built up over a century or more of profitable operations quickly eroded. MSB failures were predictable and, arguably, preventable.”
This is not the only issue, but the mismatch between long-term fixed-rate mortgages (open, if you like) and deposits which reprice frequently is serious for banks. And yes, it is theoretically possible to manage, but it is not costless, and may be subject to tail risk.
Greg: there are really two issues:
1. If banks borrow short and lend long, that creates clear risk. That’s presumably the main reason behind the S&L crisis.
2. In addition to that known risk, there is the additional risk created if your long loans are open mortgages rather than closed mortgages. Because you don’t know when they will be re-financed.
Many people say that 30 year fixed rate mortgages would not meet the test of the market, absent some form of government intervention/interference. I’m not so sure about this.
1. Empirically, as one commenter (GA?, sorry) above notes, Canada used to have 25 year fixed closed mortgages, until the government put a limit of 6 months interest on re-finance penalties. 25 is very close to 30, and now people live longer, maybe 30 is the new 25.
2. Theoretically, there seems to be a natural source of supply of fixed rate closed mortgages. Not from banks, which borrow short, but from pension plans and people about to retire. But they want to supply closed, not open mortgages.
Does anyone have any immediate thoughts on this? Is this worthy of a separate short post? “30 year fixed mortgages can meet the test of the market, if they are closed, and the government doesn’t screw up the right of free contract”.
It was Determinant, sorry. Let me repeat the important bit from his comment above:
“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.”
Wow!
Who/what killed the 30 (or 25) year mortgage? I used to think it was inflation. But that argument never really worked theoretically, since it’s inflation uncertainty, rather than inflation, that would be expected theoretically to kill off long fixed rate mortgages. But then they didn’t reappear when inflation and inflation uncertainty came down with inflation targeting. Now determinant comes up with a much better theory. The limit on prepayment penalties is what killed the 30 year mortgage. I like it.
Dammit. This really deserves a post.
Is determinant right? (And was it 25 or 30? I had better be exact, if I can.)
sorry Nick, again. I’m not reading the comments so maybe this has been covered but why is paying for your prepayment option at exercise time better than paying for it over the life of the bond (via a higher interest rate)?
Is it a behavioural argument you’re making?
Adam: If you know in advance that you would want to exercise, because you will come into a wad of cash in 10 years’ time, for example, then it would be better to just get a 10 year mortgage.
But if you don’t know whether or not you will come into a wad of cash in 10 years’ time, it would be better to wait until you have the cash before paying to exercise. Because the cost of exercising the option would be correlated with your coming into a wad of cash. Correlated across time, and across states of the world.
And if you exercise the option just because interest rates have fallen, there is no social benefit to your doing that ex post, since it’s merely a transfer of resources from lender to borrower. And ex ante that option seems to just create additional risk for both parties, and so is socially inefficient.
“And ex ante that option seems to just create additional risk for both parties, and so is socially inefficient.”
No, it shifts risk from borrower to lender. Usually the lender will be in a better position to hold the risk or hedge it (can hedge it far more cheaply).
Your middle paragraph is utter nonesense.
Also, what’s wrong with non-recourse loans? Most credit is limited liability in some sense or other. Do you also think the limited liability company is weird, stupid and dangerous?
Nic,
I’m not sure why this matters. US mortgages are essentially callable bonds. Are corporate bonds with embedded call options weird stupid and dangerous? If I’m a bank or investor holding a mortgage, there are many ways that I can hedge the risk of declining interest rates and/or prepayments(swaps, options, ect).
The real problem was that borrowers, lenders, investors, rating agencies and regulators all assumed that a 30% decline in US home prices was impossible. And it turned out that it wasn’t.
Adam: If you and I take a bet, that usually makes us both worse off ex ante, if we are risk averse. The bet increases the variance of consumption for both of us. It’s inefficient. Only if the thing we are betting on is correlated with the consumption of one of us would it be efficient to bet. Like when I take out fire insurance on my house.
As far as I can see, the bet involved in an open mortgage just increases the variance of consumption of both parties. It’s inefficient.
So, you might be asking, if it’s inefficient, why does it exist? Why does the US market create these open mortgages? My guess is that there is some sort of legal restriction, or failure to enforce the right of free contract, or some sort of implicit subsidy at the root of it. And we are getting at that in the good comments above. The best explanation is that the government sets arbitrary limits on pre-payment penalties, effectively killing the market in closed mortgages. Though I wouldn’t rule out some sort of behavioural explanation. People are just confused, or don’t see the costs of the option.
