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Mon March 25, 2013
Ask A Banker: Why Do People Keep Trying To Give Me Money?
Originally published on Mon March 25, 2013 12:17 pm
Today's question is from Chris:
Q. Why are so many people willing to lend huge amounts of money (current mortgages) at such low interest rates? (My last refinancing was 15 years at 2.5%.) I realize that mortgage-backed securities used to be considered a more stable investment, but with the last couple of years of housing bust, foreclosures and short-sales, who is investing so much money at such low interest rates?
The short answer to your question is "because the government really wants you to buy a house." I mean, you're okay, Chris, you've got a house, and you're refinancing it and we certainly hope taking out some money to spend on jet skis or whatever. But the rest of you: Buy houses! And, actually, Chris, since we've got you here and you seem like an upstanding guy: Have you ever considered buying another house? Or two?
I'll go into a bit more detail on that answer but first a word of warning. When you talk about financial markets, and mortgages, and the government's role in the two, you will say controversial things. I'll try not to but I will anyway. There's a whole internet devoted to getting really mad about some of the questions we'll talk about below; I'll try to footnote some of them but I can't give you detail on all the controversies. That's what that internet is for.
Okay, so, why is your mortgage so cheap? Well, what are you paying for? I think there are about three things: the cost of money, the cost of risk (that is: the risk you won't pay back your mortgage), and the cost of administering your mortgage.
1. The Cost of Money
There is just a generic cost to borrow money, which economists sometimes call the "risk-free rate." This is the answer to the question "how much would it cost to borrow money for a given period of time if everyone knew you were absolutely certain to repay it?"
This is not an observable thing: there's no one going around borrowing money who is absolutely certain to pay it back, and so you can't just point to the risk-free rate. (In fact there's a long history of things thought of as risk-free, and for that matter of things thought of as risk-free rates, that turned out not to be.)
But for practical purposes, the U.S. government is a risk-free borrower when it borrows dollars, because it can always just print dollars to pay back its debts.* So the interest rate that the federal government pays on its borrowings - the "Treasury rate" - is taken to be the risk-free rate. That rate is very low right now. I mean, it's low because it's risk-free, obviously, but it's also lower than it has been for most of history. Why? I mean, good Lord, the controversy.** Let's throw up a blanket "Outside the Scope of This Column" for our own safety.
But one simple and plausible thing that at least partially explains why rates are so low is that the Federal Reserve, which is among other things the bit of the government that actually prints money,*** has spent the last few years printing lots of money to buy those Treasury bonds.
The Fed buying all those bonds pushes up their price, which pushes down the yield for other people who buy the bonds.****
(Quick explainer: When you buy a bond, you're lending money to whoever sold the bond. In the case of Treasuries, you're lending money to the U.S. government. The government pays you interest on the loan. Yield is basically a measure of how much you get in interest payments. The higher the yield, the more interest payments you get for every dollar you lend.)
The idea here is that lowering the yield on risk-free assets like Treasuries will make risk-free assets less attractive investments for people sitting around wondering what to do with their money. With yield on risk-free investments so low, people will invest in riskier assets and thus help the economy grow. You wouldn't even believe how controversial this is; here is one brilliant investor who disagrees, but if you want to read more opposing arguments just search the comments to this post for the words "Ron Paul," "gold," or "hyperinflation." That should get you started.
2. The Cost of Risk
So the Fed is trying to jump-start the economy by making risk-free investments unattractive — and making risky investments more attractive. Risky investments like: lending you money to buy a house. Right?
Sure, right, whatever. Here is a chart of mortgage rates (in blue) against Treasury rates (in red):
You'll notice that you pay more to borrow money than the Treasury does, which is as it should be. In fact you pay about 1.6 percentage points more for a 30-year mortgage than the Treasury pays to borrow money for 10 years. And that spread is pretty stable: for the last 30 years, the average difference between mortgages and Treasury rates was about 1.7%, though it's been as low as 0.19% and as high as 3.37%:*****
Wait a minute, you might say: with the last couple of years of housing bust, foreclosures and short-sales, who is investing so much money at such low interest rates? Oh, right, you did say that. Anyway, yeah, why is the spread between mortgages and Treasuries so low — pretty much as low as it always is — given the recent unpleasantness?
This gets to the second thing you might be paying for: credit risk. When actual people who aren't governments borrow money, they pay not only the risk-free rate but some premium for the risk that they won't be able to pay back the loan.
And since people sometimes don't pay back mortgages — even now over 10% of mortgage borrowers are behind on payments or in foreclosure — people who provide mortgages need to be compensated for that risk. Sort of.
Actually the way mortgages work mostly goes like this:
- A bank lends you money and gets a mortgage on your house.
