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Let’s Do The Time Warp Again; Advocates of a 4.5% Mortgage Rate Must Have Come From Another Time And Place

When I hear peo­ple talk about the gov­ern­ment essen­tially man­dat­ing that banks and Fred­die Mac and Fan­nie Mae orig­i­nate 4.5% 30 year fixed mort­gages I think of the Rocky Hor­ror Pic­ture Show and The Time Warp. Mem­bers of Con­gress and econ­o­mists who are push­ing under­priced mort­gages must be from another time and place oth­er­wise they couldn’t seri­ously advo­cate this really dumb idea. I admit that 4.5% mort­gages make for good pop­ulist TV news “sound bites”, and 4.5% mort­gages will def­i­nitely stim­u­late hous­ing, but hyper low inter­est rate mort­gages will sooner or later kill off what­ever is left of the bank­ing, mort­gage bank­ing and finan­cial ser­vices sec­tors. And, that makes 4.5% mort­gages a bad idea.

Pro­po­nents of a 4.5% mort­gage inter­est rate either don’t know or don’t care that their solu­tion will destroy any finan­cial insti­tu­tion or investor that actu­ally agrees to hold these newly orig­i­nated assets. Dis­as­ter will strike when inter­est rates rise from their cur­rent lev­els and cause a cat­a­strophic drop in the value of these mort­gages. Essen­tially, if the politi­cians and econ­o­mists get their way, banks and other lenders that agree to own mort­gages with a 4.5% fixed inter­est rate will have the gov­ern­ment telling them what yield they should earn on their assets while the mar­ket sets the inter­est rate on their lia­bil­i­ties. It won’t be long before their lia­bil­i­ties reset and cost more than the yield on their assets. This “mis­match” can’t be hedged and, in cer­tain inter­est rate envi­ron­ments, can cause vir­tu­ally a 100% loss of value of 4.5% mortgages.

As it turns out, there is his­tor­i­cal prece­dent for what hap­pens when mort­gage yields are very low in a ris­ing inter­est rate envi­ron­ment, and the prece­dent isn’t good. It’s hard to believe that econ­o­mists and politi­cians don’t remem­ber what hap­pened to banks and thrifts dur­ing the 1970’s and 1980’s when the cost of their deposits rose but yields on their assets were stuck at low lev­els. As Vol­cker raised inter­est rates, deposit yields and other bor­row­ings costs went up. But, own­ers of low rate mort­gages were stuck with them and lost their shirts. Volcker’s high inter­est rates were like spray­ing bug killer on the sec­tor, banks and thrifts dropped like flies as losses mounted.

Even more shock­ing, some “experts” are actu­ally sug­gest­ing that if the cur­rent mort­gage mar­ket was nor­mally func­tion­ing it would vol­un­tar­ily orig­i­nate 4.5% fixed rate mort­gages. These pun­dits and econ­o­mists demon­strate that they have no work­ing knowl­edge of bank­ing or mort­gage finance and no idea of what hap­pens to low coupon mort­gages when inter­est rates rise. Some of the advo­cates of this idea include R. Glen Hub­bard who is the Dean of the Colum­bia Uni­ver­sity Busi­ness School and a for­mer Chair­man of the Coun­cil of Eco­nomic Advi­sors to George W. Bush. With econ­o­mists like Mr. Hub­bard hav­ing influ­ence and power in the White House, it is not sur­pris­ing that Bush left the econ­omy in sham­bles when he left office (it is also scary to think of what is being taught at Colum­bia). And, the 4.5% mort­gage idea con­tin­ues to have “legs” among some mem­ber of Con­gress. Cur­rent advo­cates include Nevada Repub­li­can Sen­a­tor John Ensign who spon­sored 4.5% mort­gage leg­is­la­tion that 35 Sen­a­tors voted for in recent days.

The cur­rent inter­est rate envi­ron­ment dis­torts con­ven­tional finan­cial analy­sis and makes peo­ple believe that it is OK to drop mort­gage rates below safe and sound lev­els. The dis­tor­tion takes place when con­ven­tional analy­sis doesn’t account for the one direc­tional nature of future inter­est rate move­ments, i.e., the only mate­r­ial thing that is going to hap­pen to inter­est rates is they are going up. In Decem­ber, when the Fed­eral Funds rate was cut to an effec­tive 0% yield, most other gov­ern­ment oblig­a­tions began a down­ward yield march to what is likely their all time and absolute yield trough. While some addi­tional rate mod­er­a­tion is pos­si­ble for some longer matu­rity gov­ern­ment secu­ri­ties, it is impos­si­ble for future inter­est rates drops to be large because inter­est rates can’t drop below 0% and they are pretty close to that absolute floor. On the other hand, the mag­ni­tude and risk of future rate increases is mate­r­ial and dwarfs any addi­tional yield mod­er­a­tion that might occur. As such, inter­est rate risk is more or less only the risk of upward move­ment in inter­est rates. This phe­nom­e­non is called “asym­met­ric inter­est rate risk” and has never before existed like it does today.