Both recourse and non-recourse loans may be efficient, in different circumstances. But if the government and courts refuse to enforce recourse loans, we have a prime facie inefficiency. In effect, the government is forcing us to take non-recourse loans, so it’s unsurprising that non-recourse loans sometimes create inefficiencies.
Good questions by the way. You are forcing me to make explicit something that was implicit in my argument.
Gregor: There’s a good comment by K above that clears up our confusion regarding callable corporate bonds. Here is it:
“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.”
So, if I read K correctly, a corporate bond is no more callable than a closed mortgage. You can repay it, but have to pay the interest rate spread if you do so. So it’s neutral.
“The bet increases the variance of consumption for both of us.”
Why? Somewhere in here you might have an argument but you haven’t got it out yet.
Let’s keep in mind that the option hedges me against falls in interest rates (as opposed to low interest rates). To the extent that falls in rates tend to happen when income/consumption is falling (recessions, I got fired) the ability to refinance and lower my monthly payment reduces the variance of my consumption path.
Now, as for the lender they make their living insuring various risks so it appropriate for them to hold this risk. They should have sufficient access to captial markets and expertise to manage the risk.
Now their maybe an argment in here somewhere. As far as I see, behavioural is not how you want to go. It’s going to have to be about market incompleteness/imperfections. But “I don’t understand why they do this” says only that you don’t understand, it does not imply that “this” is weird, stupid or dangerous.
“So, if I read K correctly, a corporate bond is no more callable than a closed mortgage. You can repay it, but have to pay the interest rate spread if you do so. So it’s neutral.”
No, you don’t read him correctly. He said, that it is an option on credit spreads not on interest rates. This doesn’t imply that the bond is no more callable than a closed mortage. Basically it means you don’t call the bond by pre-paying (ie. buying back for par), you buy it back at a fixed spread to treasuries.
Nick: “(Assuming no inflation) if I get a 100% fixed interest 30 year mortgage and buy a house I have hedged/covered? my short position in housing perfectly, by selling a portion of my stream of future wages forward to cover my stream of future rental liabilities.”
Good question. And I agree that your way of looking at problem is better. Housing is covered if you own a house. The problem is always wages. So if we go with your no inflation hypothesis then rates will be determined by growth expectations alone. So then it really depends how you think your wages are influenced by growth. So if you are at or below the median wage, the answer, sadly, is no, you just get inflation. No real raise for you. But then, you are probably stuck paying rent anyways. If you are at or above the mean, which is the category of people who get to make mortgage choices, then you participate significantly in growth (at least on the upside). So you still ought to get a floating rate to protect you in a recession. And because floating mortgage rates don’t go negative you should probably buy some long bonds to get some protection against negative growth (note that this is the opposite position of a fixed rate mortgage).
So is there any reason to go fixed? Maybe if you have some reason to expect that your wages will not participate in growth, e.g. because your income is relatively low (near the median). But you would have to be sure that your wages will not participate in negative growth, which is probably a bad assumption if you are receiving a low wage. Unemployment, for example, is likely to be probable for you in a recession. So then what you need is a floating rate with a cap. And still you probably need to hold some bonds. But going fixed would be the perfect disaster for you in a severe recession.
And if median income earners need interest rate capped mortgages, who should sell them the cap? High income earners could since they seem to outperform nominal growth in the long run.
So as far as I can tell, even without inflation risk, the conclusion is largely similar: fixed rates bad, floating rates (possibly capped) + long bonds good.
Maybe that last post was premature…
I seem to have implicitly assumed that annual income was equal to the size of the mortgage so that a nominal growth=rate increase would cause an increase in income equal to the increased interest cost. Obviously flawed… Maybe you do need the portion of your mortgage that exceeds your annual income to be fixed when the ratio of mortgage to income is greater as is typical. Need to think some more, but maybe there are some useful ideas here.
@Nick:
I drew that fact from an excellent article that gave a great history of the mortgage market in Canada, but I can’t find it on the Internet. I think it’s by Freeman, published in 1996. I remembered the penaltyas six months, but it appears now from that Re/Max site that it’s three months.
To be clear, in Canada the traditional limit was always 25 years, 30 in the US. Longer terms are permitted, but have never taken off here.
Here’s an excellent primer on why Canadian mortgages look the way they do:
Click to access el0610_cdn_mort_market.pdf
Per the article, the Canada Interest Act allows borrowers to break a mortgage at the five-year mark with only a three-month interest penalty. Therefore banks have little incentive to offer fixed terms beyond this mark.
Second, banks fund their loans out of their deposit book. The Canada Deposit Insurance Corporation only insures deposits up to a 5 year duration. Therefore banks’ deposit books are heavily tilted to 5-year terms and under. Canadian banks have historically chosen not to pursue the same path as US Savings & Loans and limit their term matching risk accordingly.
