The Death of the 30-Year Mortgage?

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.

That makes the question a little clearer: can the private market bear default risk on its own? Of course it can. It just needs to ensure that this risk is kept in check.

Default risk could be minimized in a few ways. First, more prudent underwriting requirements should be sought. How conservative must they be? We don't have to get too crazy. Other than in the recent housing bubble, home prices had never fallen by more than 15% nationwide since the Great Depression, and that includes during the high unemployment recession in the early 1980s. Underwriting requirements weren't crazy conservative prior the bubble either. Since 1965 through the mid-1990s, the home ownership rate was steady between 63% and 65%, and only peaked at 69% during the housing bubble. It's back down to around 67% today. So step one would be to fix mortgage underwriting.

Second, down payments must return. As long as housing prices are stable -- and not growing at bubble pace -- then large home price drops should not follow. That means even 10% down payments could be enough in many cases to avoid big losses. But 20% down payments would almost certainly do the trick. As just mentioned, other than in the past decade, when a gigantic bubble formed, home prices had never declined by more than 15%. So a down payment of that size would easily insulate lenders, if their underwriting requirements are more conservative than they were during the recent boom.

For borrowers who could not afford 15% or 20%, another common option that used to be utilized with smaller down payment was private mortgage insurance. Some private mortgage insurers ran into trouble during the housing bust -- for the same reason that everyone else got into trouble. But if these firms are more carefully regulated and take countercyclical measures, then they should be more stable.

History has shown us that the loss rates on prime mortgages are generally quite low over time. Things only change when the lenders get carried away. And in the past decade that was due in part to banks and investors having little fear of default risk, precisely because they knew that the government was standing behind most mortgages. Without guarantees, the market should act more prudently, because moral hazard will be reduced. Returning to more reasonable underwriting practices, like those used prior to the bubble, should allow banks to take on mortgage default risk without drastically changing how the mortgage market looks.

And that should mean keeping 30-year, fixed rate mortgages around. If there's strong consumer demand for a product, then the market will find a way to make it work. The product might look a little different -- with higher down payments and slightly higher interest rates than people got used to over the past decade -- but that's okay. The market will be safer and more stable as a result.