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Scary stories #3

August 23rd, 2002

One of least-known disaster scenarios for the US economy arises from the peculiar structure of US mortgage contracts. Unlike Australian mortgages which have either a variable interest rate or a fixed rate and fixed term, US contracts typically have a fixed rate, but allow early repayment without penalty. In effect, this means interest rates are variable but only downward, since householders can refinance whenever rates fall. They are doing this in droves right now for 30-year and 15-year terms, producing A New Refinancing Boom in Mortgages
For those who like the jargon of finance markets, US mortgages are like fixed-rate contracts with a bundled put option – comparing the terms with Australian mortgages this option appears to be free, but it’s very valuable to the borrower and potentially very costly to the lender.
If US long-term interest rates rise significantly, lenders will be stuck with a lot of long-term mortgages at low rates while they have to finance their activities at the high rates. They will have to bear the difference. Thanks to the securitisation of mortgages it’s unclear who will bear this loss, but the loss is potentially massive. It was precisely this feature of US mortgage arrangements that generated the S&L crisis two decades ago, but no lessons seem to have been learned. Although interest rates aren’t likely to vary as much as they did in the 1980s, the ease of refinancing means that the volume of the problem could be huge even for a rise of a few percentage points in the longterm bond rate.

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