Here’s another overview of Canada’s mortgage market history.
http://www.simonaheather.com/cgi-bin/realestate/mortgage_financial_history
@GA:
Per the Bank of Montreal (and any other chartered bank), variable mortgages compound monthly, fixed mortgages compound semi-annually. It’s a legacy of the agricultural boom of the late 19th and early 20th Century. Farmers took loans for planting and paid them off at harvest. The restriction on compounding was designed to be a tradeoff between farms and banks. Anybody who spends any time with an interest rate table in Canada (as I have) knows that Canadian mortgage rates have to be converted to per-annum compounded monthly rates.
@Nick (and apologies, I have perhaps muddied the waters by posting here as GA and Greg):
-I still think you are fixating (pun intended) on the wrong aspect of Canadian mortgages. It’s not the closed/open aspect that is fundamentally different, but the maximum term of fixed-rate. Essentially, the more important bit is that they are floating rate mortgages with a fixed rate portion that does not exceed five years.
-Corporate bonds are mostly callable. The part that I believe K and I were drawing attention to is that either a) they are floating with minimal penalties, or b) they are fixed with unwinding costs/make whole (cost of calling depends on rates at the time of calling) – essentially closed, and equivalent to (how I understand) Danish closed mortgages work – borrower buys out their own mortgage at prevailing interest rates. When floating, calling has little advantage unless there are other changes (spread compression, borrower does not need the borrowed funds, etc); when fixed and closed, calling does not provide gain either.
That is incorrect. If the risk premia does not change, there is no difference between corporate and mortgage refinancing with a small prepayment penalty. It is not even close to being closed. This is why yield to first call is more important than yield to maturity for pricing. Now corporates do generally have a set call schedule rather than at will, but they are very much like fixed rate mortgages.
@K: “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.”
I think you’re looking at that wrong. Asset markets are incomplete and (with respect to shelter) lumpy, and people need to live somewhere. If you don’t own a house, you still need to live somewhere, so you have a liability equal to the present value of your future shelter needs: you are effectively short the housing market. If you have tradable assets, you might be able to offset that short position, but if (like most young people, and I imagine most first-time home buyers) your assets are largely in the form of untradable human capital, then you’re forced to hold a second-best portfolio. When you buy a house, you settle out your short position in housing, but (if you don’t have a lot of other tradable assets) that improvement in your portfolio is bundled with a requirement to lever up your human capital. (The first best would be to sell off part of your human capital to finance the house purchase, but you can’t do that.) To minimize risk, you want the cash flows of your liability (mortgage) to match as closely as possible those of your asset (human capital). Of course, the distribution of possible cash flows from human capital is complicated, and no conventional kind of mortgage is going to be a very good match. But until someone convinces me otherwise, I will continue to guess that a prepayable fixed-rate mortgage is a better match than either a variable rate or closed fixed rate mortgage. You’re protected against a deflationary depression, which would hit your human capital (in nominal terms, anyhow), and you are not vulnerable to a real interest rate spike on the liability side. Sure, there are still a lot of things that can go wrong, but that will be the case with any kind of mortgage.
Actually (continuing from my last comment), if one accepts my argument that a mortgage is actually being used to finance human capital, then I think I can make a slightly more elegant case than “this is what I think” when it comes to the risk-return characteristics. You need to start with the assumption that the next 30 years are a series of random draws (maybe, say, 2 years at a time) from a population of which the past 60 years have been representative. In that case, the worst way to finance human capital is with a variable rate mortgage, because you are risking drawing 1981-1982, when the nominal value of your human capital declines dramatically, while the nominal value of your mortgage liability rises dramatically. That’s like Russian roulette. You don’t have to assume a high degree of risk aversion before that option is clearly eliminated. A closed fixed rate mortgage would be better, and the remaining question is how much you would be willing to pay for the prepayment option. I would argue that you would attach substantial value to that option, because it helps in the second worst case scenario, 2008-2009, when the nominal value of your human capital falls significantly while the nominal present value of your liability also rises.
The indenture will set for the call provisions for the bond. It can uae any formula for the call value. It could include a make whole clause, but that would be a rarity. Most commonly used is par plus 1 years interest diminished by the expended life of the bond, the equivalent of a prepayment penalty but if rates drop significantly well worth paying. Corporations call bonds all the time when rates are low.
@Andy:
1981-1982 is a red herring and doesn’t support your argument. Given that the average Canadian householder has to sit down and figure out what length of term they want when they take out their mortgage or renew, the study of which strategy (5 5-year rate terms over the length of a 25 year amortization or 25 1-year rate terms) is of great practical interest in Canada and has been extensively studied by economists.
