The 30 Year Fixed Rate - Is It Needed?

March 25, 2013

I find the debate over whether the 30 year fixed rate is necessary and whether the private sector could provide it in America to be an interesting one.
On the one hand it could be argued that the fully pre payable 30 year fixed rate loan was not a necessity in looking back historically. There is some truth to that - to be clear - mortgage interest rates have been on a steady decline for over three decades since their peak in 1980.
While clearly home-owner preference for the 30 year mortgage has been high, borrowers would have clearly benefited from an adjustable rate product that would have adjusted naturally downward over the past three decades. In hindsight, borrowers would have avoided all of the expense and time associated with refinancing as mortgage interest rates essentially dropped from their peak of 18% down to about 3.5% at bottom a few short weeks ago.

Yes. their were a few spikes along the way, but these were very short lived and would have been more than offset by the eventual rate declines that followed these infrequent corrections.
So Yes, to those those that argue this point, they are correct - in hindsight. And hindsight is always perfect.
The concern I have is the affect of a mortgage market that is absent the 30 year fixed rate on a forward looking basis where almost absolute certainty calls for interest rate increases.
Lets think about a few variables associated with this climate we currently face.
1. The Spike - Hybrid Arms or Balloon loans have a built in adjustment period where the borrower has to face an interest rate adjustment. We know that the future won't be anything like the past, that there is little hope for further rate declines; after all you can't go below zero. The planning of the rate change at the first adjustment in an ARM or Balloon can be modeled by risk managers. The "spike" is something that ARM investors have long modeled as they had to plan for prepayments, either from default rates or wealthy borrowers who would pay off their loan. The question is, how does a a senior citizen on a fixed income deal with a spike? If a 5 year balloon was at 3.5% on a $300,000 loan and rates rise 2%, their payment would climb $350 per month. If on a fixed income, this could cause defaults to those individuals. The point is non fixed rate mortgages pose significant default risks to borrowers in a rising rate scenario - we just haven't experienced that.....yet.
2. Compensating factors - One thing we know is that the largest segment of home-ownership demand over the next decade will come from first time buyers. The borrowers will have low down-payments. Layering risks of low down-payment mortgages combined with a shorter term mortgage that will have a spike, leaves little cushion for the borrower. I'm not passing judgement here on whether lower home-ownership rates are good or bad, but the impact to home-ownership rates could be implicated as a result of the higher risk of these combined effects.
3. TBA - The 30 year fixed rate predominance is largely the result of the ability of the GSE's (Freddie and Fannie) and GNMA to make a market, hedge basis risk forward, and drive enough liquidity to provide this nation with the 30 year mortgage. In the United Kingdom, as a comparison, there is no 30 year mortgage. The vast majority of mortgages are 5 year balloon loans that require larger down-payments. "Generation Rent" is the outcry in England as the home-ownership rate has been dropping and access has become a huge concern. Those that would completely eliminate government support for housing should look at the UK as a model for what the market in the US could look like.
4. Private Sector Role - One thing we have learned in history is that the banking industry is not good at long rate mortgages. Lending long and borrowing short has created enormous issues for the banking sector, once having been the fuel for the savings and loan crisis of a few decades ago that cost the taxpayer hundreds of billions of dollars in bailout funds. We should not expect to see a viable, functioning 30 year market without some formal support.

Look, I'm not advocating to keep Fannie and Freddie in their current state, I have spent a lot of time working with others on ideas to transition them and yet consider the need for liquidity in the mortgage markets. I am saying that I don't think anyone can forecast how important the fixed rate mortgage will be in the years ahead as rates move in the opposite direction from where they came and perhaps expose our nations housing market and millions of Americans to a very serious set of challenges that could have their own systemic impacts.
Getting this right, in a balanced way, will be critically important as we move forward.
Photo credit: Supri Suharjoto / Shutterstock

Posted by: