The 30-Year Mortgage is an Intrinsically Toxic Product

Illustrative diagram: housing as an asset class (top) and the financial underpinnings of its future price appreciation.

The Mortgage Bet

A residential mortgage is a financial instrument. That is, it’s a bet on several factors. Let’s go through each in turn, from smallest to largest:

  1. A mortgage is a bet on the value of a specific home: it’s a bet that you won’t burn your house down, turn it into a meth lab, or otherwise diminish its value. In some cases, a mortgage is implicitly a bet that you’ll fix things up a bit, but a responsible lender won’t lend against the expected full value of yet-to-be-improved collateral.
  2. It’s a bet on local real-estate prices. Crucially, this means a mortgage is a bet on the local labor market. What determines rents is is the availability and median wage of jobs. (Exhibit A: the Bay Area. Exhibit B: Detroit.) If you consider the typical consumer’s theoretical balance sheet, the single biggest item on that balance sheet is the net present value of their future wages: unless you’re quite late in your career or made some very savvy trades, this dwarfs your savings and investments. From the consumer’s perspective, this asset is very hard to hedge: if your savings are in stocks, you can sell stocks or buy put options; if your net worth is the net present value of the next 30 years of your earnings as a radiologist or car mechanic, there isn’t a trade you can make that pays off directly in proportion to how much those wages drop. And due to Baumol’s cost disease and the Alchian-Allen effect[1], your wages will have a location-based premium that’s also hard to hedge. Whatever you do for a living, you’ll be doing it for more money in Manhattan than in Montana.
  3. A mortgage is a bet on interest rates, but it’s an esoteric one. If a company borrows money for 30 years, they can often pay it back at any time, but if rates have dropped (and thus the present value of that bond has risen), they’ll have to pay it back at a premium. For example, suppose a company borrows at 4% for 30 years, and the next day the prevailing rate is 3%. To buy back that bond, they’d need to pay about 120 cents on the dollar. Not so for a mortgage borrower: the borrower has the option to refinance their mortgage if rates move to their advantage, but can keep the mortgage if rates rise. Essentially they have an embedded option. Depending on the volatility of interest rates, this can be quite valuable. Certainly, the paucity of companies making this bet implies that it’s not the approach everybody chooses when they’ve done the math.

A Bit of History

Why do consumers bet this way? We pay them to: home mortgage interest is very tax-optimized compared to other ways you might borrow money to fund more consumption that you can afford, such as putting a Vegas weekend on your credit card. For lenders, mortgage lending is subsidized through cheap default insurance provided by Fannie Mae and Freddie Mac, (also known as Government-Sponsored Entities — from here on out I’ll call them GSEs).

  1. Benefits: The real estate buyer can afford more real estate if they irresponsibly lever up.
  2. Costs: The price of the real estate rises commensurately.
  3. Result: Instead of being able to afford only $X worth of property, you can afford, say 1.2 * $X worth of property. Also, 1.2 * $X buys you as much property as $X would have under a different tax regime.
  1. Catch-up growth: in the 1930s, we had a huge ramp-up in productivity, but many people were still out of work and unable to participate. In the 1940s, we got our industrial base humming again by cranking out armaments. So by the end of the war, the US was in the same position as a developed nation catching up to the rest of the world: we could just roll out stuff we’d already figured out and see continuous improvements in living standards.
  2. Male wages were high enough to support a family; female wages were low enough to lower the opportunity cost of family formation. This is the perfect recipe for housing demand; kids are a strong proximate cause for finally saying goodbye to your parents or roommates and getting a place of your own. Gender inequality actually encourages earlier marriage and childbearing since there’s less of a career for mom to give up on. This is self-perpetuating in two ways: first, earlier childbearing means that women are more likely to leave the workforce, which puts pressure on their wages. Second, few double-earner households means less competitive bidding for real estate. Now the norm is either two earners forever or two earners until the couple can afford a down payment and save some more besides; since they’re house-shopping as two full-time earners, this puts housing out of reach of most single-earner households.
  3. We had a few more years of productivity growth ahead of us. The postwar productivity story is really a story about winning the Cold War by showing off whiz-bang gadgets. The US and USSR had both just demonstrated that they could mobilize for conventional war, and that the limiting factor for both was manpower. That puts them in a game theoretically awkward spot: there’s no way to be more aggressive when you’re already close to maximal aggression — except by demonstrating expertise in un-conventional warfare. So you have things like the space program to showcase our ability to accurately aim missiles containing astronauts, as a way to demonstrate that we can also accurately aim missiles containing, say, a neutron bomb. You have ARPANET, a communications network meant to be robust in case the Soviets shot back. (You may recognize ARPANET as the ancient ancestor of the network via which you’re reading this article.) And there was a boom in communications gadgetry.[4] This Cold War competition paid a peace dividend by subsidizing the development of electronics that had useful civilian applications. And coincidentally, the aerospace industry was concentrated in a few places on the West Coast that were pretty low-density, and could thus support lots of housing-price-accretive population growth.
  1. A general increase in rents, which just means an increase in local wages relative to the supply of local housing stock
  2. An increase in the price to rent ratio

The Lender’s Perspective

Who supplies the capital for mortgages, and what are they getting out of it?

  1. Mortgage rates drop.
  2. Homeowners prepay their mortgages, shortening the duration of mortgage-backed securities.
  3. Agency bond owners compensate by buying treasuries.

The GSEs and Agency Debt: Even Worse Than Meets the Eye

The GSEs, Fannie Mae and Freddie Mac, played and play a crucial role in residential housing finance.

What to Do About It

For the individual, the fact that encouraging 30-year mortgages is a bad policy does not imply that getting one yourself is a bad deal. The policy wouldn’t be bad if it weren’t effective, and it’s only effective to the extent that it encourages people to actually get the loans. So while I think there are prudent asset allocation reasons to favor renting over buying, if you don’t buy into those a standard mortgage is a relatively tax-efficient way to pay for housing.

  1. Long-term interest rates are more volatile than they should be, and are a misleading indicator of economic activity and investor sentiment;
  2. Individual savers in the US are overweight residential real estate compared to other asset classes, so US consumption growth is strongly tied to real estate;
  3. The main channel by which monetary stimulus turns into higher consumer spending is through solvent homeowners deciding to spend more money — so when we cut rates, we get more of what the upper middle class likes to buy (healthcare, education, and more houses); and
  4. The US labor market is artificially immobile during recessions (exactly when mobility matters the most).

Further Reading

Some works I found useful:

  • Shaky Ground is a quick read, mostly focused on the post-crisis legal quagmire around the GSEs.
  • Even though they’ve been socialized, part of the book-cooking chicanery around the GSEs entails that they remain public, and continue to file 10-Ks. Here’s Fannie and here’s Freddie. You’ll laugh, you’ll cry, you’ll wonder why this could possibly be the correct approach.
  • This dissertation by Sarah Lehman Quinn is a very good overview of the history of US housing policy, which puts many of this century’s developments in context. It closes with a revisionist view of the accounting reasons for Fannie’s privatization.
  • Laurie Goodman at the Urban Institute does some great work on this beat. Her reports are a good source for up-to-date data on the mortgage market and the role of GSEs.



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Byrne Hobart

Byrne Hobart

I write about technology (more logos than techne) and economics. Newsletter: