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Those who seek a continued government role in housing finance frequently contend that the 30-year fixed-rate mortgage will not be available without a government guarantee. On its face, this is not true, since anyone can go to the Internet and find lenders offering jumbo fixed-rate thirty-year loans which, by definition, have no government backing.
It is true that a 30-year fixed-rate mortgage is somewhat more expensive than a government-backed 30-year, since the lender is taking a longer-term risk on interest rates, but the lower cost of the government mortgage simply means that the taxpayers–as well as all other mortgage borrowers who are not taking thirty-year fixed-rate mortgages–are providing a subsidy (in the form of government guarantees and eventual taxpayer bailouts) to the person who wants a government-backed mortgage with these terms.
Given two spectacular failures of U.S. housing finance tied to the thirty year fixed rate mortgage in the last 20 years, and the attendant cost to taxpayers of two massive bailouts, the housing industry should be required to show why it needs government support again.
History has shown–and simple economics would anticipate–that a government subsidy for a freely prepayable 30-year fixed-rate mortgage is not good policy. This subsidy causes most borrowers to choose the 30-year fixed-rate loan, since in general it offers a fixed low monthly payment with a government-subsidized free prepayment option.
Supporters point to the apparent stability it provides to borrowers. This stability is akin to the eye of a hurricane. In fact:
Thus, the freely pre-payable 30-year fixed rate loan is neither a stabilizing factor nor free.
No proponent of government guarantees has ever explained why the taxpayers and other mortgage borrowers should be subsidizing this particular type of mortgage. For homeowners who want a thirty-year fixed-rate loan, it is available at a slightly higher cost without the risk of a taxpayer bailout.
What would happen if the private housing finance market operated without a government guarantee? Treasury Secretary Geithner recently testified that under any of the three options recently outlined in his report to Congress, mortgage rates might go up a moderate amount. Under a privatized housing finance market operating without a government guarantee, borrowers would have a variety of solidly underwritten loan choices–including both prepayable and loans prepayable upon payment of modest fees during the first few years. What the interest rates would actually be depends, of course, on monetary and fiscal policy in the United States.
In the list below, I use the 6 percent jumbo fixed-rate mortgage as a benchmark to estimate the range of probable rates for a series of mortgages with different characteristics that would be available in a nongovernment market. The administration has proposed that Fannie and Freddie be stripped of their unfair pricing advantages over the private market. Once this is done, the difference between a Fannie rate subsidized by the government and a market rate will be quite modest.
Some borrowers would select a thirty-year fixed-rate freely prepayable loan at an interest rate of 6 percent, with others selecting a different option based on their needs and cost. These options offer a lower rate for a shorter maturity and/or a lower rate if borrowers choose a loan with a prepayment fee:
6.00% 30-year fixed-rate term with no prepayment fee
5.625% 30-year fixed-rate term with a 3%-2%-1% prepayment fee
5.375% 30-year amortization with fifteen-year fixed-rate term and a 3%-2%-1% prepayment fee
5.375% 15-year fixed-rate term with no prepayment fee
5.125% 15-year fixed-rate term with a 3%-2%-1% prepayment fee
5.00% 7-year ARM with 30-year amortization underwritten at fully indexed 7-year rate with no prepayment fee
4.75% 7-year ARM with 30-year amortization underwritten at fully indexed 7-year rate with a 3%-2%-1% prepayment fee
Given the demonstrated instability caused by the widespread availability of the freely prepayable mortgage, proponents cannot possibly justify putting the taxpayers at risk a third time.
Edward Pinto is a resident fellow at AEI.
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