The mortgage subsidy

Freddie Mac and Fannie Mae are limited to purchasing loans of a certain size, called conforming loans.  Larger loans are called "jumbo" mortgages.  Traditionally, the spread between the interest rates on jumbo loans and conforming loans was about one quarter of one percentage point.  Lately, it has been well over one percentage point.

The standard view is that the wide spread demonstrates market failure in the mortgage market. That is, the private sector cannot provide mortgage funds nearly as efficiently as the two government-sponsored enterprises.

I think that the opposite is the case.  The failure is on the part of Fannie and Freddie to set mortgage rates that are high enough to cover the likely cost of funding them.  People who take out mortgages today can be winners.  The losers will be taxpayers, who, if my thinking is correct, will pay a huge price down the road.

Suppose that over the next thirty years, interest rates average seven percent.  For example, we might have four percent inflation plus three percent of required real return.  In fact, given the crazy Federal budget, both of those figures could end up higher.

If you can borrow at five percent for thirty years (and people are getting mortgages at that rate and even lower these days) and lend at seven percent, you will make a nice profit on the transaction.  The loser will be the holder of the mortgage, which means Freddie or Fannie, which means us as taxpayers.

My wife and I have owned our house free and clear for about twenty years.  But I think we probably should take out a conforming mortgage and invest the proceeds in a municipal bond that matures in 2011.  It looks as though on an after-tax basis we would come out pretty close to break-even over those two years.  At that point, we can re-assess.  If it looks like I am wrong about the outlook for interest rates and inflation, and rates are still at five percent or less and likely to remain so, then we will unwind our position (use the proceeds of the bond to pay off the mortgage).  On the other hand, if I am right and interest rates are headed up in 2011, we can take the proceeds from the maturing bond and invest them in some nice high-yielding instrument.  If nothing else, this strategy can give me some income with which to pay off the taxes that the government is going to make me pay to cover the cost of the subsidized mortgages that Freddie and Fannie are issuing today.