The results: For any given time series INCLUDING the horrid 1981-1982 period, it was always better to take a shorter fixed term. The longer term had no net value, in fact for any given time series you would lose money on this strategy. Let me be very clear, Canadian economists have looked extensively for evidence to support your theory and they couldn’t find it. Even if you tried to make a really big mistake and make a longer term look good, you can’t try it. We just can’t stack the deck enough to make it work.
Why? First, shorter terms carry lower rates, they are lower down the yield curve. They almost always are, and inversions of the kind that people notice are extremely rare. In 2008 and 2009 the yield curve in mortgages WAS slightly inverted due to the Asset Backed Paper Market fiasco. Still, it passed soon enough that the average mortgage holder could ignore it.
It turns out that banks charge an extra percentage for a five-year fixed term compared to an equivalent series of 1-year terms. This is the premium paid to the depositor who funded the mortgage, or it can be seen the net cost the bank paid to borrow on five-year terms instead of one-year terms. Again, this simply reflects a normal yield curve.
It also turns out that even if you do get caught in an inverted situation, the flexibility to renew in short order combined with the discount you get for taking a shorter term provides a net benefit to householders who pursue this strategy. The shorter renewal period means you get relief for your “mistake” at the earliest opportunity.
@Nick:
It wasn’t inflation that killed the fixed 25-year mortgage in Canada, at least not directly, it was interest rates. Interest rates rose steadily in the late 1960’s after being stable for the previous two decades. Two percentage point increases in two years got banks and borrowers worried. Banks looked backward and didn’t want to be caught with low-rate loans on their books for 25 years. Borrowers looked forward and didn’t want to be stuck with historically high rates for 25 years if rates dropped. They looked at rate history and did the rational thing: refinance as soon as possible. The federal government facilitated this with its 3-month penalty rule.
Since borrowers didn’t want to borrow at long terms and lenders didn’t want to lend at long terms (though for opposite reasons), the federal government amended the National Housing Act in 1969 to allow for 5-year renewable terms. Previously the NHA and therefore the Canada Mortgage and Housing Corporation nd its all-important insurance insisted on 25-year terms. They could not maintain this insistence if their terms caused the pool of deposits available for mortgage lending to dry up. So the government relented, and the 5-year Canadian rollover mortgage was born.
There is another subtle thing here about why Canada never when for an equivalent of Fannie Mae: our banks are national in scope. Fannie and Freddie were reformed in the 1960’s to even out mortgage rates in the US. What was happening is that due to a fragmented banking market interest rates between cities were quite variable. 1.5% was not uncommon. Of course with national media people complained about uneven rates and their effects on affordability. The solution was to spread the funds and risk around through a secondary market.
Canada never had this particular problem. With national banks and trust companies (remember those?) interest rates were always even across the country. The “smoothing” function the secondary market in the US was naturally performed by the consolidated financial positions of our chartered banks and trustcos without need for a secondary market.
@Determinant:
Either we are misunderstanding each other, or interest rates behave very strangely in Canada. For the term from Dec 1977 through Dec 1982, the US Treasury paid 7.5% p.a. to borrow 5-year fixed. It paid an average 11.4% to borrow consecutive for 1-year terms over the same period.
Granted, I’ve chosen what may be the worst possible period, but it was also one of the worst periods for human capital, in nominal terms, which is my point: the variable rate borrower took the interest rate hit at the worst possible time. And of course, Treasury rates aren’t mortgage rates, which data I don’t have at my fingertips, but I don’t see why there would have been a dramatic opposing change in the spread between the two over that period.
Was the situation so very different in Canada? In any case, the original post was about American mortgages, so the appropriate question would be about American interest rates.
Lord:
I don’t know which corp market you are referring to but make whole at treasuries + spread is very common in the US market. The call spread is typically very low – much lower than the issue spread so the option isn’t worth much. Calls at a fixed price are also done sometimes for high yield issues, but most are not callable. The reason for this is the same as what Nick has been pointing out all along: People (investors in this case) don’t want random, especially short, option positions in their portfolios. They generally want bonds that are like treasuries but with some credit spread. Issuers, on the other hand, want all kinds of features. But when push comes to shove, they rarely want to pay the market price for them. So most bonds are fairly plain vanilla.