- The bank sells the mortgage to Fannie Mae or Freddie Mac or another "government sponsored entity" that pools the mortgage with piles of other mortgages into securities.
- Fannie and Freddie sell those pooled mortgages to investors - hedge funds, mutual funds, pension funds, but also a whole lot of banks, including a lot of banks who sold them the mortgages in the first place.
Why would banks sell mortgages to Fannie and Freddie and then buy them back? Because a crucial piece of magic happens at Fannie and Freddie: they guarantee that the mortgage will be paid back. And that guarantee is, in turn, backed by the full faith and credit of the United States government. You can tell because it says it right on the front cover:
We guarantee to each trust that we will supplement amounts received by the trust as required to permit timely payments of principal and interest on the certificates. We alone are responsible for making payments under our guaranty. The certificates and payments of principal and interest on the certificates are not guaranteed by the United States and do not constitute a debt or obligation of the United States or any of its agencies or instrumentalities other than Fannie Mae.
Umm, well, anyway. I'm sure it says it somewhere in the back.******
If you trust that guarantee — and you basically should — the credit risk vanishes, and these guaranteed mortgages (called "agency" or "GSE" (government sponsored entity) mortgage-backed securities) are as good as Treasury bonds. And there are a lot of them.
Fannie and Freddie and similar government and government-ish guarantees account for something like 86% of mortgages issued in 2012, and got as high as 97% of mortgages issued in 2009, when nobody wanted to take any risk on mortgages.
Since Fannie and Freddie are on the hook if you don't pay back your mortgage, they tend to be pretty picky about whose mortgages they'll guarantee. Fannie and Freddie-guaranteed "conforming" loans tend to go only to low-risk borrowers. People with bad credit tend not to be able to get conforming mortgages. This in turn means that they have a tough time getting mortgages at all, since the housing bust has made those risk-free Fannie/Freddie mortgages a lot more appealing to lenders and investors than the risky alternative.
The trillions of dollars of mortgage-backed securities guaranteed by Fannie and Freddie serve an important function in the economy: they're (credit-)risk-free assets, almost as good as Treasury bonds. This makes them incredibly valuable for things like collateralizing repo transactions, for instance: $700 billion of the $1.9 trillion tri-party repo market is collateralized by agency mortgage-backed securities. (My last column explained the repo market.) This means these mortgages are in heavy demand — so their prices are high — so their yields are low.
You are buying a mortgage, Chris, but you are also selling the main ingredient in one of the economy's most important sources of risk-free assets. People are clamoring for what you've got. No wonder they're willing to give you a good deal.
Incidentally, it's not just banks. Remember how I said that the Fed has bought lots of Treasury bonds as part of its interest-rate-lowering program? Actually, the Fed, like other investors, thinks that Fannie- and Freddie-guaranteed mortgage bonds are really just as good as Treasuries for many purposes, including (1) not losing money because of defaults and (2) the Fed's lowering-interest-rates goal. So, in fact, of the Fed's $3 trillion and change of assets, some $1.77 trillion are Treasury bonds, and some $1.06 trillion are agency mortgage-backed securities. And the Fed is reinvesting around $30 billion in mortgage bonds each month, or around $360 billion a year. Something like a quarter of the mortgages originated this year will find their way to the Fed's balance sheet.
3. The Cost of Everything Else
So rates are low and risk is low so it's no wonder that your mortgage is cheap. There's one more element of cost in your mortgage and that is — eh, like, miscellaneous stuff.
It's all the stuff that sits between the clean, beautiful government-guaranteed mortgage-backed security that sits in the Fed's vault, and the actual guy shaking your hand and giving you your loan. Like: that guy's salary. And the cost of mailing you a bill every month and cashing your check (this is called "servicing," more or less). And the cost of paying Fannie or Freddie's fee for their not-quite-government-but-really-government guarantee. (There's a fee.) And the cost of paying your bank's CEO her multizillion-dollar salary. And profits.
That set of costs is up a touch versus historical levels: over the life of a loan, it seems to be something like 5% of the amount of your mortgage, whereas historically it was more like 1 to 3%. (This is not, to emphasize, per year; it's in total. Over your 15-year loan you can sort of think of it as 0.33% per year added on to your interest rate, though it doesn't exactly work that way.)
There is some controversy over this fact: one way to read it is that the government is spending zillions of dollars to make your mortgage cheaper, but it's all ending up in the pockets of big banks profiting from your misery. Another way to read it is that the costs of mortgage lending have actually gone up: Fannie and Freddie are charging more for their guarantees, and banks are now actually making you fill out paperwork to get a mortgage instead of just flinging cash at anyone who comes within fifty feet of a branch.
So that's another controversy, but in the grand scheme of things it's not such a big one: you're not all that miserable. Your mortgage is cheap! Not all-time-cheapest cheap, but close.
