Housing finance in other countries

In testimony before a House committee, Mike Lea writes,

The standard mortgage instrument in other countries differs significantly from the US FRM. The standard product in Canada, Germany and many other European countries is a short to medium term fixed rate mortgage sometimes referred to as a rollover. The rate is fixed for a 1 to 5 year period (up to 10 years in Canada and Germany) after which the rate is reset at the current market interest rate. The loans have amortization terms of 25-30 years. The borrower can select the same or a different fixed rate term at reset. This feature allows borrowers some protection against potential interest rate shocks (e.g., if the reset rate is high and the borrower expects it to fall she can select a one year fixed rate term; conversely if she believes rates are low and likely to rise she can opt for a 5 or 10 year fixed rate term). There is a prepayment penalty during the fixed rate period (a yield maintenance penalty that removes the financial incentive for refinance).

…Mortgage loans are recourse obligations in all of the countries surveyed and default rates have been and are significantly less than in the US. With recourse lenders have the right to pursue deficiency judgments against borrowers providing a significant deterrent to mortgage default.

If you are at all interested in the subject, read the whole thing.

If we want a housing finance system that is as safe as that of, say, Canada, then we need to evolve away from the 30-year fixed-rate mortgage. But if you take the 30-year fixed-rate, no-recourse mortgage as a given, then my line is that our current housing finance system is about as safe as we are going to get.

Back when they were planning these hearings, they solicited my testimony. They ended up not soliciting it for the actual hearing. I am not complaining, because I don’t glory in giving this sort of testimony. But below is what I wrote.

In my testimony today, I wish to emphasize two points.

First, the housing finance system currently operates about as well as we could hope, given the tension that exists between important policy objectives. Later in this testimony, I will suggest minor tweaks to the current system, but I caution against grand attempts to redesign or re-engineer housing finance.

Second, the biggest problem in housing markets in the United States today is that in several major cities house prices are very high relative to salaries for typical middle-class jobs. This housing affordability problem is caused primarily by local supply-side constraints, and subsidized mortgage lending does more to exacerbate this problem than to alleviate it.

Housing finance must find a way to balance two important policy objectives. One objective is to try to minimize the exposure of taxpayers to the risk of having to bail out housing lenders, as happened in the 1980s with the S&L Crisis and more recently with the financial crisis of 2008. A second objective is to preserve the 30-year fixed-rate loan as the main instrument for home purchases, especially for first time home buyers. These objectives are in tension with one another, because the private sector cannot supply sufficient capital to bear all of the risks of the 30-year fixed-rate mortgage in high volume at a reasonable cost.

Given the challenge in balancing these two objectives, the current system works about as well as one could hope. With the backing of the Federal government, agencies like Freddie Mac and Fannie Mae can keep the market supplied with adequate capital to provide 30-year fixed-rate mortgages. At the same time, by using securitization and credit risk transfers, the agencies off-load the greatest proportion of risk to private entities.

Securitization means that the agencies do not directly fund the mortgages that they buy. Instead, they sell the cash flows from mortgages to private investors, in the form of securities. This insulates taxpayers from interest-rate risk.

The market for mortgage securities works because private investors are insulated from the risk of mortgage defaults. Instead, the agencies guarantee security investors that they will receive their full principal even if the underlying mortgages default.

In 2008, it turned out that Freddie Mac and Fannie Mae had taken on too much of this mortgage default risk, and taxpayers were forced to bail them out. That was when the Treasury took those entities into conservatorship.

To avoid a repeat of that debacle, the Federal Housing Finance Administration has encouraged the agencies to undertake credit risk transfers, which off-load much of the risk of mortgage defaults to private entities. This program, initiated shortly before Congressman Mel Watt took on the role of head of the agency but greatly expanded during his tenure, would appear to provide taxpayers with substantial protection against having to bail out Freddie Mac and Fannie Mae. Assuming that the private entities that take on mortgage default risk do not themselves require bailouts in the event of an adverse swing in housing markets, this would mean that credit risk transfers have successfully insulated taxpayers from default risk.

As a result, we have arrived at a housing finance system that, while not perfect, is much better at meeting the major policy objectives than any system that preceded it. The thirty-year fixed-rate mortgage is alive and well, and most of the risk has been off-loaded from taxpayers to private entities.

Today, the United States faces a major housing affordability problem, but the issues are local and on the supply side. Historically, housing has been affordable when the median house price is about 4 times the median income. In some cities, such as San Francisco, the ratio is more than double that. The cities with major affordability problems are all cities where development is held back by a long and difficult process of obtaining permits to build. As a result, supply is limited. With limited supply, subsidized mortgage credit simply serves to drive away middle-class home buyers. The loan amounts required to purchase a house are so high that only upper-income borrowers are able to qualify. In short, for today’s affordability challenges, government subsidized loans may contribute more to the problem than to the solution.

To improve the current finance system, I would recommend the following changes.

1. Federally subsidized lending for single-family homes should go only to owner-occupants. Investor loans should not receive Federal subsidies. There is research that suggests that the boom and bust of a decade ago was caused more by affluent non-owner-occupant housing speculators than by sub-prime borrowers.

2. The status of Freddie Mac and Fannie Mae as government agencies ought to be clarified. Some resolution needs to be made with the holders of the common and preferred stock of those enterprises. In my view, those holders have contributed nothing to the health of the companies, which depended entirely on the taxpayers giving the entities the ability to use the government’s credit rating for borrowing.

3. The mortgage purchase/guarantee programs of Freddie Mac and Fannie Mae ought to be consolidated into a single program. Currently, they have slightly different pricing and credit policies, and this could open gaps for unscrupulous mortgage lenders to game the system. Eventually, it might make sense to combine the two companies operationally, although this would be more difficult. Ideally, all of the government’s mortgage guarantee channels, including FHA and the Federal Home Loan banks, would have a unified structure of pricing and credit policy.

