Is the 30-year, fixed rate mortgage -- so beloved by Americans -- in danger of extinction? That's what banks, investors, and realtors would have you believe. They have been warning that if the government steps back from insuring the mortgage market, the product will vanish. Their deafening chorus has grown so difficult to ignore that a front page article in the New York Times today focused on the potential death of the 30-year, fixed rate mortgage. Is it really in jeopardy, or is this fear mongering by the financial industry?
First of all, why might the 30 year, fixed rate mortgage be in danger? Currently, Washington is considering different ways to reform government housing finance policy. If you don't think it needs to be fixed, then you haven't been paying attention. The poor practices of government-sponsored enterprises Fannie Mae and Freddie Mac caused their collapse. Facing a catastrophic economic event if they failed, the government stepped in and rescued these firms, resulting in a loss of $150 billion and counting for taxpayers.
Lately, the big question has been: how significant an influence should the government have? Possible solutions were framed last month when the Treasury released a paper on policy alternatives. They range from government helping only a small portion of lower- to middle-income Americans achieve home ownership with its backing to providing a catastrophic backstop for all mortgages after banks or investors take a first loss. Republicans, who now control the House, appear to favor less government involvement. The Obama administration hasn't taken a clear side yet, but it will likely be more open to government intervention.
But it's the Republican view that scares the financial industry. Naturally, they want the government to stand behind mortgages, because then banks and investors don't have to worry about losses. The question, of course, is whether such support is actually necessary to preserve a healthy mortgage market, or if it's just something the industry would strongly prefer to allow it to continue to take excessive risk at the taxpayer's expense. To be sure, banks, investors, and lenders have a strong motivation to want the government to stay involved, even if the 30-year, fixed rate mortgage could survive without federal guarantees.
To determine the whether heavy government involvement is really necessary, it helps to understand what a federal guarantee does and does not do. It would pay whoever owns the mortgage (an investor or bank) principal and interest payments if a borrower defaults. In other words, it covers default risk. The insurance would not pay banks and investors higher interest if rates begin to climb -- so it does not help with interest rate risk. In fact, a government guarantee would not help make a 30-year mortgage any more attractive than a 20-year mortgage, assuming each has a similar down payment. So we can push interest rate risk aside for now.