30-Year Fixed Rate Mortgages: Why They’re So Weird

Mortgages seem strange. Often the borrower seeks a loan through a mortgage broker instead of a bank. And even if a bank handles the mortgage, the borrower can send payments to another company — and that other company can change from year to year. And if there is ever a problem, the bank or broker that originated the mortgage cannot be called. And many consumers, and even mortgage professionals, don’t understand why.

Years ago we lived with a simpler mortgage system. But that system collapsed and nearly destroyed the housing sector. What replaced the old system looks strange and clumsy, but ultimately proves resilient in different economic conditions – but still has some shortcomings.

Simple mortgages were dangerous

Borrowers used to borrow from financial institutions, usually savings and loan associations (S&Ls). The S&Ls took deposits, mainly short-term certificates of deposit (CDs). They might pay 4% interest on deposits, then turn around and borrow money to purchase a house at 7% interest. The S&L earned 7% interest income and paid 4% financing costs; the rest paid the costs of operations, bad loans and profits.

This worked very well in the 1950s and early 1960s, when inflation was usually between one and two percent. Regulations limited the interest banks and S&Ls could pay on deposits so they didn’t compete with each other to lend money, which helped profits.

Inflation then rose, to four percent in 1968, and then to above five percent in the following two years. Interest rates generally rose across various financial instruments, quite predictably, as those who saved money wanted compensation for the declining purchasing power of their dollars. However, S&L depositors could no longer earn money because of the interest rate cap. Then, in 1971, the first money market fund was created, allowing people to earn market interest rates. Many savers have moved their money out of S&Ls.

The disappearance of deposits threatened the lives of the S&Ls. They had good assets – the mortgages – but they couldn’t call in the loans. That is, they could not demand that the borrowers pay back the money immediately. But savers could ask for their money once their CDs reached maturity.

Regulators have changed their rules to allow for higher interest rates. This allowed the S&Ls to keep the money on deposit, but their profits turned negative. They had to pay higher interest rates on their deposits, but most of their income came from old mortgages taken out at low interest rates. In our earlier example, loans were made at an interest rate of 7%, but deposits cost only 4%. In the early 1980s, when interest rate caps were abolished, deposits might cost the S&L 10%, but those old mortgages still paid only 7% interest.

Here’s the crux of the problem: If savers can demand money immediately, but homeowners pay fixed interest rates on a fixed schedule, then higher interest rates are the financial institution’s ruin.

Secure mortgages through financial engineering

The S&L crisis threatened the housing sector of the economy. At their peak, S&Ls held 45% of residential mortgages. When these institutions failed, economists worried that housing would collapse.

The solution to the problem involved financial engineering, or perhaps better described as financial surgery. Now a bank or mortgage broker provides cash to the borrowers for the purchase of homes. They bundle many mortgages together and sell them all to an institution such as Fannie Mae or Freddie Mac. But these institutions do not want to hold the mortgages any more than a bank does. Instead, Fannie or Freddie looks for investors to buy the mortgages piecemeal.

Think of a 30-year mortgage with monthly payments as a stack of 360 IOUs. A thousand of these piles can be combined and then sorted by date. The first set of dates, which should occur within one to twelve months, can easily be sold to money market funds. The payments for the next few years can be bundled and sold to banks and insurance companies that want investments for two or three years. The final payments, due over 25 to 30 years, can be sold to university endowments or other long-term investors.

It is not easy to tell borrowers to send this payment to one company and the next payment to another company. That’s why a mortgage servicing company handles the money. This could be the bank that granted the loans, but it could also be another company. The service companies receive compensation for their efforts. They receive payments from borrowers and send them to whoever should receive each payment. But the right to repay the mortgages can be bought and sold, so sometimes a borrower will receive a notice to send payments to a new servicer.

Mortgage prepayments create complications

Mortgage prepayments are a crucial complication. Borrowers can make additional payments, or they can pay off their entire balance, which usually happens when they refinance or sell their home. So an investor who purchased the right to receive payments eight years after the mortgage began could receive a lump sum years earlier. That often happens when interest rates drop, prompting many homeowners to refinance. This is ugly for the investor. Just as interest rates are falling, the investor gets his money back and now has to reinvest it at lower interest rates.

All investors know that prepayments will occur, although no one knows the exact timing. Some will guess what percentage of future payments will be made early, and use their guess to decide if the investment is a good deal. As interest rates rise, prepayments are not as common as previously expected. This also hurts the investor, who would like to have cash to invest at the new, higher interest rates.

Apparently, the early repayment option works in favor of the borrowers at the expense of the investors. But the investors know this when they come in. The price they pay reflects the risk they take. Borrowers could get a lower interest rate if they commit to never paying off their mortgage early, or if they agree to pay an additional fee for a prepayment. This does not apply to mortgages guaranteed by the federal government, but some private mortgages do require prepayment fees. Business loans with fixed interest rates typically come with prepayment fees.

The role of the government in mortgages

Several government-sponsored entities (GSEs) buy mortgage packages and sell the pieces to investors. These include Fannie Mae, Freddie Mac and Ginnie Mae, which are shortened forms of more complicated names. They offer credit guarantees (only accept mortgages that meet their standards), but do not guarantee the market value of the mortgages. (If interest rates rise, the value of old loans at lower interest rates will decline.) Although the federal government would not be legally obligated to help the GSEs if credit losses exceeded the GSEs’ assets, investors assume the government would intervene. Estimates of the value of the implied warranty are not precise, but half a percentage point would be in the ballpark.

Home buyers may find the process, including occasional changes in managers, too complicated. But it’s not easy to set up a system where a home buyer can get a long-term, fixed-rate loan, with the option of early repayment, in a world where inflation and interest rates can change substantially over the course of thirty years.

The system of bundling mortgages and packaging them into different mortgage-backed securities allows borrowers to get the kind of loans they want while protecting investors from interest rate fluctuations. Most mortgages receive a credit guarantee, backed by the government, but that is not a crucial part of the system. Although not absolutely necessary for the finances to function, the guarantee is extremely popular with the powerful real estate lobbies. So this system will probably last for many years to come.