I suppose there's a bigger question, which is: Why is the government so keen on your buying a house?
Again I will default to some simple answers. For a whole lot of Americans, their home is their most important asset and the biggest component of their wealth. During the financial crisis, the average American household lost about $30,000 in home value. That in turn hurt the rest of the economy, making people less likely to spend money or invest because they were all of a sudden a lot poorer.
Making people richer would, on one reasonable theory, help the economy get back on a stable footing. And the easiest way to make people richer is by making their houses more valuable. And the easiest way to do that is by making it easier for other people to pay a lot of money to buy houses. And the easiest way to do that is by making mortgages cheap. Did I mention that every step of that theory is pretty controversial too? It is.
There's a related point, which gets back to one of the controversies we discussed above. I edited Chris's question a bit; he goes on:
Are there enough people's retirements that want guaranteed income funds to back these mortgages? Since I am decades away from retirement I can assure you I'd be disappointed in ~2% return on my investments.
Sure, but your investments don't care about your disappointment. The question isn't "What is a return I would like to receive on my investments," the question is "What are my alternatives?"
Two percent isn't great, but it's better than, like, negative twenty percent, which is why investors who need risk-free assets will suck it up and buy mortgages despite their pretty lame yields. But if you don't like that you have other choices.
You could take more risks. You could, for instance, invest in non-government-guaranteed mortgages like "jumbo" loans that are too big for Fannie and Freddie to buy, or "subprime" loans that are too crappy. Both sorts of mortgages aremounting comebacksas low-yielding risk-free mortgages don't appeal to everyone.
Or you — and here I may be thinking more of hedge funds and banks than you, Chris — could make productive investments in risky companies. You could help a start-up company build a new manufacturing plant, or fund a biotech's development of a new drug.
You — and here we're back to you — could just invest in stocks. Part of the government's goal in making your mortgage cheap is to make mortgages attractive for borrowers, so they can buy more houses.
But the other part is to make (risk-free) mortgages unattractive for lenders, so they're forced to put more money at risk. Risk is, of course, how they lose money, sometimes, but other times it's how they contribute to economic growth. And if the only way for investors to get a decent return is by making investments that also happen to create economic growth, then that's — maybe — what they'll do.
* First controversy! There's an argument that actual features of U.S. law and politics make the U.S. not a risk-free borrower. For instance, the debt ceiling debate demonstrated the possibility that the government would decide not to pay back our debts. That actually drove the cost of government borrowing down: people freaked out about that risk and so moved all their money into risk-free securities. Which happened to be U.S. government bonds. So.
*** Ooh that's a metaphor too. They credit accounts of dealers and banks, not so much with the literal printing.
**** Start with a $1,000 Treasury bond paying 5% interest - $50 a year. The Fed buys and buys and buys until the going price is now $1,100. Then its yield - interest divided by price - has gone down to 4.55% ($50 / $1,100). This is all pretty wrong but good enough to explain the cliché in the text. Here is more.
***** Various things: 1. Why 30-year mortgages versus 10-year Treasuries? Oh various reasons. One is that the 10-year Treasury is the easiest to graph: it was the longest bond issued by the Treasury for some stretches of the last 30 years. Another is that a 30-year mortgage doesn't really feel as long as a 30-year bond, since you pay some of the principal every month instead of paying it all back at the end, and since people tend to prepay their mortgages a lot (when they move, for instance). 2. This reminds me: there are risks to mortgages besides interest rate and credit risk - "prepayment risk" is the big one - that we won't discuss here. The best place to learn about them is, true story, Liar's Poker. It's not the clearest explanation of prepayment risk but it's at least the fiftieth-clearest, and it's a better read than the other forty-nine. 3. The chart and the data come from FRED, the Federal Reserve Bank of St. Louis's magical data and charting website, which you can go to here. 4. More precisely, the average difference between the rates over the last 30 years is 1.69%, median is 1.61%. In the last 10 years the average is 1.74%, median is 1.63%, minimum 1.20%, maximum 2.97%. The current difference is 1.59% (2.04% Treasury rate vs. 3.63% 30-year mortgage). 5. When I say "the average difference between mortgages and Treasury rates was about 1.7%," etc. etc., I mean "... was about 1.7 percentage points," but you knew that and we're not going to be pedants here.
****** For years Fannie and Freddie were viewed to have "implicit" government support. Then they blew up in 2008 and: the government stepped in to support them. So that "implicit support" view was 100% correct. Now they're in a conservatorship where basically the Treasury provides them all the money they need to pay for their losses on mortgage guarantees and other things they like to lose money on, which are plentiful. So they have more-explicit support than they used to, though still not so explicit that they can say it on the cover. And many people are trying to figure out a way to get them off government support, including notably the government. Background here and here.