November 17, 2011
Taking on the conventional wisdom about fixed rate mortgages
The long-term fixed rate mortgage (FRM) is a central part of the mortgage landscape in America. According to recent data, the FRM accounts for 81 percent of all outstanding mortgages and 85 percent of new originations.1 Why is it so common? The conventional wisdom is that the FRM is a great product created during the Great Depression to bring some stability to the housing market. Homeowners were defaulting in record numbers, the story goes, because their adjustable rate mortgages (ARMs) adjusted upward and caused payment shocks they could not absorb.
In a Senate Committee on Banking, Housing, and Urban Affairs hearing on October 20, some experts presented testimony that followed this conventional wisdom. As John Fenton, president and CEO, Affinity Federal Credit Union, who testified on behalf of the National Association of Federal Credit Unions, laid out in his written testimony:
Prior to the introduction of the 30-year FRM, U.S. homeowners were at the mercy of adjustable interest rates. After making payments on a loan at a fluctuating rate for a certain period, the borrower would be liable for the repayment of the remainder of the loan (balloon payment). Before the innovation of the 30-year FRM, borrowers could also be subject to the "call in" of the loan, meaning the lender could demand an immediate payment of the full remainder. The 30-year FRM was an innovative measure for the banking industry, with lasting significance that enabled mass home ownership through its predictability.
Of course, this picture of the 30-year FRM as bringing stability to the housing market has profound implications for recent history. Many critics attribute the problems in the mortgage market that started in 2007 to the proliferation of ARMs. According to the narrative, lenders, after 70 years of stability and success with FRMs, started experimenting with ARMs again in the 2000s, exposing borrowers to payment shocks that inevitably led to defaults and the housing crisis. Indeed, one of the other panelists at the hearing, Janis Bowdler, senior policy analyst for the National Council of La Raza, argued in her written testimony that "when the toxic mortgages began to reset and brokers and lenders could no longer maintain their refinance schemes, a recession ushered in record-high foreclosure rates."
I argue, on the other hand—both in my testimony at the hearing and in this post—that the narrative of the fixed rate mortgage as an inherently safe product invented during the Depression that would have mitigated the subprime crisis because it
eliminated payment shocks does not fit the facts.
Parsing the myths around the fixed rate mortgage
First, the FRM has been around far longer than most people realize. Most people attribute the FRM's introduction to the Federal Housing Administration (FHA) in the 1930s.2 But it was the building and loan societies (B&Ls), later known as savings and loans, that created them, and they created them a full hundred years earlier. Starting with the very first B&L—the Oxford Provident Building Society in Frankfort, Pennsylvania, in 1831—the FRM accounted for almost every mortgage B&Ls originated. By the time of the Depression, B&Ls were not a niche player in the U.S. housing market. They were, rather, the largest single source of funding for residential mortgages, and the FRM was central to their business model.
As Table 2 of my testimony shows, B&Ls made about 40 percent of new residential mortgage originations in 1929 and 95 percent of those loans were long-term, fixed-rate, fully amortized mortgages. Importantly, B&Ls suffered mightily during the Depression, so the facts simply do not support the idea that the widespread use of FRMs would have prevented the housing crisis of the 1930s.
Source: Grebler, Blank and Winnick (1956)
Note: Market percentage is dollar-weighted. Building and loan societies were the main source of funds for residential mortgages and almost exclusively used long-term, fixed-rate, fully amortizing instruments.
To be sure, at 15–20 years, the terms on the FRMs the FHA insured were somewhat longer than those of pre-Depression FRMs, which typically had 10–15 year maturities.3 The 30-year FRM did not emerge into widespread use until later. It must be stressed that none of the arguments that Fenton made hinge on the length of the contract. Furthermore, the argument that Bowdler made in her testimony—that by delaying amortization, a 30-year maturity lowers the monthly payment as compared to a loan with shorter maturity—applies as much to ARMs as it does to FRMs.
But even though the ARMs may not have caused the Depression, FRM supporters might ask, didn't the payment shocks from the exotic ARMs cause the most recent crisis? Again, the data say no. Table 1 of my Senate testimony shows that payment shocks actually played little role in the crisis.
Source: Lender Processing Services and author's calculations.
Note: Sample is all first-lien mortgages originated after 2005 on which lenders initiated foreclosure proceedings from 2007 to 2010.
