After being debt-averse my whole life, I finally got a mortgage in 2020 when the prevailing interest rate dropped below the expected inflation rate. Because that meant real rates were negative, and sure, I'd love to get paid for taking out debt. At least so far, it's been a great trade, with me paying 2.75% on my mortgage and my home's value up about 35%.
Out of morbid curiosity, I'd like to know who I'm screwing over. Somebody out there is getting a 2.75% cash flow in a 7% inflation environment. Is it my mom's pension fund? The Saudi sovereign wealth fund? Wells Fargo? The Federal Reserve, and hence everybody who pays for goods with dollars?
[1] https://www.bogleheads.org/wiki/Three-fund_portfolio
[2] https://investor.vanguard.com/mutual-funds/profile/portfolio...
The interest represents the time value of money, which may be different to each side.
Maybe the other side thinks that the 7% inflation is just a short spike over the duration of the mortgage.
Maybe they would like to get USD in the future from a stream of USD denominated mortgage payments if they think the dollar is going up relative to their own currency.
Aside from the time value there may be other reasons, too:
Maybe there are regulatory reasons forcing them to buy a certain amount of mortgages or bonds to diversify across asset classes with different risks.
Or maybe it is just their own diversification strategy to do so.
Financial risk relates to how much the value of an asset changes over time (its variance) so in many cases holding “too many” high-growth stocks in a portfolio is beyond the risk appetite for many investors. Lower yield more stable assets are desirable to balance this.
There are no situations in which every participants wins. There are always "losers" as long as there are finite resources.
Like you said, both participants in the mentioned deal could be profiting, but there are more participants involved on the open market which are affected.
The "losers" are often hard to determine, as the previous commenter correctly pointed out. Nonetheless, the wealth came from somewhere. If it really was "created" from the interaction then this creation causes inflation, effectively removing wealth from everyone holding the currency in which the money was "created".
It's true that this particular deal will have a miniscule effect, but in does matter in aggregation with everyone else that made similar deals.
Macroeconomics is a much more challenging topic then you seem to realize
How about the comparative advantage that Ricardo developed in 1817? https://en.wikipedia.org/wiki/Comparative_advantage
It's true that people can gain efficiency with specialization for example, but that's not necessarily a gain unless you define efficiency as the primary goal to be achieved.
This gained efficiency will then over time make this the most economical way to produce. This effectively harms everyone that hasn't adapted yet
It's just not an easy topic and claiming it is doesn't help whatsoever
Nor did I ever claim that it was Zero Sum at any point. I just pointed out that there are, by necessity, always "losers". That doesn't make it a zero sum game, as the values can be different and have very confusing side effects.
Presumably what you're referring to is that in a realistic market, there are also tons of other people who are willing to swap their wares, and maybe they'll offer me something better for a gallon of water than a pound of meat. So sure, I could be taking a sub-optimal deal by trading with you at the rate you want. But the trade is still positive-sum, no loser in sight. In an efficient market most trade is net beneficial to everyone and doesn't necessarily have losers, including when you start layering in credit and derivatives and inflation and velocity of money and whatnot, even if it gets really complicated. That is possible because we all have slightly different self-valuations of money, goods, and risk at different scales, and the markets let you trade each for the other until you've self-optimized your portfolio blend.
That's not to say you can't come up with scenarios where there are unambiguous losers, but it's definitely not some law of economics or anything like that.
> it's definitely not some law of economics or anything like that.
This is a no true scotsman fallacy. It's true that this is not a preordained truth, but you'll realistically always have someone at a loss for as long as resources are limited. And if you can't see one than you're just ignoring the one's at a loss as irrelevant.
I.e. descendents with natural resources or even non-human entities in the context of meat production etc
Edit: I flatly reject the notion that strictly someone's gain requires someone's (non-proportinate) loss, ie that there are always "losers". That notion is also not really a current macroeconomic position.
Now imagine actually having a mortgage with an interest rate that was negative:
* https://www.theguardian.com/money/2019/aug/13/danish-bank-la...
Ahhh, there it is. So they probably just make Central Bank finance their fees, using borrowers as a conduit. Clever.
