The NYTimes has reported that once again President Obama is urging the US Congress to pass legislation that would make it possible for homeowners to refinance their mortgages at the currently very low mortgage interest rates.
“I am sending Congress a plan that will give every responsible homeowner in America a chance to save about $3,000 a year on their mortgage by refinancing at historically low rates,” he told an audience in Falls Church, Va. “No more red tape. No more runaround from the banks.”
These types of plans bother me for several reasons:
- When banks grant mortgages, they do so in a highly competitive market. People can, and do, shop around to get good deals. Not all homebuyers shop around or negotiate hard, but many do.... enough so that the rates strongly tend to be driven by the forces of supply and demand in the market for lendable funds.
- Given that mortgage interest rates are competitively determined when someone takes out a loan, I see no reason why those who choose to sign up for a long-term mortgage should expect to be able to refinance at lower rates if mortgage rates drop. They could have opted for shorter-term loans.
- If homebuyers get to refinance their mortgages if interest rates decline, should financial institutions be allowed to require refinancing of the loans at higher mortgage rates if interest rates rise?
- One aspect of mortgage financing is that both the homebuyer and the mortgage company are speculating about future interest rates, whether they like it or not. If a homebuyer thinks interest rates are going to fall, s/he can take out a short-term mortgage and refinance the loan a few years later. People who have done that over the past two or three years have done very well as a result. At the same time, if a homebuyer thinks interest rates are going to rise, s/he will have an incentive to lock in lower long-term mortgage interest rates (an option not available for most (any?) homebuyers in Canada).
- Lending institutions are also speculating about future interest rates. They lend long-term and borrow short-term. If they lend money long-term at low interest rates and then interest rates rise, these institutions have to pay higher rates to attract deposits (i.e. to borrow short-term). This divergence between long rates and short rates contributed mightily to the savings and loan crisis of the 1980s. To cover this risk, the institutions charge higher rates for longer-term loans. If interest rates rise, they are partially covered. If interest rates fall, they make big profits.
- Many lending institutions in Canada offer variable-rate mortgages. When interest rates fall, borrowers end up with lower monthly payments. But if/when interest rates rise, borrowers who took out mortgages under these terms will end up with higher monthly payments.
Suppose the US Congress actually passes a law requiring lenders to allow people to refinance their loans if/when interest rates fall (but, given the bias against big financial institutions, does not allow the banks to require refinancing if interest rates rise!). The effect will be to reduce the number of mortgage loans made (i.e. reduce the supply of lendable funds) and drive up interest rates, especially for the long-term loans that involve the greatest interest rate risk.
The result will be that US and other financial institutions will gravitate away from issuing long-term loans, granting only mortgages that are renewable with short-term maturities, e.g. two-year or five-year terms. Homebuyers will no longer have the opportunity to lock in low rates for long terms.
Quite frankly, given the unsettled political environment in the US and given the potential threats of further interventions in the mortgage markets by the President and some members of Congress, I don't understand why any financial institutions issue long-term mortgages. A plausible explanation for their doing so must be that they can foist off the interest-rate risk onto other gubmnt agencies. And apparently that is what is being proposed:
For those with privately held loans, the president will ask Congress to allow the Federal Housing Administration to refinance their mortgages in a program to be financed by a fee charged to large banks based on their size and the riskiness of their portfolios. The estimated cost of the program would be $5 billion to $10 billion, depending on the number of participants. Only houses whose values fall within F.H.A. guidelines, from about $270,000 to $730,000 depending on location, would qualify.
So the gubmnt will allow smaller financial institutions to have issued long-term mortgages to borrowers, and then allow borrowers to refinance these loans at their advantage. This is a money-losing proposition for the lenders. And so the gubmnt will tax the large banks to subsidize the lending institutions who in turn now have an incentive to subsidize asymmetric interest rate speculation by borrowers: if interest rates go up, the borrowers win by having their mortgages locked in at low rates; and if mortgage rates decline, the borrowers win by being able to renegotiate at the expense of big banks.
Sheesh. What a way to increase distortions in the economy.