There has been a lot of discussion on this site about how derivatives are the cause of the financial crisis of the last eighteen months. At various times, I have seen suggestions to tax derivative transactions, make derivatives illegal, and even on occasion threatening violence to those who work with derivatives. While I agree wholeheartedly that the unregulated use of derivatives (and the leverage they allow) has caused harm to the real economy, I would like to present a cautionary tale of the law of unintented consequences. Specifically, a discussion of the risks of the derivative that is considered a bedrock financial transaction, the fixed rate mortgage.
Let me clarify what my goal is in this diary. I am not trying to take a position as to whether derivatives are good or evil, what should be allowed and how they should be regulated, or even to what extent our current crisis is caused by them. I simply would like to show that fixed rate mortgages, the transaction that tens of millions of Americans participate in and are quite happy with, are in fact derivatives and quite complex derivatives at that. In the discusion of the complexity, I will point out a number of situations where the lender loses money on the mortgage. I will say so as if that were a bad thing. Some might say that they don't care if banks lose money, they may even deserve it for what they have done to our economy. However, if in the long run, lenders can not make money (or at least breakeven) when lending for homes, the money lost will have to come from somewhere. This is a big piece of what is happening now; the govetnment is covering the losses that are resulting from bad home loans. In full disclosure, I have generally agreed with the various bailouts (although certainly not all the details). However, I think we can agree that a system where the lenders lose money as a rule, which means that bailouts of home loans are the norm instead of the exception, is not the way we should design the system.
The basic idea of a fixed rate mortgage is simple. I buy a house, making a down payment of 10%; you, the lender, make a loan for the other 90%, setting an interest rate for the entire 10 or 30 year span. Each month, I pay the interest for that month, plus some of the amount of the initial loan. Because the amount of the loan is smaller after this payment, my payment the next month will include less interest and more loan repayment. At the end of the term, the loan has been fully repaid, and I own the house fair and square. A derivative is a contract that is based on the value of an underlying asset. Thus, the fixed rate mortgage is a derivative, with the underlying asset being my house. Let's consider the position of the bank who has made this loan. You, the bank, have borrowed money from your depositors for 2% (just for an example) and loaned it out to me for 6% interest. You should make 4% profit on the size of the loan - fantastic, right?
The problem comes when the situation changes; there are a number of factors that can change to hurt the lender's situation.
- Interest rates increase. This is what happened in the late 1970s. Because of rampant inflation in the economy, the Fed increased interest rates as high as 20%. Our hypothetical lender is now paying about this much to finance a loan which pays only 6% - and losing 14% per year in the process. Adjustable rate mortgages were invented shortly after this period as a less-risky product for lenders to offer.
- Interest rates decrease. If increasing interest rates hurt the lender, then decreasing rates must help, right? Unfortunately, no. Again we can look to a former Fed Chairman, this time Alan Greenspan, who lowered the Fed Funds rate to 1% for more than a year. In our hypothetical example, because interest rates are lower by 1%, mortgage rates will also decrease by 1%. In order to take advantage, the borrower will simply take out a loan with the new, lower rate, repaying the old loan with the proceeds. Generally, the lender at best will break even in this case.
- The homeowner chooses to repay the loan early. People move all the time. People move for jobs, for personal life, for weather. When they do, they sell their old house, using the proceeds to pay back the mortgage (and keeping anything that is left). Again, while this is not necessarily bad for the bank, it is almost certainly not good for them, especially if they are not able to lend the money out immediately (paying their deposit interest in the meantime).
- The value of the house decreases. Remember that out of the original $100 purchase price, only $10 was put up by the buyer. So, if the house decreases in value to $80, the bank is in a difficult situation. The buyer may stay in the house and continue to make payments. However, they could also choose (or be forced by financial situations) to stop making the payments. In this case, the lender is permitted to repossess the house, but even in the best case, they will lose $10 of their original $90 loan. Generally, the lender will lose even more, because reselling the hosue will carry significant costs (and banks are also notoriously bad at managing property). Again, if things move the other way, and the value of the home increases, the bank does not share in any of the profits, which go exclusively to the owner.
Again, it was my hope here to just talk a bit about what mortgages look like from the lender side. The four reasons (interest rate increase, interest rate decrase, pre-payment, erosion of value) described here are a big reason why it is very difficult to determine the proper "price" of a mortgage. In our example, the bank notionally makes a profit of 4% at the time of the transaction; but is this enough to pay for the costs of all of the future movements in interest rates and home values? The inability to answer this question is a big reason why lenders are hesitant to make home loans, even though they may not be in as dire a situation as three months ago.