Don't Mourn the 30-Year FRM

Discussions of housing finance give a shining religious aura to 30-year fixed-rate mortgages. They are the last refuge of the defenders of Fannie Mae and Freddie Mac, who argue that we have to have government guarantees so we can have 30-year FRMs. First, this argument is wrong. Second, the 30-year FRM is not the unmitigated blessing the Fannie and Freddie loyalists imply. Indeed, it is a big reason U.S. mortgage markets are in such bad shape.

No instrument is universally good in all times and economic situations. Let us consider not only the advantages, but also the dark side of the 30-year FRM. For borrowers of 30-year FRMs, the advantageous situation is when interest rates and house prices alike are rising. Then borrowers have the same mortgage payments despite rising interest rates, and get to keep the whole inflationary premium in the house price.

But suppose interest rates fall to very low levels and house prices also fall. This is the reality of the last few years. The borrowers often cannot refinance because of the fall in house prices, so they are stuck with a very high nominal and even higher real interest rate, and their payments stay the same despite falling interest rates. The entire deflationary discount in the house price is imposed on them. Defaults rise; house prices are pushed further down. In this situation, it becomes quite difficult to modify the 30-year FRMs that cannot be refinanced, as the many government modification programs have demonstrated. In contrast, a floating-rate mortgage, say of the typical British variety, does not need to be modified-the interest rate automatically falls with market rates. This relieves the cash payment burden on the borrowers and shares the deflationary discount with the lenders.

Of course, American mortgage borrowers and lenders did not expect house price deflation and interest rates near zero, but they got them anyway, in large part because they believed in house price inflation. No loan is the best for all seasons, alas.

Alex J. Pollock is a resident fellow at AEI.

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About the Author

 

Alex J.
Pollock
  • Alex J. Pollock is a resident fellow at the American Enterprise Institute (AEI), where he studies and writes about housing finance; government-sponsored enterprises, including Fannie Mae, Freddie Mac, and the Federal Home Loan Banks; retirement finance; and banking and central banks. He also works on corporate governance and accounting standards issues.


    Pollock has had a 35-year career in banking and was president and CEO of the Federal Home Loan Bank of Chicago for more than 12 years immediately before joining AEI. A prolific writer, he has written numerous articles on financial systems and is the author of the book “Boom and Bust: Financial Cycles and Human Prosperity” (AEI Press, 2011). He has also created a one-page mortgage form to help borrowers understand their mortgage obligations.


    The lead director of CME Group, Pollock is also a director of the Great Lakes Higher Education Corporation and the chairman of the board of the Great Books Foundation. He is a past president of the International Union for Housing Finance.


    He has an M.P.A. in international relations from Princeton University, an M.A. in philosophy from the University of Chicago, and a B.A. from Williams College.


  • Phone: 202.862.7190
    Email: apollock@aei.org
  • Assistant Info

    Name: Emily Rapp
    Phone: (202) 419-5212
    Email: emily.rapp@aei.org

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