And a minor point. You seem to refer to credit spread as risk premium in your earlier comment. Credit spread is partly risk premium and partly compensation for expected credit loss. And maybe this is good time to comment on the debate over the meaning of “risk neutral”. It generally (and surely originally) refers to an investor who is indifferent to investments with the same expected return, no matter how different the risk profile. The risk neutral measure is called that because it computes prices as expectations of payoffs divided by the value of a future bank account. That is, it is a pricing measure that is indifferent to a random payoff vs one earned in a bank account. Risk premium is the difference in expected return between the risk neutral measure and some investors subjective measure. (Or typically the oft discussed but rarely observed text book objective measure).
Andy Harless: “I think you’re looking at that wrong.” You’re right. I was looking at it wrong (see my (also confused) comment at 12:33)
Reading this article, a word “ratchet” popped up in my mind. And by googling, I found that there really exists such thing as “The Ratchet Mortgage“. It seems that “US fixed rate mortgage” is more close to this product than true fixed rate mortgage in the first place.
Determinant: That article by Eric Lascelles at TD you recommended is indeed excellent reading. http://www.td.com/economics/special/el0610_cdn_mort_market.pdf
I have done a bit of a Google search, and I can’t find any references to Canadian mortgages ever having had the interest rate fixed for 25 years (or any longer than 10 years. As far as I can see, the reason is Section 10 of the 1886 Canada Interest Act. It has always allowed any borrower to pay off any loan after 5 years with a maximum of 3 months interest as penalty.
So closed mortgages, or almost all commercial loans (there may be some exceptions, but I couldn’t understand the legalese) ate effectively prohibited in Canada, because that maximum 3 month interest penalty makes them unenforceable.
Andy:
Take a look at the Federal Funds rate, which topped out at 18.5% in 1982. According to Business Week, the US Dollar yield curve inverted by only 2% in 1980. So individual auction rates for long Treasuries should be considerably higher.
Here’s the article: http://www.businessweek.com/bwdaily/dnflash/jan2006/nf2006019_5024.htm
In Canada mortgage rates are highly correlated to the Bank of Canada’s Overnight Rate. The Overnight Rate controls bank prime.
Again, because Canadian mortgages adjust more rapidly than American ones do and with far fewer frictional costs to refinance (zero if you time it right, which can be easily done by the average person), according to the time series you would have come out ahead if you took a 1-year term in at 18% in 1982. The subsequent drops in interest rates made you come out ahead since you got to take advantage of those in short order. Plus you didn’t pay the long-term premium.
My point is that 30-year rates don’t protect you from anything and even if you choose the worst possible moment to get a Canadian-style rollover mortgage, the rollover still provides you a house at less total cost than the American one does. 1982 provides no evidence that longer terms are more advantageous, in fact the opposite is true. Therefore it does not support your argument, it contradicts it.
Nick, what about this point that I made and also Andy Harless made a bit later? (reproduced below):
Nick: “The bet increases the variance of consumption for both of us.”
Why?
Let’s keep in mind that the option hedges me against falls in interest rates (as opposed to low interest rates). To the extent that falls in rates tend to happen when income/consumption is falling (recessions, I got fired) the ability to refinance and lower my monthly payment reduces the variance of my consumption path.
Now, as for the lender they make their living insuring various risks so it appropriate for them to hold this risk. They should have sufficient access to captial markets and expertise to manage the risk.
So, I spent the past half hour looking for callable bonds (I would have done it last night, but didn’t have access to my Bloomberg). I have checked thousands, a few hurndred more carefully. Almost all investment grade (IG) issued bonds are either vanilla or make whole + spread (about half of each). The spread is about 1/6 or 1/7 of the issue spread. Some have zero spread which seems funny since you’d think you could always buy back a bond at zero spread in the market. But then when you think about the fact that USA CDS trades around 40 bps, and some US corps are tighter than that it makes sense.
The only IG price callables I have come across are long term financials, e.g. JPM 30 yr or perpetuals. That would make sense as a hedge for US 30 yr mortgages. Most financial bonds are vanilla though. And many junk bonds have fixed price calls. Assuming rates don’t explode, these calls are struck so as to be deep in the money assuming all goes OK from a credit perspective. It gives the company some hope of reissuing earlier at a lower spread. So there is still not much of an interest rate component to these calls. As the bond approaches maturity it is most likely to either roll down in spread or become distressed. In either case, rates are unlikely to play a significant role in the exercise decision. Most callable junk bonds also have a make whole provision. Make whole is decidedly not “a rarity”.
Other, much smaller categories of bonds include converts and funky financial bonds (e.g. I saw a Morgan Stanley bond that pays quarterly 4 times the difference between 30y swap and 2y swap rates???). So apart from bonds that appear to be specifically designed to hedge mortgages, I dont see any evidence of a significant role for callability relevant to interest rates in the US corporate bond market. I had a look at Europe too. Even more vanilla.