Of the large sample of borrowers who lost their homes, only 12 percent had a payment amount at the time they defaulted that exceeded the amount of the first scheduled monthly payment on the loan. The reason there were so few is that almost 60 percent of the borrowers who lost their homes had, in fact, FRMs. But even the defaulters who did have ARMs typically had either the same or a lower payment amount due to policy-related cuts in short-term interest rates.
To be absolutely clear here, my discussion so far focuses entirely on the question of whether the design of the FRM is inherently safe and eliminates a major cause of foreclosures. The data say it does not, but that does not necessarily mean that the FRM does not have benefits. As I discussed in my testimony, all else being equal, ARMs do default more than FRMs, but since defaults occur even when the payments stay the same or fall, the higher rate is most likely connected to the type of borrower who chooses an ARM, not to the design of the mortgage itself.
The difficulty of measuring the systemic value of fixed rate mortgages
One common response to my claim that the payment shocks from ARMs did not cause the crisis is that ARMs caused the bubble and thus indirectly caused the foreclosure crisis. However, it is important to understand that this argument, which suggests that the FRM has some systemic benefit, is fundamentally different from the argument that the FRM is inherently safe. This difference is as significant as that between arguing that airbags reduce fatalities by preventing traumatic injuries and arguing that they somehow prevent car accidents.
Measuring the systemic contribution of the FRM is exceedingly difficult because the use of different mortgage products is endogenous. Theory predicts that home buyers in places where house price appreciation is high would try to get the biggest mortgage possible, conditional on their income, something that an ARM typically facilitates. When the yield-curve has a positive slope (in most cases) and short-term interest rates are lower than long-term interest rates, ARMs loans offer lower initial payments compared to FRMs. Thus, it is very difficult to disentangle the causal effect of the housing boom on mortgage choice from the effect of mortgage choice on the housing boom.
In addition, there is evidence from overseas that suggests that the FRM is not essential for price stability. As Anthony B. Sanders, professor of finance at the George Mason School of Management, points out in his written testimony, FRMs are rare outside the United States. A theory of the stabilizing properties of FRMs would have to explain why Canadian borrowers emerged more or less unscathed from the global property bubble of the 2000s, despite almost exclusively using ARMs.
By Paul Willen, senior economist and policy adviser at the Boston Fed (with Boston Fed economist Christopher Foote and Atlanta Fed economist Kristopher Gerardi)
1 First liens in LPS data for May 2011.
3 See the discussion in chapter XV of Leo Grebler, David M. Blank, and Louis Winnick (Princeton, NJ: Princeton University Press, 1956), 218–235; available on the website of the National Bureau of Economic Research.
November 17, 2011 in Homeownership, Housing prices, Mortgage crisis, Mortgage default, Subprime mortgages | Permalink
May 21, 2010
Are there really social benefits of homeownership?
Over the past half century or so, the U.S. government has supported homeownership with numerous policies. For example, it created the government-sponsored enterprises (GSEs) to develop a stable secondary mortgage market so that households could obtain the necessary financing, with particular focus on less advantaged households. The federal government has also chosen to subsidize homeownership through the tax code, implementing tax deductions for mortgage interest and property taxes. The result of such policies has been the upward trend in the homeownership rate from about 62 percent in 1960 to a peak of 69 percent in 2004. (The foreclosure crisis has resulted in a decrease in the homeownership rate to about 67 percent as of the first quarter of 2010.)1
One of the main rationales for the government's pro-homeownership stance is the social benefit that homeownership is believed to produce. Basically, many perceive that homeownership gives individuals a stronger incentive to improve their neighborhood and community. A fairly extensive literature on this subject has purported to confirm such beliefs. Evidence supports the notion that homeowners participate more in the political system than renters (DiPasquale and Glaeser 1999) and are more likely to become involved in community activism in general (Rohe and Stegman 1994). Alba, Logan, and Bellair (1994) and Glaeser and Sacerdote (1999) have found a negative correlation between homeownership and the incidence of crime. Other researchers have found some evidence that homeowners take better care of their homes than renters do (Mayer 1981).
Other factors may drive both homeownership and community activism
But there is a very difficult econometric problem that many of these studies either do not address at all
or do not address completely: the possible existence of unobserved characteristics that are correlated with both homeownership and the tendency to participate in community activism. That is, the types of people who are likely to become homeowners may also be the same people who are more likely to participate in their community. If this is the case, then these studies are mistakenly identifying homeownership as a causal factor of these social outcomes and falsely concluding that homeownership yields positive social benefits. To avoid this econometric issue and truly identify the causal effect of homeownership on participation in these various activities, we need to find some way to create random variation in homeownership decisions that is not correlated with any unobserved characteristics of individuals.
