Why an Interest Rate Freeze won't solve the Subprime Problem

I. Freezing interest rates on Adjustable Rate Mortgages would have little impact on the current mortgage crisis.

As I noted in a previous post, a recent paper by Federal Reserve Bank of Boston economists Kristopher Gerardi, Adam Hale Shapiro, and Paul S. Willen take a careful look at the characteristics of 2-28 ARM mortgages. Among its findings are that interest rate resets have little if anything to do with the large number of defaults we are observing. For the vast majority of subprime loans, defaults or refinances happen before resets take place. Moreover, the size of the resets is smaller than most of us think, because the initial teaser rates are pretty high. Also, because the Federal Reserve Board has cut interest rates so aggressively, reset rates will not be as high as people have feared.

The authors also note that while ARMs have higher default rates than FRMs, putting ARM borrowers into FRMs (which is what a freeze would effectively do) will not necessarily reduce defaults. The difference in default performance between the two instruments may reveal more about the borrowers than the instruments themselves. ARM borrowers by their very nature are more prone to risk-taking that FRM borrowers.

Finally, some of the most potentially explosive mortgage products, such as Option-ARMS, have negative amortization features—that is, borrowers actually accrue interest, so their mortgage balance rises each month for awhile. These features produce default incentives independent of changes in interest rates; an interest rate freeze will not help home borrowers who are under water because early payments did not pay for all interest due.

II. Freezing Rates on all Adjustable Rate Mortgages could reduce the availability of mortgage credit in the future.

Sometimes in the search to find the source of a tragedy, people try to settle on a villain. There have been lots of villains to go around in the sub-prime tragedy: unscrupulous brokers, speculative borrowers and lax rating agencies among them. But to the extent that investors in mortgages are villains, they are already being punished pretty severely, as they have taken on billions upon billions of dollars of losses.

It is therefore not surprising that investors—some of whom include the pension funds that provide the retirement incomes for schoolteachers and firefighters—are being frightened away from mortgages. The upshot is that the subprime market has nearly vanished for the time being, and mortgage credit more generally has become more expensive and scarce in high cost areas such as the coasts.

In light of this, policy responses that add to the perceived risk of investing in mortgages—including safe mortgages – would be counter-productive. A policy whereby the government freezes interest rates is a policy in which the government changes the terms of contracts, and thereby adds both to the perceived and real risk of investing in mortgages. This will make it harder and more expensive for borrowers to obtain mortgage credit, and could spill over to the point where it becomes more difficult for all entities in the US—including the U.S. Government—to borrow.

Other countries around the globe, such as India and Korea, have experimented with major government intervention in the enforcement of mortgage terms. These have produced stunted mortgage markets. We need to remember that the United States had until quite recently the most robust mortgage market in the world. We also need to remember that the adjustable rate mortgage saved the mortgage market in the 1980s, when macroeconomic conditions were unstable. Had it not been for the adjustable rate mortgage (along with investor confidence that those mortgage rates could reset with the market), housing conditions in the US in the 1980s would have been far worse.

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