Andy and Determinant:
You are having a well informed, intelligent debate about what historically was more successful: fixed or floating. I think it misses the point a bit though. First of all, there are not very many independent periods in your sample – business cycles are long. Second, mortgage rates were astronomical over much of the period compared to today. Then they fell to near zero. Not bullish for fixed rate mortgages. These periods aren’t relevant to what might happen when the short rate is at zero. Third, the belief that fixed rates are safer causes excessive demand, causes fixed mortgage rates to be excessively high, causes fixed mortgages to underperform. Give people enough time to see the pattern and they will switch away from fixed. “Anyways, the Bank will never lose control of inflation”, etc, etc… This could skew the market towards floating and balance the risk (or drive the car right into the other ditch). Never underestimate the propensity for humans to 1) assume things will never change, 2) completely fail to hedge themselves against such change, and 3) try to hedge themselves at the last and worst possible moment, thereby bringing about the change they never thought could happen.
Adam: Your and Andy’s point is potentially a valid one. But an open mortgage makes a one-way bet. Wouldn’t a symmetric 2-way bet be better? Like with a Variable rate mortgage? And are all recessions associated with falling interest rates? 1982? But finally, I say that open mortgages fail the test of the market in Canada, except for 6-month and 1 year terms (people selling houses in the near future?). Given the choice, people choose closed. And closed mortgages longer than 5 years are banned by Section 10 of the Canada Interest Act. All Canadian mortgages longer than 5 years must by law be open. None exist. 5 year closed beat more than 5 year open. Doing a new post on this.
yes, but a one way bet that’s entirely to the benefit of the borrower because the lender is in a position to deversify and/or hedge the risk!
the point here is that they’re not ineffecient as you claimed. Borrower risk is reduced and if lenders diversify and/or hedge the risk then aggregate welfare is improved.
Determinant:
We are still clearly misunderstanding each other (plus it may also be true that Canadian rates behave differently than American). If you took out a 5-year fixed-rate mortgage in 1978 in the US, you surely did a lot worse than if you took out a 5-year variable rate mortgage. (The fixed rate I quoted for 5-year Treasuries was the reported average for December 1978. The floating was an average of 1-year rates for that and the next 4 Decembers. Technically I shouldn’t have used an arithmetic average, but it’s close enough.)
You can rightly argue that, if you’re not liquidity constrained or at risk for becoming liquidity constrained, then, over any 25-year period, you would have done better (in the sense of paying less interest) with a 1-year than a 5-year reset. But my argument assumed a liquidity constraint as the motivation for getting the mortgage in the first place. (Because human capital is illiquid, you take out a mortgage instead of selling some of that asset to purchase the house.) In practical terms, if you got a mortgage during the late 1970’s, you had (ex post, cross-sectionally) a very high risk of losing your job in the subsequent recession(s) and having difficulty making your mortgage payments. If you had a variable rate mortgage, the risk of losing your house was significantly higher.
I wonder, also, about the correlation with other assets. If one isn’t liquidity constrained, the motivation for getting a mortgage must involve a desire to maintain some other asset that is expected to have a higher return than the rate on the mortgage. Do the studies take into account the possible need to liquidate stock at the bottom of a bear market in order to make a mortgage payment? A fixed rate taken out in the late 1970’s would have left you with more money with which to buy stock in 1981-1982. Offhand, I would guess that the returns on that stock would be more than the extra interest you paid in subsequent years.
Nick:
Why would a 2-way bet be better? What you want is to do well in bad scenarios, which could involve either falling or rising rates. You want to maximize your flexibility when something weird happens, which means you want to buy options, not make a simple hedge bet.
And you’ll have to forgive me if, after just having lived throught the first decade of the third millenium CE, I am a bit skeptical as to the validity of the test of the market, particularly where mortgages are concerned.
K:
I went with historical data as a way to given some quantitative substance to my intuition. I still think historical experience is a reasonably good guide to the type of patterns that might emerge. As they say, history doesn’t repeat itself, but it rhymes. In particular, there still exist the two risks with which I am concerned.
On the one hand, when the economy recovers, there is a risk that the Fed will have to spike up interest rates and induce a new recession to prevent an actual or imagined resurgence of inflation: hence, for human capital and interest rates, a scenario similar to the early 80’s, which would wreak havoc on people with variable rate mortgages and liquidity constraints who are at risk for job loss. Granted, there is not the history of ingrained inflation that existed in the early 80’s, but there are high public debt and unconventional central bank assets, which might cause expected inflation once a recovery runs its course, plus there is plenty of room for a crash in the dollar, so it’s not too hard to imagine a fairly drastic and persistent rise in short rates (to well above where long rates are now) coupled with a fairly serious recession at some time in the next 10-20 years.
The other danger scenario — where interest rates fall dramatically along with the value of human capital, as in 2008-2009 — is in my opinion still very much a risk too, even with interest rates already low in historical terms. One only needs to look to Japan’s experience to see the possibility — but note that Japan had the advantage of being only one country and therefore the possibility of increasing net exports to blunt the deflation. Today it’s not too hard to imagine the entire developed world falling into a deflationary depression, which could conceivably reduce US rates even below where Japan’s are today.
With either of my worst-case scenarios, you can certainly make arguments as to why it is unlikely, or not likely to be as bad as I imagine, but we are concerned here with what might happen, not with what is likely. For a typical first-time home buyer, the risks of a variable rate or closed fixed rate mortgage are still severe, and the amount of protection provided by a prepayable fixed rate mortgage, while far from complete, is still worth the cost. US 30-year mortgages are normal, smart, and safe.
Adam P: “Borrower risk is reduced and if lenders diversify and/or hedge the risk then aggregate welfare is improved”
You’d think that’d be more or less true … but evidence of recent events doesn’t lend support.
@Nick:
Prior to 1969, the CMHC under the authority of the National Housing Act insisted that mortgages be made by a single borrower at a fixed rate for 25 years. Essentially the same as what happened in the US at the time pre-Fannie. To wit, National Trust would lend you money at 7% for 25 years. The term and amortization where identical. The borrower could pay it off with a penalty, but the lender was stuck with the loan. A lender had to keep the loan on its books for 25 years and had no opportunity to change the rate.
With rising rates in the 1960’s, this seemed a poor strategy to many banks and trust companies and they wanted to move to more flexible terms to keep their loan and deposit books more current. They did not want be stuck with 7% loans and 9% deposits. We didn’t have a secondary market and with fewer institutions had little reason to develop one.
@Andy:
Variable mortgages in Canada don’t work like that Andy. True variables have a fixed payment and a variable amortization. Interest rate increases cause the amortization to lengthen. Again, however you are compensated by the lower rate. Pursuant to this idea, Canada now has a rule that you must qualify at the highest five-year rate in order to get any mortgage. In a new rising-rate environment, this is sound.
You can also lengthen your amortization on a closed renewable mortgage if you want to, but banks generally frown on this.
Second, I an fundamentally unimpressed by your arguments because Canada experienced similar interest rate increases in the 1980’s as the US but this didn’t result in a huge wave of defaults. Banks adjusted to keep their customers and their income streams. Customers adjusted to pay off their mortgages as quickly as possible. We have achieved a similar (in fact now 1% greater) rate of home ownership by making almost the opposite choices the US has. You can’t argue the benefits of US amortization structure when its absence has not had a demonstrable ill effect in Canada. There is no better experiment than that. I’m saying the facts don’t fit your theory.
I’m also saying your interest rate evidence is faulty and I’m deeply sceptical of it. 8% mortgages when the Fed Funds rate is at 18%? No, you need better evidence. Interest rates at that time were extremely volatile and the arithmetic average does not give an accurate picture of what happened.
Also in Canada mortgage interest is not and has never been deductible from income tax. While much ink has been spilled on this subject, it does mean that Canadians have a strong incentive to pay off their mortgages. The choice of making retirement savings over paying down a mortgage is considerably weighted towards paying down a mortgage up here. In 1981 it would have been a no-brainer.
Patrick, well I did say “if”:)
But the thing is, I don’t think you can pin the bubble and subsequent crisis on the prepayment option. There’ve been many housing bubbles and bubbles in other assets that didn’t require this feature of the debt contracts.
You can argue that it was a regulatory failure or just a combustible mixture of greed, denial and stupidity (or even give an explanation that I agree with) but I just don’t see how you pin it on the specification of the mortgage contract. I mean, was this type of mortgage in any sense new?
It wasn’t the prepayment option, it was lax lending standards as a result of greed combined with poor oversight.
It’s clear that in the US many people were sold mortgages who couldn’t afford it. You can blame it on mis-sold ARM’s, but I blame it on poor standards. In Canada the CMHC is an insurer and as such has a clear and continuous interest in ensuring that banks maintain adequate lending standards so that defaults are minimized.
Lending standards in Canada are clear and didn’t change through the 1990’s or 2000’s. Neither did our default rate.
Institutions in the US sold mortgages to anyone with a pulse and then bundled the results off to investors. The combination of poor underwriting and poor regulation to ensure that underwriting took place is what caused the crisis to occur.
Determinant:
“8% mortgages when the Fed Funds rate is at 18%?”