4. Aid to first-time home buyers should be oriented less toward providing loans with low down payments and more toward assisting borrowers with saving for down payments.

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7 Responses to Housing finance in other countries

  1. Nick Rowe says:

    Canadian mortgages come in two types: “open” and “closed” (most are closed). We would call the US “30-year fixed rate” mortgage an “open” mortgage. It’s not really a fixed rate mortgage at all. It’s a one-way bet that rates will fall. It looks very strange to us. Why would (presumably) risk-averse home-owners and banks take a side-bet on the direction of rates?

  2. collin says:

    I still don’t see how supply side

    1) These are local issues where long time landowners tend to dominate local government.

    2) What most citizens don’t like on the supply is not primarily home prices, but “More Traffic” Living in SoCal where building is occurring, the main thing I hear complaints about is the freeway on- & off- ramp traffic. (It is bad) How do you fix this? You could increase taxes but that tends to fall on current homeowners.

    3) TBH, I still don’t see changing permits is going to transfer a coastal hot housing market. You may lower prices ~10%. There is not a lot of open land and a significant high rise apartment would need numerous current homeowners to sell.

  3. ColoComment says:

    Ignorant question here:
    Why 30 years? What’s the history of that mortgage loan period & why is it still the preferred length of a home loan in the U.S.? What am I not understanding?
    Our society is far more mobile that it’s ever been (except maybe during the settlement of the West, and maybe post-WW II?) With the typical mortgage loan amortization schedule, the interest is front-loaded on the first 1/2 of the 30 year schedule. So if a homeowner stays in one home for up to 15 years*, is he not, from a practical perspective, in a sense overpaying the interest cost for the privilege of obtaining a 15-year home loan? I know that some [many?] have refinanced into 15-year loans, now that they can afford them with the current lower interest rates. So, why not make 15 years the “preferred” lifespan of a home loan?
    Obviously, if the majority of home loans were [gradually?] reduced to 15 years, it would affect home prices, affordability, etc., but over time would it not make more sense? Note: I also understand that’s not taking into consideration any changes in tax deductibility of home loan interest….
    If I’m being stupid, please don’t hesitate to point that out — my ego can take it…. :-)
    * http://www.chicagotribune.com/business/ct-remodeling-booms-as-homeowners-wont-move-0827-biz-20170823-story.html

    • RohanV says:

      Why 30 years? What’s the history of that mortgage loan period & why is it still the preferred length of a home loan in the U.S.? What am I not understanding?

      My guess would be that it coincides with the remainder of your working life. Buy a house at ~30, have it paid off at ~60, retire a few years later.

      As for why delay so long, maybe your income is lower when you’re young, so it’s harder to afford a large mortgage payment. The magnitude of the monthly payment is more constraining than the total cost.

    • mike shupp says:

      There’s nothing particularly sacred about the fixed rate 30-year American mortgage; it just happens to be something that works. Once upon a time, in the idyllic 1920’s, there was no Fanny Mae, no Ginny Mae, no long term & small down payment scheme in America. We had short term purchase plans for housing — typically something like five year loans, with interest-only payments, and a balloon payment at the end which repaid the loan and thus completed the purchase.

      After 1929, this didn’t work so well. FDR’s people decided some alternative scheme was desirable to keep people in their houses and revive the construction industry, resulting — eventually — in the small down, long term mixed interest-and-principal payment system enabled by thousands of smallish savings-and-loan institutions and backstopped by FNMA and GNMA and FHLMC.

      I won’t do a song and dance about the splendors of a government program on this website; I’ll just note this one worked reasonably well for about sixty or seventy years, and made the USA the leader in percentages of owner-occupied housing for a long time — maybe still, most likely. That used to be seen as desirable.

      Anyhow. The standard 30-year term was something that worked, that allowed some reasonable rate of equity buildup along with interest payments; the fixed rate was just something that simplified calculations for lenders and appeared to reduce risk, so it was desirable for psychological purposes in the pre-computer age. You could then, as today, have looked about for other loan terms — 15 year fixed rate, 20 year, 25 year, mixed fixed and variable rate mortgages, etc. — but they weren’t government backed because it was never the government’s intent to monopolize the housing industry.

  4. EMichael says:

    They should have let you testify, your suggestions are great. The only one I question(not that I am totally against it) is #4. I don’t see the difference really.

    One big omission I see is in the discussion of how the GSEs can avoid “a repeat of that debacle “. While credit risk transfers are certainly viable, this is ignoring what actually caused the debacle, the lack of accountability by the originators of mortgages.

    An ounce of prevention is worth a pound of cure. Make it easier for the GSEs to force buybacks of mortgages on the originators that violate the reps and warranties the originators guaranteed. Then the amount of cure, like credit risk transfers, would be held to a minimum.

    At the FCIC hearing, Richard Bowen of Citi testified that more than half of the mortgages Citi sold contained violations of their reps and warranties.

    http://fcic-static.law.stanford.edu/cdn_media/fcic-testimony/2010-0407-Bowen.pdf

    I would not want to bet that Citi was an outlier in this practice.

    Make it clear that this widespread fraud will result in buybacks and you will take an awful lot of risk out of the mortgage market.

  5. GU says:

    Low down payments (or more accurately, the ability to qualify for a mortgage with a low down payment) drive prices way up. Mandate at least 15% or 20% down payments to get a mortgage and prices will be more in line with reality. In libertarian paradise, I’d never advocate for a policy like this. But here in the real world, this is paternalism I can get behind.

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