Missing mortgage contract innovation

From WSJ 

"Many Americans who want to move are trapped in their homes—locked in by low interest rates they can’t afford to give up. 

These “golden handcuffs” are keeping the supply of homes for sale unusually low and making the market more competitive and pricey than some forecasters expected.   

The reluctance of homeowners to sell differentiates the current housing market from past downturns and could keep home prices from falling significantly on a national basis, economists say."

What's going on? US 15 or 30 year fixed-rate mortgages have a catch -- you can't take it with you. If interest rates go up, and you want to move, you can't take the old mortgage with you. You have to refinance at the higher interest rate. It's curiously asymmetric, as if interest rates go down you have the right to refinance at a lower rate. 

As a result, yes, people stay in houses they would rather sell in order to keep the low interest rate on their fixed rate mortgage. They then don't free up houses that someone else would really rather buy. (In California, the right to keep paying low property taxes, which reset if you buy a new house also keeps some people where they are. And everywhere, transfer taxes add a small disincentive to move.) 

This is a curious contract structure. Why can't you take a mortgage with you, and use it to pay for a new house? Sure, mortgages with that right would cost more; the rate would be a bit higher initially. But fixed rate mortgages already cost more than variable rate mortgages, and people seem willing to pay for insurance against rising rates. I can imagine that plenty of people might want to buy that insurance to make sure they can live in a house of given cost, though not necessarily this house.  Conversely, fixed-rate mortgages that did not give the right to refinance, where you have to pay a penalty to get out of the contract if rates go down, would also be cheaper up front, yet people aren't screaming for those. 

Even the right to refinance at a lower rate is weird. A straightforward mortgage would have a 30 year fixed rate, but automatically lower that rate as other interest rates go down. Instead, you have to go through the formalities of refinancing, which adds a lot of fixed costs to the decision. I know a lot of very sophisticated finance people. Not one has ever reported that they've really solved the complex option pricing problem, when is it optimal to refinance a conventional mortgage?

The 15 and 30 year fixed rate mortgage, with right to refinance, is peculiar to the US. You can't make a psychological argument for it. Most of Europe has variable rate mortgages. And a lot less interest rate risk on bank balance sheets! 

So why are we here, and given that we are here why does this strange contract seem so resistant to innovation. I think the answer is simple: 15 and 30 year fixed rate mortgages were a creation of the federal government during the Great Depression. And today the vast majority of mortgages are securitized via Fannie Mae, Freddy Mac, VA etc, along with a generous government guarantee. Those have to conform to specific contract structures. You can't innovate better contracts and then pass the loan on via government agencies. (Commenters, correct me if I'm wrong. My recollection of the history is foggy here.) 

This all points to an interesting and usually unsung problem with extensive government intervention in the mortgage market: It freezes contract terms. Contracts that might be very popular -- such as the right to transfer the mortgage to a new house, or the right to settle up in both directions, marking the mortgage to market so you can pay a new higher rate -- don't get innovated. 

Updates:

The is not, of course, a particularly original thought. Alexei Alexandrov, Laurie Goodman, and Ted Tozer at Urban Institute have a nice article advocating streamlined refinancing. They also point out the Fed should care, as it wants interest rates faced by borrowers to adjust more quickly. Ted Tozer points out that you can leave it behind -- a new buyer can assume an existing mortgage. However this feature doesn't often get used. 

I once was at the Swedish central bank talking about monetary policy. They were worried about raising interest rates. I presumed they were worried that too big to fail banks would have trouble. No, they said. In Sweden practically all mortgages are floating rate. And you can't just mail in the keys and default on mortgages. If you default, they take all your assets and garnish your wages. (So much for soft hearted socialist Scandinavia.  They are actually quite attuned to incentives.) The banks were going to be fine. They were worried that if they raised interest rates, people would do anything to pay their higher mortgage rates, and this would tank consumption. Talk about effective monetary policy! At the time however they were worried about house prices, and didn't want effective monetary policy. Long story short, mortgage contracts matter.  

(Martin Flodén, Matilda Kilström, Jósef Sigurdsson and Roine Vestman document this "cashflow channel" in the Economic Journal. It's on the back of my mind also in the search for better mechanisms to understand whether and how higher interest rates lower inflation.)  

Roger Baris writes: 

I thought you might want to know a bit about the Danish mortgage market, which basically has the features both you and the Urban Institute mention.

1. A very old securitization market. Created in the early 19th century to help rebuild Copenhagen after the Brits shelled it when Denmark complied with Napoleon's "Continental System" which blockaded trade with England. I guess the Brits really hated being cut off from all that fine Danish butter and bacon.

2. At the initiation of the mortage, the borrower basically swaps his commitment to pay a 30-yr, fixed rate mortgage for bonds in a large, largely homogeneous  (with respect to maturity and interest rate) bond issuance. The bonds are then sold at the prevailing market price, with the proceeds providing the financing for the house buyer.

3. The loan is prepayable at any time. Like the UI proposal, the originating bank (which continues to service the loan) actually prompts borrowers with high interest rates to prepay (since the bank earns some fees in the process and therefore has an economic motivation). There is no re-underwriting of the loan at this point so long as the amount of the loan does not increase. This is a very quick and very cheap process. This is used if interest rates fall (in which case, the borrower's new loan is instantly securitized into a new bond issuance with uniform characteristics, with an equivalent amount of the old bond being prepaid) or if the borrower wants to prepay the loan for a house move. (If I remember correctly, the loan may be also be "portable" to a new house but in this case, the value of the new house has to be re-underwritten.)

4. Note that the servicer in a US mortage is contractually forbidden to prompt prepayments in this manner, although enforcement of this provision is sometimes difficult, as you can imagine.

5. If interest rates rise, conversely, the borrower has the option (if he/she wants to prepay the loan for any reason, especially a house move) of going into the bond market (which is highly liquid with large, uniform pools) and buying an equivalent face amount of bonds (at a discount because rates have risen) and then delivering these bonds to extinguish his/her mortgage liability.

6. In practice, all the bond market activity (both at issuance and extinguishing) is handled for the borrower by a mortgage bank.

 The net effect of all of this - the loan prepayment right, the "portability" and the option to deliver bonds to extinguish a loan - is to make the embedded interest rate option in a Danish fixed-rate mortgage more optimal than the same option in a US mortgage. This means that, as you would expect, the borrower pays a higher "spread" on the loan from the beginning in return for the greater optionality.

PS. The Danish mortgage system also has some interesting characteristics in terms of mutualizing risk; these characteristics also interact with the interest rate option.