A Mortgage in the State of Nature?

Nick Rowe writes US fixed rate mortgages aren’t fixed rate mortgages; they are weird, stupid, and dangerous. It’s a good discussion, especially in the comments.

For the bond nerds in the audience, Nick thinks they are stupid because they are callable (can be prepayed) which creates negative convexity, which is dangerous with a fixed rate.

It’s interesting, one of the reasons investors desired subprime was that it was believed to be more stable on the prepayment front; everyone was looking at interest rate risk instead of credit risk, and while the former was fine the second exploded (a situation relevant to Fannie as well, as John Hempton points out). I’ll have more to say on this when we start to dig into housing reform, but I just want to point this out for now.

I do want to post this paragraph from Arnold Kling:

In any case, regardless of what Green or Rowe or I believe is the right mortgage, I think that the market ought to decide. It is my hypothesis that, in the absence of government support (including loading the tail risk onto taxpayers), the thirty-year fixed-rate mortgage with no penalty for either prepayment or default would be priced too expensively to attract borrowers.

I’m not sure what he means by “the market ought to decide” what a mortgage looks like. A fully deregulated mortgage market? I’m fairly certain every modern nation has some sort of regulation on mortgages, and those nations that are modernizing are looking around for first-world solutions to emulate and guide them. (Another reason I take the financial reform movement seriously is that the developing world will have to live with it too. Here are notes on Mexico looking to the Danish mortgage market to modernize itself from Risk.net and Global Banking and Financial Policy Review.) This is because developed mortgage markets require developed capital markets, which also go with a system of regulation.

Mortgages in the State of Nature

We do have a case study of what deregulated lending looks like: the subprime market. It’s worth remembering that subprime lending was not on the books of any of the relevant consumer laws in the country. Alan Greenspan refused to enforce consumer protection laws, most importantly the 1994 The Home Ownership and Equity Protection Act, which bans “extending credit without regard to payment ability of consumer” and put strict rules on prepayment penalties, negative amortization, and balloon payments. Ned Gramlich urged Greenspan to have the Fed start regulating subprime, which he could do with Citigroup, and HSBC started buying out subprime lenders. So did the GAO and a HUD-Treasury task force. Greenspan wouldn’t. (Since it is off the shelf, this is from Our Lot p. 67-68.)

Leading conservative and libertarian think tanks were also touting the idea that subprime was the future of a deregulated mortgage market, replacing the need for consumer protection and lending laws. My favorite (h/t James Kwak) is this 2000 Cato publication, Should CRA Stand for “Community Redundancy Act”?, which informs the reader that the CRA isn’t responsible for the increases in homeownership, or much of anything, since financial statistical technology and subprime are taking its place (how talking points change!).

So how did subprime work out? I walk through the experience of a subprime homeowner here as well as the “fake homeownership” part of it here, but in general in a consistently refinanced short term loan most of the equity growth goes to banks, in terms of refinancing fees and prepayment penalties:

That’s how often they recycle: something like 75% are refinanced 30 months into the life. It is a vehicle that is very difficult to build equity in. Julie Gordon, from the Center for Responsible Lending, likes to say “I’m in favor of home ownership, not home buyership” when it comes to discussing these subprime loans, and I think that is accurate. Even if you weren’t mislead, which many, many people were (Broke USA opens with a representative, and heartbreaking, episode of a man being lied to about how his payments would go), this is a terrible product.

I think further deregulation would see something similar to what we see in the credit card market, where everyone’s mortgage looks like whatever the laws of North Dakota say, and that the poorest homeowners (or “inept”, if you prefer) cross-subsidize the richest.  Like subprime, the whole thing would be characterized by interest rate jumps and penalties and a whole bad-faith expectation that someone can actually pay it off. (I compare the logic of a credit-card to the logic of a subprime loan here.)

And I think that is accurate of mortgage markets in an unregulated market. The idea of home ownership for a broad class of people as a mechanism for building equity and wealth, without government intervention, doesn’t exist. It didn’t really exist before the New Deal (but please send me sources if you think I’m wrong about that), and it would look much more like subsidized renting, with the banks eating all the government subsidies. The mortgage would look, from a financial point of view, nasty, brutish and short in an unregulated market. Is that the future with more deregulation? I’m very open to all of your opinions on the matter.