> Somebody out there is getting a 2.75% cash flow in a 7% inflation environment
Everybody with cash savings, I guess. Savings rates are abysmal for a while now. Otherwise, not sure.
From what I know that's a rare scenario. Stressed asset (i.e., mortgage contract) holder typically sells off that asset to someone else at a discount. The buyers are those someone who specialise in holding semi-toxic assets and know how to make money out of it.
Lenders typically don't want to deal with the underlying assets. It's time consuming and not their speciality. Lenders just want to recoup whatever money they can fast and be done with it.
Are mortgage rates and cap note returns in the US not tied to the federal interest rate?
Here, pretty much every note traded publicly will yield x% above RBA (reserve bank) interest rates, and most mortgages will be "variable rate" - ie they'll automatically adjust to be some function dependent on the RBA rate.
You pay a higher rate for a fixed than a variable, but you get a lot more certainty.
Do people just pay the principal and interest for 30 years?
If interest rates go down, you refinance. If interest rates go up, you hold onto that cheap debt as long as you can. It’s a pretty unique product in that one party (the consumer) gets complete flexibility whereas the other (the bank) doesn’t
Or, you "refinance" your loan for a better interest rate after you have paid down the loan some. For example, I bought a house in 2018 and refinanced in 2020. Since my home price has gone up in those two years, and I had also paid some of the mortgage off, my rate was much better since my loan-to-value ratio was lower (basically the percentage of the market value of the home you are borrowing... the lower that is, the less risk the lender is taking, since they can sell the house to get back more than the cost of the loan, therefore it has a lower interest rate) I was able to save a large amount on my payment (went from paying $4700 a month to $3600), although it did extend the term of my loan for an extra two years. However, I doubt I'll be in the house that long anyway.
I believe the average mortgage duration is ~8 years, which is why the ‘mortgage rate’ tracks the 10 year Treasury rate and not the 30 year Treasury rate.
In several rounds of house buying and/or refinancing, I’ve never even seen an offer in the US that didn't expressly note the absence of an early payment penalty.
https://www.nolo.com/legal-encyclopedia/when-are-prepayment-...
Or do there tend to be clauses that allow full repayment on transfer of ownership or something like that?
Most of us have variable mortgages with less conditions placed upon them.
A typical value is 5 years.
Only briefly; the 30 year fixed has been a norm for a very long time, and the expansion of ARMs and more exotic creative financing instruments in the bubble leading up to the 2008 finance crises was itself a short-term aberration; there was also a brief run up in popularity when interest rates spiked in the 1980s (to avoid locking in sky-high rates.)
When I first bought my house interest rates were over 7%, so getting discount on the interest in exchange of the risk of an adjustable rate mortgage made some sense.
The bank doesn't care what interest rates are going to be next year, because they sell the mortgage now and collect the cash for it. The buyer cares, but the buyer is probably a hedge, pension, or sovereign wealth fund that in theory at least should be able to estimate & offset interest rate risk.
I wish the article went into more detail about exactly who the losers are in this system. I suspect that it's essentially a policy by the U.S. government to increase social stability (in the form of homeownership, stable residence, investment in communities) at the expense of holders of U.S. dollars and dollar-denominated assets (i.e. most of the rest of the world). In other words, it's transferring wealth from non-citizens in exchange for keeping citizens happy, which is a pretty typical government play. It also looks like the system is on the verge of collapsing, in the sense that it pumps up house prices and encourages artificially low interest rates and high inflation, and hence an increasing number of American renters are being caught on the wrong side of the equation.
Interest rates are set in a competitive market. At any given point, there's a relatively fixed supply of money being put into what's on offer.
For buyers like pensions, it's simple: get the highest rate they can with acceptable risk and diversification. Keep in mind that not all of a fund's assets should be invested in super-long duration loans. Anyone running a fixed income portfolio understands this is a major source of risk (interest rate risk) as long-dated bonds are one of the most rate-sensitive investments possible. You'd do better with a blend of short, medium, and long-duration debt to ensure you don't end up hosed when rates move the wrong way.
Also keep in mind, many net buyers of this stuff are using it to offset long-term liabilities -- insurance loss payments, pensions, etc. Insurance companies will adjust premiums based on earnings of their investment portfolios.
