The Strangest of All Mortgages

I was listening to the NPR Planet Money podcast and I found it interesting enough to write about it in today's blog.
(source http://www.npr.org/rss/podcast/podcast_detail.php?siteId=94411890).
(source: http://www.nytimes.com/2011/01/06/opinion/06mclean.html?_r=1)


Most people have no clue of what a mortgage is, how the interest rate is calculated and why the US Government is knee deep in shit with Fannie Mae and Freddie Mac. Before The Great Depression in the last 20's and 30's, US mortgages were issued by your local bank and kept on their books. There was no national/global market in trading baskets of mortgage backed securities. Most importantly no 30 year fixed rate mortgages.

Let's go back in time and found out how a person would get a mortgage. A person who visit their local bank ask for a mortgage and the bank will access the person's credit worthiness (their ability to pay back the loan). After the assessment the bank would grant a mortgage but with conditions. These conditions were usually strict to protect the bank from default. The person must have a down payment of 30%-50% of the mortgage, the maturity was usually 5-10 years and the interest rate would be high relative today's rates at the same maturity.

Why would a bank place such restrictions? It's very simple, one is that bank was is worried about credit risk. Credit risk is the risk a borrower not paying back the loan. In the case of a 30 year fixed rate mortgage, there was no guarantee that a person will be able to pay back the mortgage. A person could die, lose their job, become disable and a host of many other factors.

Also the bank was worried about interest rate risk. Interest rate risk is the risk of losing money earned on the bank's loan due to inflation or rising rates. Since their income is fixed on the loan and the cost of money is rising, the profitability of the loan falls. Basically it cost more money to buy the same quantity and type of good. This is also known as purchasing power.

Now The Great Depression occurred and the housing market collapsed. To stimulate the housing market and banks the government creates Fannie and Freddie. These government organizations would purchase all the mortgages from the local banks thus creating a national market and guarantee the payment of the mortgages if the borrower defaults. This had a tremendous effect on the banks, it was safer for them to issue 30 year fixed mortgages because they no longer had to worry about credit risk and secondly it caused the interest rates to fall and increase availability of these mortgages. Now people were able to afford to buy home with a lower interest and a very low down payment.

However during the Vietnam War this all changed. President Johnson wanted to reduce the government budget deficit so he privatized Fannie and Freddie. Doing so caused a drop in the budget deficit. Fannie and Freddie still had the government implied guarantee. Since this guarantee was still in place Fannie and Freddie had a huge advantage in the free market. This government guarantee gave Fannie and Freddie a monopoly in the mortgage market because investors will charge them a lower interest rate than they would to a private company. This also caused many unprofitable loans very profitable because of the lower interest rate charges.

Now Fannie and Freddie being private companies start to sell mortgages to investors offering a guarantee it will pay the mortgage if the it defaulted. In addition, Fannie and Freddie expanded their loan portfolio into riskier mortgages such as sub prime. We all know where this story goes, $100 billion later and counting, both companies were bailed out.

This bailed out pissed people off but they are hypocritical because they all want cheap affordable mortgages. This can only be accomplished by the government being in the mortgage market. Today 95% of all mortgages are backed by the US Government. Without the US Government being in the mortgage market interest rates will go up, the down payment will go up and the availability of affordable mortgages will go down. So pick your poison, have your dreams shattered and live a more modest life or live the "bling bling" life in a socialist government control housing market?