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9 Responses to A Mortgage in the State of Nature?

  1. Franklin says:

    I understand that when Herbert Hoover was Commerce Secretary in the early 1920s he worked with private industry and banking groups to encourage home-ownership — although I’m not aware of the details of the plan. My sense is that you probably would have seen something even closer to the libertarian dream-world — especially given that no one in the 1920s or early 1930s could have plausibly believed that the government would back any home loans.

    As far as the impact on the present market goes, it doesn’t take a genius to figure out that the entire housing market would crash even further below current levels. You’d have an entirely new pricing mechanism for the market — something that literally hasn’t existed since the Roaring 20s.

    Since 2008 something like 97 percent of the activity for new mortgage activity is going through GSE’s. The remaing 3 percent of the market is likely compromised of non-qualifying non-GSE loans — i.e. JUMBOS with a capital J — meaning mortgages at the very, very top of the mortgage market for highly qualified borrowers ($725K and above in the top markets).

    So the net result of pulling government backing over the next year or two or three would be that most home sales would be done via cash — no bank is likely to extend loans in an environment where home prices are rapidly declining in value — especially if banks are going under as well due to the economic harm caused by the new payment structure.

    There would likely be consequences at the very top of the market too as super-qualified borrowers might find that they could get better value in the cash-only market.

    The only people selling under conditions of steep decline would be distressed owners, or the handful of owners with some residual equity, since no owner is likely to want to sell a home for a loss unless she or he needs too.

    The net result would be that you’d have a market dominated by cash-only buyers purchasing foreclosed property combined with those cash buyers who were purchasing homes from people who had some residual equity left over from their home purchase 30 or more years ago and who owned their homes free and clear. There would be little incentive for new construction. So once the remaining inventory cleared . . .

  2. A Young says:

    Mike-
    I’d have to agree with your characterization of a deregulated mortgage market: that it would lead to the poorest homeowners getting fleeced. As for cross-subsidizing the rich, this might happen to a small degree, but I think most of the gains would go straight into mortgage lenders’ pockets. The problem with the “libertarian dream-world” (Franklin’s term) is it ignores both human nature and basic economic principles.

    As far as human nature goes – people aren’t perfect and they’re prone to deception. It’s easy to say “caveat emptor” should be the law of the land, but that’s just not realistic. Anybody’s mind who started to deteriorate from age would immediately become prey to financial predators (to a greater extent than they already are). Meanwhile, such a plan could not coexist with the modern progressive welfare state since when predatory lending inevitably forces people out on the streets, society will be left to foot the bill. Are we really going to let children starve because mommy and daddy didn’t read the fine print?

    It’s not even desirable from a more conservative economic standpoint. Already we live in a world where verbal assurances, unless caught on tape, are worthless. It’s far too easy for a lender to promise one thing, while putting another thing in the contract. Business heavily depends on trust and one of the things that encourages trust is the knowledge that there are laws that protect people from abusive contracts. A world that fosters constant distrust will ultimately be bad for business. Banks would engage in a race to the bottom, until finally, fewer and fewer people would be willing to take out a mortgage. It’s the proverbial deal with the Devil – no matter how sweet his offer sounds, who’s foolish enough to chance it? Even if the importance of preserving one’s business reputation limited the worst abuses, there would still be some equilibrium between the honest broker and the one who used the profits from his deception to fund deceptive advertising.

    Fortunately in this country we still live in a democracy, where every citizen has one voting share in USA Inc.. Like any business, USA Inc. is free to set terms of contracts with any parties that do business with it, and since it enjoys a monopoly on all publicly owned lands and property, it has free reign to demand whatever it wants within its domain. Isn’t that the ultimate libertarian ideal? If you own part of something, you’re entitled to whatever you can get from it? So as long as mortgage lenders want to be able to use public streets (and I here living can get hard when you’re landlocked on a city block with no grocery store), they’ll agree to its terms and like it. And if they don’t – too bad hippies, you should have read the fine print in the social contract.

