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December 17, 2008

No Lender Risk in Housing Plan

Catherine New
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In a December 17 op-ed in the Wall Street Journal, Senior Vice Dean Christopher Mayer and Dean Glenn Hubbard expressed their support of a U.S. Treasury plan to lower mortgage rates for new homebuyers to as low as 4.5%. The Treasury’s plan closely parallels Mayer and Hubbard’s own plan, which they unveiled in October. The op-ed follows Mayer’s presentation about mortgage rates and homeownership at the Bernstein Center research symposium, “Preventing the Next Financial Crisis,” on December 11.

In the op-ed, Mayer and Hubbard demonstrate the strong relationship between housing prices and mortgage rates and how lowering mortgage rates now will likely increase homeownership rates in 2009. They also argue that house prices are already at or below where they should be based on fundamentals (download research paper PDF).

They also address one of the main concerns swirling around the Treasury’s possible plan: its risk to lenders:

Some have argued that lenders should earn more than the average 1.6% spread, to compensate for the fact that housing is a much riskier investment today. We don't think so. Recall that a mortgage can be thought of as a risk-free bond plus two possibilities that increase risk to lenders: default and/or prepayment. Historically, the risk of default adds about 0.25% to the interest rate. The remaining spread of the mortgage rate over the Treasury yield represents the risk of prepayment and underwriting costs. With falling house prices, the risk of default could indeed add 0.75% or more for a newly underwritten and fully documented loan. But 4.5% would be the lowest mortgage rate in more than 30 years — so the additional risk to lenders of prepayment would be almost nil. And low mortgage rates would substantially reduce the risk of further house price declines.

Professor Charles Calomiris, speaking at the Bernstein Center symposium, supported Mayer’s plan, saying, “The incremental costs to the taxpayers are negative. The GSEs that we now own have $5 trillion of mortgage debt, $1.6 trillion is subprime with 10 times the current default rates of the normal remainder in that portfolio. We also have trillions of dollars of FSA mortgages and, of course, [the ones] in the private sector. If you look at expected losses on those subprime pieces, which are somewhere between 20 and 25% right now, that the effects of [Mayer’s] proposal would be to reduce taxpayer’s fiscal costs going forward.”