Imagining Life After the 30-Year Fixed Rate Mortgage

Homeownership is the heart of the American domestic experience. But with 5 million homeowners pushed out of their homes since the current economic crisis began, it is time to re-evaluate how we are making that happen.
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Sometime over the past few generations, the government-backed 30-year fixed-rate mortgage became enshrined as a sacred piece of Americana, as fixed a national good in our imaginations as home runs and Motown. What's curious is why it remains so beloved despite the economic scandals in which its repeatedly been implicated.

These mortgages had charmed homeowners by providing them with steady payments even as interest rates and housing prices rose. But they proved damningly inflexible when both housing prices and interest rates fell, as they have the past few years. Borrowers found themselves unable to refinance, and their payments remained high as interest rates fell, leading to trouble for both payer and payee.

To be sure, irresponsible lenders and borrowers created the conditions in which these mortgages no longer worked to our advantage. But having experienced their downside, we should now be questioning whether it's in the national interest to continue propping up the institutions that make a pro-borrower, anti-lender loan possible, particularly when the lender is the American people.

Is the 30-year fixed-rate mortgage, as economist Alan Kling recently wrote, "an artifact of government intervention," without which "we would have a simpler, safer mortgage finance system"?

In February, the Obama administration released a paper outlining three possible strategies for housing finance reform. One of the strategies -- the first, in fact -- imagined a largely privatized system of home financing with the government providing support only for low- and moderate-income housing. A central part of this strategy would be a gradual government divestment in Fannie Mae and Freddie Mac.

The American Enterprise Institute took a close look at this option, and in March released a paper imagining such a mortgage market. AEI's conclusion is that a system in which the government backs as few mortgages as possible would be an altogether healthier, more stable system than the one we have now, resulting in higher rates of homeownership, fewer disclosures and healthier banks.

The problem with government guarantees is that they "eliminate an essential element of market discipline -- the risk aversion of investors," the report says. Government backed-mortgages invite risky investments because investors know their money is guaranteed, even when it shouldn't be. The result is the deterioration of underwriting standards, which inevitably leads to an economic day of reckoning for taxpayers.

The rationale for government-backed mortgages is that they promote home ownership. By making more mortgages attractive to investors, more aspiring homeowners will be able to get their loans. But as the AEI report points out, "high-quality mortgages are good investments and have a long history of minimal losses."

Not only is government backing not needed to make the mortgage market attractive to investors, it weakens it by propping up bad investments.

By moving mortgages off the books of government-backed entities like Fannie and Freddie, we encourage more small banks to pick them up, giving everyone -- borrower and lender alike -- more skin in the game. Small banks are less likely to give loans to people who shouldn't get them, and more likely to work with struggling borrowers to pay off their loans. Homeowners will also be required to put more money down and pay off their mortgages faster, making them more invested in their own homes and less likely to walk away from a bad deal.

The fact is that "no other developed country provides anything that approaches the support for housing provided by the US government," as the AEI report says. One might expect that, as a result, the U.S. mortgage market might perform better than those of other countries. But in 2008, the U.S. would only have ranked 9th among Western countries for rate of owner occupancy (67.8 percent, just above Finland but well below Spain, Belgium and Iceland).

Much more common around the world is the more flexible five-year adjustable rate mortgage, or an effective facsimile. Such is the case in Canada, where the government provides no backing for mortgages. Those who preach against the demise of the 30-year-fixed rate mortgage need only look north to see how a country fares without it: When America's housing market has faltered -- both in the 1980s thanks to the S&L scandals and in our more recent downturn -- Canada has remained steady. In 1985, nearly 3,000 American banks failed, but only two Canadian ones went out of business (the first such failures since 1923). Two hundred American banks have failed since early 2008, whereas not a single Canadian bank has.

Homeownership is, and will remain, the heart of the American domestic experience. But with 5 million homeowners pushed out of their homes since the current economic crisis began, and 13 million more expected to be forced out by 2015 it is time to re-evaluate how we are making that happen. Taxpayers have twice had to bail out elements of the government-backed housing system in the past 20 years: the S&Ls in the 1980s and Fannie and Freddie just a few years ago.

Any serious examination of the U.S. mortgage market can't help but arrive at the same conclusion: it often succeeds in spite of the government's intervention, but rarely because of it.

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