Monetary policy and golden handcuffs
The United States is a quirky place, and its mortgage industry is no exception. Instead of borrowing at variable rates like we do Down Under, when you take out a mortgage in the good ol' US of A you’re generally locking in the rate for 15 or 30 years.
Now banks borrow short and lend long – how on Earth do they manage the enormous risk of maturity mismatch that this model entails? The simple answer is that they don’t; a legacy of the Great Depression, most US bank-issued mortgages are sold on to the US Government (Fannie Mae or Freddie Mac), which then guarantee it against default, package it up with a bunch of other mortgages into what’s known as a mortgage-backed security, and sell it on to investors (or the US Federal Reserve if no buyers can be found, as was the case during the Great Recession).
In other words, the US taxpayer takes on all the risk of that 30-year, fixed rate mortgage (FRM). And it’s not a great deal:
“The interest rate and prepayment risk in the FRM are costly and difficult for investors to manage. There is a premium for both the long-term and the prepayment options that are paid by all users of the mortgage. The FRM causes instability in the mortgage market through periodic refinancing waves. The FRM can create negative equity in an environment of falling house prices. And the taxpayers are on the hook for hundreds of billions of dollars in losses backing the credit risk guarantees provided by Fannie Mae and Freddie Mac to support securities backed by the FRM.”
But there’s also another consequence of the US government’s decision to structure the housing market so that FRMs are the norm, the so-called ‘golden handcuffs':
“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.”
This is a fundamental difference between the US and Australian economies. When our respective central banks hike rates to tackle inflation, many Australians feel the pain directly in their hip pockets. Sure, depositors benefit, but the ratio of household deposits to liabilities is around 53%, meaning in aggregate higher mortgage repayment rates are likely to sap far more purchasing power out of the economy than is put back in via higher deposit rates.
In Australia the ratio of household deposits to liabilities is well below 100, so higher rates are likely to sap consumption.
While many American homeowners are able to dodge the impact of higher interest rates on mortgage repayments due to their fixed rates, they feel it elsewhere. Namely in the form of decreased mobility: to move to a better job in another location, a household with a juicy 30-year, 2.6% rate locked in during the pandemic would have to give it up for something closer to 6.3% today.
Add stamp duty and other fees onto that and you get a huge economic allocation issue caused by very large transaction costs. Not only are people with mortgages ‘handcuffed’, but even those without a fixed mortgage are worse off: housing isn’t being freed up for people looking to move in the other direction, either.
Rather than combating inflation primarily through the monetary transmission mechanism (higher mortgage rates reducing household consumption), as occurs in Australia where variable rates dominate, in the US monetary policy slows inflation by throwing sand in the gears of economic activity.
While no monetary regime is perfect, compared to the US the Australian model doesn’t seem all that bad.