Monday, October 06, 2008

Jane Albrechtsen says America is dumb for having 30 year fxied rate prepayable mortgages.

In yesterday's Wall Street Journal, she writes:

This is made worse by the fact that traditionally many American mortgages were typically set at a fixed rate for the 25- or 30-year life of the loan and the borrower often has the nifty ability to refinance without penalty. Most Australian mortgages are usually subject to a variable rate of interest. Fixed-rate loans are limited to around five years. So when Australian lenders offer a fixed-rate loan for five years, they fund it by borrowing five-year money. If borrowers want to repay a fixed-rate loan early, sensible economics require that they pay the lender a "break" fee, which compensates the lender for the lost interest the loan would have brought in had it been carried to term.

Prepayment penalties are either prohibited or severely restricted in the U.S. Thus, an American lender who makes a 30-year fixed rate loan that the borrower can prepay at any time without penalty is simply making a bet about the average life of a loan. And while it's true that there are good quality statistics about how long American loans usually last, these are necessarily averages. Averages don't reflect actual experience and are especially misleading when real outcomes are at the extreme. If market interest rates fall below the fixed interest rates, borrowers will simply refinance at lower rates. Another fine deal for borrowers. If market rates rise above the fixed interest rates, borrowers will stand pat. So loans are terminated by borrowers when they are profitable for lenders and loans last longer when they are unprofitable for the banks. Who would want to be an American lender?

American lenders, in one form or another, have been making these loans since the 1930s. The whole idea is that lenders are more expert in managing interest rate risk than households, and that we don't want labor mobility inhibited by prepayment penalties.

But of course, the irony is that fixed rate mortgages are not the problem right now. According to the Mortgage Bankers Association, foreclosures on prime fixed rate mortgages happen at less than one-fifth the rate of foreclosures on prime ARMS; the subprime fixed rate default rate is one-third the ARM default rate. But in the eyes of the editors of the WSJ op-ed page, fixed-rate mortgages have been dangerously good for consumers.


Don Coffin said...

As I recall, Alan Greenspan also puched the "virtues" of ARMs.

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