Reform of the mortgage markets is coming. It has been mandated by the Dodd-Frank Law. But how to meet the challenge of avoiding another financial market meltdown while making sure Americans will be able to get a mortgage is not simple. The recently made public Obama Administration report offered three possible scenarios. Even among the top economic experts, there is no clear consensus about how to fix the problem
Many want Fannie and Freddie, the two government-backed mortgage giants who have required a huge taxpayer bailout to disappear. They argue that government is interfering in what should be private market functions. The problem is that the thirty-year fixed rate mortgage with its no penalty pre-payment option is incompatible with the goal of replacing Fannie and Freddie with private investment.
It's no surprise that 30 year fixed rate mortgages are popular. Borrowers are locked in at known interest rates and if these drop, they can refinance at a lower rate. But that's exactly why these mortgages are a problem for investors. Absent any kind of government guarantee to protect them against credit losses, private investors will demand a higher yield to compensate for their risk. That means higher interest rates for home buyers.
One possible plan offered replaces Fannie and Freddie with another government backstop through a form of insurance, much like the FDIC guarantees bank deposits. Again, that would add extra costs to mortgages.
The Treasury Dept. acknowledges the problem and notes that with less government backing, the 30-year fixed rate mortgage option becomes less feasible. It also notes that there would be a reward. With less money going into housing, there would be more capital available to flow elsewhere, potentially leading to more long-term growth for the economy. Plus fewer mortgages made would mean less demand for housing and would keep home prices from going up, reducing inflationary pressures. Loans would cost more but homes would be less expensive.
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