Interest rates and self-interest incentives

Below is a quote from an earlier post about historical mortgage markets. The quote is from The American Mortgage in Historical and International Context , and I thought this point alone was worth its own post.

"Perhaps most important, an entirely private market could well become one that led to an increased reliance on adjustable-rate mortgages. Work from the IMF (2004)—along with the fact that household balance sheets would be mismatched in an adjustable-rate mortgage heavy world—suggests that such an outcome could lead to macroeconomic instability."

Borrowers have a self-interest in obtaining the lowest interest rate mortgage available. During periods of high interest rates, borrowers can take out a high-rate mortgage, then refinance when rates drop, or simply take an adjustable-rate mortgage. During periods of low rates, borrowers have a strong incentive to take a long-term, fixed rate loan.

Lenders, on the other hand, have the opposite incentive. They know that borrowers will probably refinance high-rate mortgages when rates drop, yet lenders will be held to low-rate loans even after rates rise. (Pre-payment penalties discourage buyers from refinancing into lower-rate loans, or else compensate lenders for the loss of income when a buyer does refinance.) When long-term mortgages are funded from short-term money like checking deposits, lenders have a risk of losing money on loans. That's essentially what happened to the Savings and Loan institutions in the 70s, 80s, and 90s, and it bankrupted a number of S&Ls. Securitization - selling mortgage loans as investment vehicles - helps assuage the risk. But lenders still have a self-interest to maximize the interest rate return on the loans they fund.

During the housing boom, interest rates were at historical lows and the economy was booming. The most reasonable assumption about interest rates was that they would rise. Mortgages were highly profitable - a record number of people were buying houses and refinancing, and the total amount borrowed was reaching record highs. The loan origination fees alone were hugely profitable, but the loans presented a risk - if borrowers took out fixed-rate loans at historically low rates, lenders and investors would be stuck with low-paying loans when rates rose.

As housing prices climbed, more and more home purchases exceeded the price cap for government-guaranteed mortgages, which meant that more buyers than ever were taking loans from private lenders (as opposed to the government backed public lenders, Fannie Mae and Freddie Mac). Fannie Mae and Freddie Mac can afford the risk of making low-rate, long-term loans, but private lenders want to earn at least market rate on their loans - today, and in 10 years.

How do you get a borrower to take an adjustable loan when, due to historically low rates, it is in their own best interests to take a low-rate, fixed loan?

You roll out "creative" loan products. Especially since home prices were becoming ever more difficult to afford, borrowers and lenders could acheive a happy compromise - lenders essentially said "I'll give you a low initial payment if you'll agree to take the risk of rising rates." Homebuyers found that an appealing compromise, and adjustable-rate mortgages climbed to historically high levels of total market share at precisely the moment when they should have been falling.