What are you talking about? The example I gave was a mortgage originated in December 1977, when the funds rate was 6.5%. (I said 1978 in my last comment, but that was wrong. I was thinking that because 1978 was the first year the mortgage would be outstanding.) Actually interest rates were not all that volatile in 1977, and I very much doubt that it would have been hard to get a mortgage near 8% (assuming that 5-year terms were available, which I’m not sure). A variable rate mortgage (which may have been hard to get, because I don’t think they were common in the US at the time) would certainly have reset upward dramatically over the subsequent 5 years. I don’t understand your skepticism about the data. You cite data from 1982, which is irrelevant to the fixed rate case: once you have a fixed rate, it stays fixed for the entire term of the mortgage; that’s the definition of a fixed rate. Yes, bond buyers (and banks) in December 1977 were, in retrospect, clearly foolish to accept such low yields, but believe me, they did. I know people who saw the foolishness of the bond market first hand.
“You can’t argue the benefits of US amortization structure when its absence has not had a demonstrable ill effect in Canada.”
Well, I can if your evidence is only the rate of home ownership, since I’m talking about risks for the individual borrower. Average data don’t give us much information about tail risks.
“True variables have a fixed payment and a variable amortization. Interest rate increases cause the amortization to lengthen.”
You mean, a 5-year mortgage becomes a 6-year mortgage when the interest rate goes up and then a 4-year when the interest rate goes down? I’ve never heard of anything like that, but it does sound like a good idea. If such mortgages were available in the US, they would probably be a better alternative to fixed-term mortgages of any kind. So I’ll accept the argument that US open fixed-rate mortgages are not the best possible vehicle, but I still think they are preferable both to closed fixed-rate mortgages and to any kind of mortgage that I am aware of being available in the US.
I am asserting that in Canada even during the volatile 1970’s and 1980’s, the person with the shorter term came out ahead. I will let you pick the worst possible combination of interest rates you can imagine using historical data. The shorter term still wins. It benefits from cuts more quickly.
Yes, that is exactly how variable mortgages work. The payment is fixed, but the amortization lengthens from say 20 to 23 years. Or, to look at it another way, the amount you have to roll over when the mortgage renews varies. You can make this up by taking advantage of the 15-20% no-penalty prepayment privileges that banks include as standard in their mortgage contracts now, but that is the borrower’s choice.
Here, have a look at the Bank of Montreal’s rate website to see what I mean: http://www.bmo.com/home/personal/banking/mortgages-loans/mortgages#
Determinant:
I can believe that the shorter term resets always win, in terms of total interest paid, when the full period of financing is 25 years or longer. I have a very hard time believing that the shorter term resets win over the particular 5-year period from 1978 through 1982.
A critical issue here is whether borrowers are guaranteed the opportunity to roll over the loan. If you got a loan starting in 1978 with a balloon payment in 1982, you could be in real trouble if you lost your job in the recession. If your prospects appear to have weakened dramatically relative to the value of the property, the bank might decide to foreclose instead of renegotiating.
A couple of things.
First, when interest rates rise, real estate tends to remain flat or even decline.
Second, rollovers have generally not been an issue at Canadian financial institutions. As long as you continue to make the payments, it is standard and customary practice to rollover an existing mortgage without question.
In Ontario at least, mortgage default is dealt with through contractual power-of-sale provisions which take effect after 50 days of default.
The only time that rollovers did become an issue during the early 1980’s, the CHMC started a “renewal insurance” program to deal with the situation. It was more theoretical than actual and responded more to customer sticker shock on renewal rather than actual declined mortgages.
Being thrown out of your home because the bank fails to renew is almost unheard of. If your situation deteriorates you are far more likely to default first. Between two-income families and Employment Insurance, family income is not an issue on renewal.
As Canadian banks are large and diversified they have the flexibility to take a bit of risk and let the customer sort out his financial situation, so long as they are paid on time. It’s all about simple principles and standard national rules, along with a bit of patience backed up by power-of-sale provisions.
Nick: “Adam: Your and Andy’s point is potentially a valid one. But an open mortgage makes a one-way bet. Wouldn’t a symmetric 2-way bet be better?”
Not for the borrower, the option to prepay if rates go up is worthless. So are you advocating that mortgages be callable by the lender, in addition to pre-payable???? (That would be just as much a 2-way bet as a closed mortgage)
And the whole point I’m trying to make is that intermediaries whole reason for existing, in large part, is to take on these risks and diversify/hedge them more cheaply than private agents can.
I agree that the US system is weaker than the Canadian. But forgetting the obvious, the US culture is high risk high reward, and they mostly bet to win. That’s we why have these options.
Ron
mortgagebrokerstore.com