  3. Pingback: FT Alphaville » Further reading

  4. Cliff says:

    Seems like a lot of speculation. You think the credit card market does not function well?? You realize it has dramatically increased the access of the poor to inexpensive credit? Would you rather they got a payday or title loan, or loan shark loan, or just died?

  5. I think there is an ongoing confusion between the hypothetical “market” or “free market” and a small and shrinking group of politically well-connected “private” firms that enjoy massive government subsidies (JP Morgan Chase, Goldman Sachs, Citigroup, etc.) who selectively expoit “anti-government” and “free market” rhetoric and ideology to further their perceived interests.

    In the absence of Too Big To Fail, aka the “Greenspan put”, would a hypothetical deregulated “free market” have produced the current financial disaster? Would a sub-prime mortgage market have developed at all or in the disastrous form of the 00s? Who knows? TBTF is hardly new. It was clearly visible in the Long Term Capital Markets (LTCM) bailout, other financial policies of the Clinton years, and of course the Savings and Loan “deregulation” fiasco of the 1980’s.

    Why did JP Morgan Chase, Goldman Sachs, Citigroup, and the others take onto their own books hundreds of billions, probably trillions of dollars, in mortgage backed securities backed by housing bubble loans? Probably because they correctly believed that they could offload the cost of the housing collapse on the federal government and the taxpayer through TARP, favorable “loans” from the Federal Reserve, and a host of other subsidies. Quite possibly, they intended to sell the “privately” originated mortgage backed securities to Fannie Mae and Freddie Mac while publicly attacking Fannie Mae and Freddie Mac. Quit possibly, the plan to dump the bad loans on Fannie Mae and Freddie Mac did not go as planned, resulting in a blatant bailout/subsidy like TARP.

    The paradox is that the United States has developed a dysfunctional economic and political system in which giant politically connected “private” firms that depend on government subsidies utilize aggressive anti-government and “free market” rhetoric to oppose any efforts to rein them in and to lobby for government subsidies that are, with supreme hypocrisy, labeled as “deregulation” or “free market”.

    Sincerely,

    John

  6. carping demon says:

    @Cliff: What’s the real difference between “access…to inexpensive credit” and excess leverage?

  7. MI refi says:

    I don’t think those kind of mortgages lock people into place.
    I think a bad economy with low unemployment rates lock people into place.
    Most people I’ve ever talked to who bought 30 year, fixed rate mortgages, planned to sell their homes after about 5 years. Most people traditionally don’t think of these loans as something that will lock them into place.That said, I never buy a house without being willing to stay in that house forever–in case the housing market crashes and I have no chance to sell or rent it out.

  8. chris says:

    Homebuyers want the right to repay early because it allows them to sell and move if they need to. Therefore, the homebuyers who accept mortgages with no right to repay early are the ones who didn’t have any choice, who were probably getting a raw deal in other respects as well, probably because they weren’t good credit prospects in the first place, and the latter two factors explain the higher default rates.

    I have found that it’s easy to understand modern financial decisions if you don’t start with the assumption that both parties to the transaction are benefiting from it. That is only rarely the case. Ripoffs and transactions in which one party makes a guaranteed profit while the other gambles both seem to be more common than mutually beneficial deals.

    P.S. Maybe you can address something I wondered about early repayment: is it possible to “repay” a mortgage you don’t have a right to repay early by buying an annuity with the same payment schedule and telling the annuity company to send the checks directly to the mortgage company? If so, why don’t people use this trick to avoid prepayment penalties? Would it be more expensive than the actual principal balance of the mortgage?

    If the repayment option, if and when it is exercised, is substantially more favorable than buying an equivalent instrument, then it’s obvious why the borrower would value it ex ante, if they anticipate a substantial probability of needing to exercise it.

  9. chris says:

    Also: in a state of nature, there are no mortgages. When Adam delved and Eve span, who was then the secured lender? Well, nobody. Duh.

    All mortgages depend for their existence on the state’s willingness to enforce not just the loan, but the relationship between loan and collateral. It’s not unreasonable, IMO, for the state to be choosy about which mortgages it is going to put its weight behind in this way.

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