What to do with 30-year Mortgages?

The Mortgage Corner

Are 30-year mortgages a thing of the past? If so, too bad. Much of the debate over the future of Fannie Mae and Freddie Mac revolves around whether their main product—the 30-year mortgage—will disappear if Fannie and Freddie in their current form are dissolved. That would increase the costs (and decrease affordability) of home ownership.

Why the debate? Because 30-year mortgage are considered very risky extensions of long term credit, say privatization advocates, which require some kind of either explicit or implicit government guarantee and regulatory oversight. In other words, banks and other financial entities without those guarantees would want to offer shorter term fixed rate mortgages—say, with 15 to 20 year terms.

This is because shorter term mortgages have less risk, which is why loans tied to the Prime Rate—which can change overnight, and is now at 3.25 percent—offer the lowest rates for home equity mortgages, commercial lines of credit, etc.

The problem, however, is that 30-year amortized fixed rate mortgages provide the least risk to homeowners. A 30-year amortized payment is more affordable versus a shorter amortization term, and borrowers can rely on its fixed 30-year payment schedule to pay down their debt,. Though, in fact, the average life of a 30-year mortgage is seven years due to the mobility of American households.

Everyone agrees that 30-year fixed rate mortgages have made housing more affordable, and has boosted both the homeownership rate, and housing market in general. So the real debate is what to do with Fannie and Freddie, who have become government wards because of the Great Recession. Fannie guarantees some $1 trillion in mortgages, and holds $1.5 trillion in its own portfolio that has not been sold into the secondary market of mortgage-backed securities.

Treasury Secretary Timothy says we must be cautious in winding down their assets—maybe over a ten year period—so as to not flood the markets with too many mortgages, thus devaluing them. Mortgage activity is still low because of the housing bust, and Fannie and Freddie are its main conduits. The four-week moving average of the Mortgage Bankers Association purchase index is still at 1997 levels, and even with the large percentage of cash buyers recently, this still suggests fairly weak home sales through April.

Harvard economics’ Professor Ed Gleaser believes Fannie and Freddie should remain public entities, because if they were privatized, government would step in again, anyway, as they are entities ‘too big to fail’. “I support the public option not out of blind faith in the public sector, but out of profound skepticism toward mixed public-private models, like Fannie and Freddie,” said Gleaser. “The free-market friends of privatizing those entities envision a bold new world where the government no longer stands behind their debt. But if the last three years have taught us anything, it is that the government is not going to sit by and let a major part of the financial system fail.”

Barron’s Magazine has taken the privatization side of the argument in an August 28, 2010 article: “Today, Fannie (ticker: FNMA) and Freddie (FMCC) own or insure some $5.7 trillion of the $11 trillion U.S. mortgage market. Moreover, they provided around 75 percent of the funds flowing into the mortgage market in the past year.

“In a housing conference hosted by Secretary Geithner, there was some agreement that the government should either offer back-stop, catastrophic insurance on all residential mortgage securities, whether bundled by the GSEs, banks and other financial intermediaries,” said Barron’s, “or, perhaps, get out of the insurance game entirely except for affordable-housing investment pools. In other words, there would be no home-field advantage for Fannie or Freddie.“

The reason for their extreme caution? Both new and existing-home sales continue to decline, dropping 16.9 and 9.6 percent, respectively, in February. New-home sales are at a record low in part because of the large number of foreclosures flooding the market.

Whatever happens to Fannie and Freddie, Geithner asserted, they will have a much smaller footprint in the future so as to not pose a systemic risk. Among other things, the Government Sponsored Entities (GSEs) could lose the implicit government backstop on their corporate debt at some point so as to curb any future buccaneering. Or, perhaps, the GSEs would be restricted to buying mortgages or other securities merely for warehousing purposes, in anticipation of creating new mortgage-backed securities.

Harlan Green © 2011