Government Policy and the Fixed-Rate Mortgage

Abstract

A central argument in the ongoing discussion about the fates of Fannie Mae and Freddie Mac is the importance of the 30-year, fixed-rate, prepayable mortgage (FRM). The FRM has been held up as the gold standard in mortgage instrument design and as an essential element of the U.S. housing-finance system. Supporters of Fannie Mae and Freddie Mac argue that a government guarantee eliminating credit risk is essential to ensuring the FRM remains the main instrument for housing finance. The FRM has benefits for the consumer through payment stability and the right to prepay the mortgage without penalty. But these benefits come at significant cost. The interest rate and prepayment risk in the FRM are costly and difficult for investors to manage. There is a premium for both the long term and the prepayment options that are paid by all users of the mortgage. The FRM causes instability in the mortgage market through periodic refinancing waves. The FRM can create negative equity in an environment of falling house prices. And the taxpayers are on the hook for hundreds of billions of dollars in losses backing the credit risk guarantees provided by Fannie Mae and Freddie Mac to support securities backed by the FRM. International experience suggests that mortgage markets work fine without an FRM (only Denmark has an equivalent instrument). Borrowers rarely stay with the same mortgage for 15–30 years. Shorter-term fixed-rate mortgages would be less expensive than the FRM in most interest rate environments, particularly if lenders were allowed to charge prepayment penalties. The taxpayer is exposed to too much risk in supporting Fannie Mae and Freddie Mac to justify continued government support for a product for which the costs outweigh the benefits.