And finally, keep in mind that interest rates aren't just a video game. There are major "real" drivers of them, economic growth being one--the demand for credit and its supply absolutely shifts over time, and throughout the business cycle. Real economic variables like demographics, home building, population shifts, the number of retired (more savings) vs working (more wage income) people in a population, etc. cause this stuff to move around a lot. If someone gets a higher rate, it's because at the time, there was more demand for credit, it wasn't just someone "losing" or getting "ripped off" that made that trade possible.
One thing to note about securitization and prepenalties:
The risk of prepayment being priced in, but there is the opposite balance of the fact Mortgage Originators (not the borrower) in some circumstances do have a prepayment penalty; this period is typically up to 6 months after closing.
So, they care, but the risk is (like so many in finance) heavily abstracted.
People who dont qualify. People who misuse it. As is the case with much debt, there is debt given to people who consume it, spend it, lose it and owe it; and there is debt given to people who invest it, accrue with it, and profit from it. Many people may stumble through the process and benefit from it, while the purchasing power of others who cant get it is diluted.
- fallout risk https://www.investopedia.com/terms/f/fallout-risk.asp
- pipeline risk: https://www.investopedia.com/terms/m/mortgage_pipeline.asp
For the fallout risk an originator can typically model the impact on the value of a mortgage with a conservative low digit basispoint estimate (following past fallout patterns that have been observed for example), for the pipeline risk the originator may do some more exotic price modelling by deriving implied interest rate volatilities from market prices (of interest rate derivatives).
Both risks are relatively speaking minimal given their short horizons and the (current) low volatility of interest rates.
I am impressed with the quality of the website linked to by the author of this thread, great read!
If the consumer doesn't like that they can get a lower cost variable rate mortgage just as easily.
The socialization-of-losses aspect comes through interest rates. When wealth isn't held but is traded on markets, there's an incentive to hold interest rates artificially low, because that makes asset prices artificially high. High asset prices benefits all asset holders, so you can make people happier than they otherwise would be simply by keeping rates low.
2006/2007 was when the foreclosures started happening. Interest rates started going up in that timeframe [0], which lines up with the idea that folks couldn't refinance their ARMs into something they could keep paying on; first due to the higher interest rate, and second because the higher interest rate cause their house values to plummet. As these defaults piled up, in late 2007 and early 2008, the banks who later folded realized that their portfolios were not really salvageable.
All APR to keep all the payments lower... they lost them all in 08/09.
It is.
> The rate is fixed till the renewable period, typically 5 or fewer years.
Lenders and mortgage brokers will often heavily push loans like that, ARMs with a short initial fixed period, using the (usually slightly) lower initial rate and the prospect of refi before the float as a hook, but full-term fixed-rate mortgages are still more popular.
No, it doesn't. That's a chart of the average annual interest rate of 30 year mortgages, not the share of mortgages that are 30 year mortgages.
EDIT: The Mortgage Bankers Association does regular press releases of stats [0], and in them recently ARMs seem to be 3-3.5% of applications.
[0] e.g., https://www.mba.org/2022-press-releases/january/mortgage-app...
What does that have to do with the ratio of fixed rate to adjustable rate mortgages?
Categories > Money, Banking, & Finance > Interest Rates > Mortgage Rates
Unless you're not arguing against the last part of the parent comment...
But for a bank, the government requires them to maintain a certain reserve amount. This is to handle withdrawals that are greater than planned.[0] The current loan value is an asset to the bank and so counts towards the reserve ratio. If the loan value drops, then they will have to sell some assets (probably some of those same loans) in order to raise some cash. Since they're forced to do this when it's disadvantageous to them, and it's likely that other banks are also trying to unload some loans to meet their reserve requirements, they have to offer those loans at a significant discount. Meaning they get even less for them than the low value they had them for.
[0] This is what killed Wachovia. There was a "silent" run on the bank over the weekend in 2008 by wealthy customers transferring out amounts above the then-FDIC insurance limit of $100k. It wiped out their reserves and the government forced a sale.
Mortgages are generally securitized. High level, a pool of unrelated mortgages (think different parts of the US, different types of borrowers, different credit ratings) are packaged up together and then split into different tranches. Say you have tranches AAA-B. These different tranches are sold to different parties with different risk appetites.