Asym­met­ric inter­est rate risk is par­tic­u­larly acute in res­i­den­tial mort­gages because of bor­rower pre­pay­ment options. Home­own­ers that win the 4.5% mort­gage lot­tery are unlikely to ever refi­nance their mort­gage at a lower inter­est rate. Also, home­own­ers that have a 4.5% mort­gage will be less likely to move to a dif­fer­ent home since homes financed with these mort­gages will be very inex­pen­sive to live in rel­a­tive to alter­na­tive shel­ter. While the expected aver­age life of a pool of 6% mort­gages is prob­a­bly around 7 years, the expected aver­age life of a pool of 4.5% mort­gage maybe as long as 12 to 15 years. Longer expected life mort­gages fall in value much more than shorter expected life mort­gages when inter­est rates rise. Also, because of the long expected life of 4.5% mort­gages, hedg­ing against rate increases is tough if not impossible.

Since it is vir­tual cer­tainty that in the future inter­est rates are going to rise, it is also a vir­tual cer­tainty that in the future the value of 4.5% mort­gages will fall, and prob­a­bly by lot. Econ­o­mists like Hub­bard who esti­mate the eco­nomic cost of 4.5% mort­gage and say that it isn’t very big are using faulty math and don’t under­stand that the losses incurred from these mort­gages could be gigan­tic. It is a pretty good bet that for every $1 tril­lion of 4.5% mort­gages that are orig­i­nated, sooner or later almost the entire remain­ing out­stand­ing bal­ance will be lost even if all of the home­own­ers make their mort­gage pay­ments on time.

Instead of pop­ulist sound bites that make no eco­nomic sense, econ­o­mists and politi­cians need to work on well thought out solu­tions to our cur­rent prob­lems. Fix­ing today’s prob­lems at the expense of the eco­nomic future of the United States makes lit­tle sense and shouldn’t be part of the pub­lic pol­icy discussion.

Please, let’s not do the “time warp” again.



PS. For those Rocky Hor­ror fans among us below are The Time Warp’s lyrics. They seem pretty appro­pri­ate for today.


 The Time Warp

It’s astound­ing, time is fleet­ing
Mad­ness takes its toll
But lis­ten closely, not for very much longer
I’ve got to keep control

I remem­ber doing the TIme Warp
Drink­ing those moments when
The black­ness would hit me and the void would be call­ing
Let’s do the Time Warp again…
Let’s do the Time Warp again!

It’s just a jump to the left
And then a step to the right
With your hands on your hips
You bring your knees in tight
But it’s the pelvic thrust that really dri­ves you insane,
Let’s do the Time Warp again!

It’s so dreamy, oh fan­tasy free me
So you can’t see me, no not at all
In another dimen­sion, with voyeuris­tic inten­tion
Well-secluded, I see all
With a bit of a mind flip
You’re there in the time slip
And noth­ing can ever be the same
You’re spaced out on sen­sa­tion, like you’re under seda­tion
Let’s do the Time Warp again!

Well I was walk­ing down the street just a-having a think
When a snake of a guy gave me an evil wink
He shook me up, he took me by sur­prise
He had a pickup truck and the devil’s eyes.
He stared at me and I felt a change
Time meant noth­ing, never would again
Let’s do the Time Warp again!

Posted in: BANKS, Bush Administration, Business Environment, Credit Crisis, economy, Fannie Mae, Finance, Freddie Mac, housing crisis, Mortgage, Obama, Politics, Public Policy, REGULATION


  1. BMEZ

    Mark, another great pc. I very much like your anal­ogy using time warp. Will­ing to bet most of our elected offi­cials wouldn’t admit they’ve even seen it
    I under­stand why Con­gress would be push­ing cheap mort­gages and cer­tainly expect the mort­gage indus­try to process as many appli­ca­tions as they can. Why though would our finan­cial sec­tor sup­port another poten­tial mort­gage bank­ing disaster?

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