Matching savings program facilitates study of homeownership's social benefits
A new study by Gary V. Engelhardt, Michael D. Erikson, William G. Gale, and Gregory B. Mills in the Journal of Urban Economics attempts to accomplish such a task. The authors performed a field experiment with low-income renters in Tulsa, Oklahoma, from 1998 to 2003 that subsidized saving for a home purchase through what is called an Individual Development Account (IDA). They started with a pool of individual renters interested in such a program and then randomly picked a sample of them to participate. (Participation after selection was optional.) The program matched participants' saving specifically for a future home purchase at a 2:1 rate for annual deposits of up to $750 for three consecutive years. Thus, counting both deposits and matched funds, at the end of the three years, a participant could accumulate up to $6,750. This may not sound like that much, but it is a non-trivial fraction (about 11 percent) of the median house value in Tulsa for a similar low-income population of homeowners during the same period. Indeed, the IDAs appear to have encouraged homeownership: the authors find that after four years, the individuals who were given the option to participate in the program (the treatment group) had a homeownership rate of 7–11 percentage points higher than the individuals not given the option (the control group).
The authors use participation in the IDA—more specifically, the ability to participate, which was randomly assigned—as an instrument for homeownership. They collected information for their sample of renters and homeowners on these attributes: the extent of interior and exterior home maintenance expenditures; political involvement (propensity to vote, amount of support in time and money given to political candidates, tendency to write to or call public representatives); neighborhood involvement (volunteering and fundraising for a church, school, or other neighborhood organization; time spent working on neighborhood projects; and time spent participating in community associations); and time spent giving to other community members (providing childcare or care for another adult, watching someone else's home or pet, and making calls or writing/reading letters for someone else). Thus, their empirical strategy is a two-stage regression in which the first stage uses IDA participation to instrument for the probability of becoming a homeowner, and the second stage regresses the various measures of social involvement on the component of the variation in homeownership decisions that is due to the IDA experiment.
Their first finding is that when they don't instrument for homeownership decisions, they find very large social benefits, which is consistent with the previous literature. For example, becoming a homeowner increases the probability of having called or written a public representative by more than 17 percentage points and of voting in an election by almost 24 percentage points! They also find that becoming a homeowner seems to significantly increase the amount of exterior home maintenance by 13 percentage points.
Controlling for ownership finds negative relationship, underscores need for more research
But the more interesting finding is that when they do instrument for homeownership, all these positive effects disappear. In fact, in some cases the estimated effects become negative. For example, becoming a homeowner makes one less likely to volunteer or help raise money for a church, school, or neighborhood organization, and makes one less likely to become involved in local politics. The evidence regarding maintenance isn't quite as definitive. The estimated effect of homeownership on the likelihood of performing exterior maintenance is not precisely measured (the point estimate is positive but is not statistically significantly different from zero). The estimated effect of homeownership on the likelihood of performing interior maintenance is positive and statistically significant, but interior maintenance is really an internal benefit of homeownership rather than a social benefit (what you do inside of your home does not really affect the value of your neighbors' homes).
In our opinion, this is a really nice piece of work, on a very topical subject. It emphasizes the need to revisit some of the findings of the early literature on the social benefits of homeownership, as many of the positive effects found in that literature appear to be the result of spurious correlation—unobserved characteristics that influence the likelihood of an individual both to become a homeowner and to participate in his or her community to a greater extent. The study has some issues, which the authors themselves point out, with the design and implementation of the IDA experiment that might not make it completely representative of the entire U.S. population. The experiment was performed on low-income, employed individuals in Tulsa, where housing prices are relatively low. In addition, by simply signing up for the program, the individuals were likely signaling that they were more motivated to save (and thus more patient) than others. The authors also point out another potential problem, which is the possible conflation of homeownership and wealth effects resulting from the IDA experiment design. The matching funds increased individuals' wealth in addition to making them more likely to become homeowners. If increased wealth has an effect on the various social outcomes studied in the paper, then IDA participation would be capturing both homeownership effects and wealth effects. In any event, at the very least, the paper is a nice starting point for future research on this important topic!
By Kris Gerardi, research economist and assistant policy adviser at the Atlanta Fed (with Boston Fed economists Christopher Foote and Paul Willen)
May 21, 2010 in Government-sponsored enterprises, Homeownership, Individual Development Account, Positive externalities | Permalink
