Tie Me Up, Tie Me Down to Fixed-Rate Home Loan

Oct. 12 (Bloomberg) — There's nothing wrong with fixed — the fixed-rate mortgage, that is.

As the mortgage crisis has unfolded, everyone has blamed the new-fangled mortgages: Interest-only, pick-a-payment, subprime ARMs, Alt-As became pejoratives overnight.

In the midst of it all you didn't hear people talking much about the traditional model. The possibility that interest rates might go down soon and allow adjustable-rate mortgage holders to pay less for a while was tempting. The fixed format is still viewed as uncool, as paternalistic as, say, an old AT&T phone looks next to an iPhone.

New homebuyers who don't take the fixed option seriously are playing fast and loose. Even if a recession is around the corner, there are more good long-term reasons than usual to "fix" yourself. A wider mortgage crisis is still possible, and such a crisis will probably lead Washington to demonstrate paternalism on a scale that most of the iPhone crowd has never known.

Consider the emotional forces at work here. Americans have become accustomed to counting on continuous real appreciation in home values.

In the last recession, houses seemed almost business-cycle-proof. Lately, consumers have developed the conviction that inflation and interest rates will always stay low. Increasing house values and low interest rates both make taking out an adjustable-rate mortgage a no-brainer.

Nothing But Sunshine

The hundreds of millions in marketing dollars spent by Fannie Mae and Freddie Mac, along with every mortgage broker, have had their effect. From California to Nevada to Florida, states with the highest foreclosure rates in September, consumers now believe that the American dream is an American entitlement. There is something Reaganite too about the whole attitude. When you sign on to an ARM, you are saying that the future is sunlit.

But the future may not be sunlit. Today we can't expect perpetual increases in housing values or permanently low interest rates. When rates rise, homeowners, especially lower earners, will find ARMs prohibitive.

The record-high euro and Canadian dollar are signals of unprocessed inflation. A national refusal to address the long-term budgetary shortfalls caused mainly by entitlements such as Medicare may darken the 21st century.

Besides, a house is not an iPhone. It's a necessity. People want their houses to be the safe part of their lives — that's what all that marketing research about post-Sept. 11 nesting tells us. When you change jobs every 18 months, as so many Americans do, and your health insurance changes even more frequently — if you have it — a simple mortgage whose details you can remember in your sleep is a comfort.

Moses of Mortgages

The best case for a fixed life was made by that Moses of the modern mortgage: Franklin Delano Roosevelt.

In the early part of the Depression, interest-only loans were the rule: You paid off the loan, but the arrangement didn't help you accumulate equity. So were short-term loans, what we today would call home-equity loans. They seemed benignly small against the overall value of the house at the time the loan was made, but turned nasty with deflation. They often forced evictions. Predatory lenders abounded and interest rates varied wildly from city to city.

Roosevelt despised this. He proceeded to ordain the shape of the standard mortgage. Let homeowners put only 20 percent down. Let them pay a fixed rate of about 5 percent. And let them have 20 years to pay off that mortgage.

Sleep Well

That same format was what enabled our parents to sleep well through the late 1970s and early 1980s when Federal Reserve Chairman Paul Volcker put through the painful rate increases needed to rein in inflation. Younger borrowers watched in despair as their smug elders enjoyed their steady 5 percent or 6 percent.

What will happen if more vulnerable households opt for adjustable rates and interest rates do bounce upward?

Democratic lawmakers are already calling on the White House to "Katrina-ize" the mortgage problem by appointing a special housing adviser to coordinate a federal response to mortgage problems.

Republicans are almost as ready to see Washington jump. The decision by the Federal Housing Administration to rescue troubled subprime borrowers demonstrated that. The Federal Deposit Insurance Corp. is already pulling its hair and imploring lenders to freeze ARM rates. If Fannie Mae and Freddie Mac founder, as they well might, they would give new meaning to the phrase "too big to fail."

Big Bailouts

All this might mean a much larger bailout for borrowers than we saw this summer, or even than the savings-and-loan crisis of the early 1990s. Volckeresque rate increases would follow. A prime rate of, say, 20 percent will kill the blithe iPhone culture.

How to avoid mortgage paternalism later without mortgage paternalism now? Current policy is to promote unlimited homeownership with egregious tax subsidies. Washington might limit the deductibility of adjustable interest, while expanding the deductibility of interest on fixed-rate loans somehow. And it could do so prospectively, so that mortgages originated under old tax law aren't penalized.

All tax increases are heinous, but this one is worthwhile if it curtails the more heinous moral hazard in home borrowing. Both homeowners and the financial markets that serve them would feel better knowing that least one part of American life is fixed.

(Amity Shlaes, a senior fellow at the Council on Foreign Relations in economic history, is a Bloomberg News columnist. The opinions expressed are her own.

© Copyright 2007 Bloomberg

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