Each tranche has a set interest rate, and AAA will have the lowest, and B the highest. Say like 2.5% for AAA and 7.2% for B. AAA is the most "senior" and B the most "junior".
When borrowers pay back their monthly payments, first the interest gets distributed to AAA->B, then all the excess goes back paying the principal of AAA. Once AAA is fully paid back (say 5 years later for a 30 year loan), the AAA bondholders no longer care about the mortgage, and the excess gets paid towards AA principal (then A, BBB etc). This keeps going on until every tranche gets fully paid back.
By structuring it this way it's "almost impossible" for the more senior bondholders to realize a loss.
Obviously there is more risk for B bondholders (given they are being paid 7.2% interest). So in this case, losses in mortgages are borne by B principal holders until they get exhausted.
Zooming back into the pre-payment risk, it's entirely possible that prepayments/refinances will allow the more junior tranchess to avoid as much principal loss as expected while picking up that juicy yield. (note when the yield for more junior bonds are 7.2%, anyone buying these already planned for some amount of realized losses)
This pic from wikipedia illustrates some of the concepts https://en.wikipedia.org/wiki/Tranche#/media/File:Risk&Retur...
For #1, see the section headed "The risk of non-payment". Prior to the mortgages going into the pool, insurance against default is purchased from a GSE. In exchange for this insurance payment, in the event of default, the GSE buys back the mortgage for the remaining principle balance. So as an investor in the typical MBS, you don't face this risk.
For #2 and #3, while it could go into it in more detail, this is discussed in the section titled "Every other risk you could imagine, of which there are many". It notes that the value does change as a result of interest rate changes (in the context of noting this as a key reason why most mortgages are not held by banks, but other institutional investors which can better tolerate this interest rate risk).
Maybe you meant this and just wrote it differently, but I'd argue it isn't that it is worth less so much as its liquidity has declined. You felt good enough about that 5% at the time you bought out the mortgage, but now it isn't as good a return as you would get if rates were at 10%, thus it may be difficult for you to sell that mortgage off to someone else given their opportunity cost.
On the other hand, rates (at least in the US) are unlikely to jump even a full 1%,let alone 5%, in such a timeline that you couldn't retrench if you believed you were better off to liquidate and move on to higher yielding assets.
Lower liquidity would show up as wider bid/ask spreads, which doesn’t happen in that case.
There's no way to properly do this.
It's why 2008 occurred, and why it'll occur again.
https://en.wikipedia.org/wiki/Government-sponsored_enterpris...
As I understand, the goal of those entities is to simply lower the costs and increase access to loans to the US public.
The folks who bought the principle payments are very happy to get paid early.
1) Default risk - Obviously if I invest in pools of mortgages, and a lot of people stop paying their loans, I am exposed to risk. In many cases I'm insulated, because if someone defaults, I now own the home and can sell it to recoup my losses. But there's costs associated with foreclosing and in some cases, the value of the house goes down by enough that I can't recoup my money anyways (see 2008). We slice and dice mortgage pools to reflect this, so that the junk bonds are at the bottom and pay more and the AAA are at the top and don't lose anything until the lower tranches lose everything.
2) Interest rates rising - he discusses this in the article. If interest rates go up from 5 to 10% then any notes I held on a 5% loan are worth less.
3) Interest rates falling - this is called "pre-payment" risk and is what makes mortgages so interesting (and much harder to value than corporate bonds and most other loans). See point 2 for why rates rising hurts the owners of mortgage notes. You might think that rates falling would therefore help them, but it doesn't directly correlate. If rates fall enough, many people will refinance their loans. You have the right to pay off your mortgage at any time and another bank will be happy to step in and give you a new loan. So if rates fall from 4% to 2%, you can bet that most people will refinance. If I'm an investor holding a pool of 4% loans, then most of those loans will get paid off and now I'm stuck being in a market where I can only buy pools of 2% loans. Corporate bonds generally don't work this way. Auto loans technically do, but given the size and durations of the loans, it's usually not worth the hassle to refinance in the way it is for a house. This pre-payment risk makes the modeling of mortgage investment much more complicated, but also more interesting than many other financial securities.