Marc Rubinstein has written a short piece on his “Net Interest blog” outlining some of the mysteries of the the 30-year fixed-rate fully prepayable mortgage that finances the majority of home purchases in America. Rubinstein draws on Bethany McLean (Shaky Ground: The Strange Saga of the US Mortgage Giants) and Sarah Quinn (Government Policy, Housing, and the Origins of Securitization, 1780 – 1968) as well as his own experience as an investor in Fannie Mae and Freddie Mac junior preferreds (2011 – 2019).
This short extract will give you a flavour of of the piece but I recommend reading it in full
From the consumer’s perspective, it’s an amazing product. It’s a simple loan that offers stable repayments, kept low because they are spread out over such a long period of time. Its kicker is a free option to prepay, which shields the borrower from interest rate risk. If rates go up, borrowers can commend themselves on a great bargain; if they go down, stay calm—the loan can be refinanced without penalty. Win/win.
All the characteristics that make it terrific for the consumer make it terrible for a traditional lender. Thirty years is a long time to have something sitting on your balance sheet, watching the credit risk compound. Especially something that’s loaded with as much interest rate risk as this. If it’s win/win for the consumer, somebody has to be on the other side of that trade.
Sustaining such a one-sided design clearly requires work. An entire ecosystem of complex financial instruments provides one layer of support. But underneath that sits another: the US government, which now controls two-thirds of the market. By removing the credit risk and dispersing the interest rate risk inherent in long-term fixed-rate mortgages, the US government gives them life. As Bethany McLean says, they “accomplished something that Rumpelstiltskin would envy. They took the worst possible investment – a 30-year fixed-rate fully prepayable mortgage – and turned it into the second most liquid instrument in the world, just behind Treasuries.”
To many, the idea that the US, a beacon of the free market, should support its mortgage market so directly seems odd. The former Governor of the Bank of England, Mervyn King, once remarked: “You Americans are so strange. Most countries have socialised healthcare and a private market in mortgages. You have socialised mortgages and a private market in healthcare.”
Tony – From the Outside
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