Tag: adjustable rate mortgages

ARMs as Automatic Stabilizers

An argument often heard for keeping Fannie Mae and Freddie Mac, or some sort of subsidy for mortgages, is the desire to keep the 30 year fixed rate mortgage “affordable.” The 30 year fixed certainly has some merits - which borrowers should be willing to pay for - but it also has the downside of reducing the impact of monetary policy in stabilizing the economy.

Generally interest rates go down in a recession and up in an expansion.  Part of this is the reaction of the Federal Reserve, which tends to cut rates in a recession, but part is also the fact that the demand for credit also declines in a recession and increases in an expansion.

If borrowers moved to adjustable rate mortgages, then in recessions they would likely see a reduction in their mortgage rate, resulting in a reduction in their monthly payment, which would increase their disposable income, which itself should have some positive impact on consumption, helping to stabilize a weak economy.

The reverse would work in an expansion.  If the economy became over-heated, interest rates would likely go up, pushing up monthly payments, resulting in reductions in income and consumption.  While of course this would be unpleasant for the borrower, it would have the benefit of moderating a booming economy, reducing the likelihood of inflation and the occurrence of bubbles.

The latter effect would also increase the degree to which consumers care about inflation and demand price stability from the central bank.  Normally, borrowers have an incentive to favor inflation, as it reduces the real value of their debt.  If however, inflation resulted in an increase in their mortgage rate, their preference could switch toward price stability, which would in the long run be better for growth and the overall economy.

While I do not expect the above to settle the debate over the role of the 30 year fixed rate mortgage, we, as a society, should openly and loudly debate its costs and benefits before we simply assume it needs to be subsidized.

Why Mortgage Modifications Aren’t Working

As covered in both today’s Wall Street Journal and Washington Post, the Obama administration has called 25 of the largest mortgage servicing companies to Washington to try to figure out why the Obama efforts to stem foreclosures has been a failure.

The reason such efforts, as well as those of the Bush Administration and the FDIC, have been a failure is that such efforts have grossly misdiagnosed the causes of mortgage defaults.  An implicit assumption behind former Treasury Secretary Paulson’s HOPE NOW, FDIC Chair Sheila Bair’s IndyMac model, and the Obama Administration’s current foreclosure efforts is that the current wave of foreclosures is almost exclusively the result of predatory lending practices and “exploding” adjustable rate mortgages, where large payment shocks upon the rate re-set cause mortgage payment to become “unaffordable.”

The simple truth is that the vast majority of mortgage defaults are being driven by the same factors that have always driven mortgage defaults:  generally a negative equity position on the part of the homeowner coupled with a life event that results in a substantial shock to their income, most often a job loss or reduction in earnings. Until both of these components, negative equity and a negative income shock are addressed, foreclosures will remain at highly elevated levels.

Sadly the Obama Administration is likely to use today’s meeting as simply an excuse to deflect blame from themselves onto “greedy” lenders.  Instead the Administration should be focusing on avenues for increasing employment and getting our economy growing again.  Then of course, this Administration has from the start been more focused on re-distributing wealth rather than creating it, which explains why it views mortgage modifications as simply a game of taking from lenders (in reality investors - like pension funds) and giving to delinquent homeowners.