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Mortgages are a manufactured product (kalzumeus.com)
198 points by smitop 7 days ago | hide | past | favorite | 222 comments





This is generally a pretty interesting article, but I wish he'd expand into the other risks inherent to pools of mortgages:

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.


I also wish there was more about inflation risk.

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?


Vanguard's trademark total bond ETF BND, which is a part of the classic 3-fund portfolio [1], a cornerstone of passive investing, has 2.2% commercial and 20% government-backed mortgage backed securities [2]. So a lot of everyday folks across America, especially those retired looking for a stable cashflow for retirement, are helping fund your mortgage. It's a bit of win-win situation (albeit a loss for them during high inflation as you point out): you need money now, and they need a mostly guaranteed return on their money in 10-20 years time that pays out better than Treasuries, and gives them diversification compared to bonds (either Treasury or commercial).

[1] https://www.bogleheads.org/wiki/Three-fund_portfolio

[2] https://investor.vanguard.com/mutual-funds/profile/portfolio...


You are not screwing over anybody. It is a two-sided deal that both parties find good.

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.


> You are not screwing over anybody. It is a two-sided deal that both parties find good.

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


> There are no situations in which every participants wins. There are always "losers" as long as there are finite resources.

How about the comparative advantage that Ricardo developed in 1817? https://en.wikipedia.org/wiki/Comparative_advantage


The theory is valid but too abstract to really point out where people lose something in return for what they've gained.

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


Macroeconomics are not a zero sum system and wealth creation is also not money creation.

No, it's not. A full field of research can never be adequately reflected with a single term.

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.


There are not always losers, though, in a very real sense. If I have nothing but 100 gallons of water and you have nothing but 100 pounds of meat, then an exchange of some amount at the margins benefits both of us in every way. If we set the amounts that we trade carefully enough, then we'll both win by the exact same amount (however we measure that in our own heads), and it's really hard to call anyone in that situation a "loser".

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.


This discussion is quiet far from what I've initially said from my perspective, nonetheless...

> 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


Not sure there is a strict necessity for "losers", either, if you want to go to positive sum, but claim some gain more than others lose. Situations where in a small world both sides gain (ie no loser) are conceivable.

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.


You're screwing the people who have to pay much more to get on the property ladder than those before them. In essence, it's a transfer of wealth, predominantly from younger people (getting on the property ladder) to those who have been on it for a long time. What the younger generation will do when it's their turn (when most of them couldn't even afford to get on the ladder in the first place, nowadays), I don't know.

Can you explain the "ladder" aspect of this?

The idea of the "property ladder" is that your first house is (relatively) cheap, and then as your get older your earnings increase and the old mortgage seems cheap, and maybe you now have children and want a bigger place, so you sell your property, hopefully making a profit on it, and buy something bigger that you couldn't have afforded before, and repeat. The reason for the ladder metaphor is that each house is a step towards the next bigger house, but if you hadn't bought the first house, probably you wouldn't have the increased equity available to make the more expensive house available to you. Likewise, with a ladder, you have to do all the steps in order.

> 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.

Now imagine actually having a mortgage with an interest rate that was negative:

* https://www.theguardian.com/money/2019/aug/13/danish-bank-la...


> In reality, the Jyske mortgage borrower in Denmark is likely to end up paying back a little more than they borrowed, as there are still fees and charges to pay to compensate the bank for arranging the deal, even when the nominal rate is negative.

Ahhh, there it is. So they probably just make Central Bank finance their fees, using borrowers as a conduit. Clever.


I'm still not sure how comes we have inflation closing in to 10% but banks are willing to give me mortgages under 3%. Somebody is getting suckered here, and I suspect it's me, but I am not sure yet how.

> 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.


Probably just future generations of taxpayers and/or the people you will eventually sell your house to?

> because if someone defaults, I now own the home and can sell it to recoup my losses.

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.


I'm slightly confused by 2 and 3, as I own cap notes and have friends with mortgages (in Australia).

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.


Many people have variable rate mortgages, but the standard mortgage that most people try to get is a "30 year fixed", where the interest rate is locked for the entire 30 year term.

You pay a higher rate for a fixed than a variable, but you get a lot more certainty.


In Australia the amount you can overpay a fixed mortgage before you incur fees is relatively low. (Ie if you pay beyond an additional $20,000 per annum you start incurring fees.) Is it the same in the states?

Do people just pay the principal and interest for 30 years?


> 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


No, in general there is no prepayment penalty. In fact, it is relatively rare for a 30 year mortgage to last the entire 30 years. Normally it is paid off early, either because the person sells the home and moves somewhere else, meaning they pay off their old mortgage with the proceeds from the sale and get a new mortgage for the new house.

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.


> No, in general there is no prepayment penalty. In fact, it is relatively rare for a 30 year mortgage to last the entire 30 years.

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 Australia the amount you can overpay a fixed mortgage before you incur fees is relatively low. (Ie if you pay beyond an additional $20,000 per annum you start incurring fees.) Is it the same in the states?

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.


Except for certain very restricted circumstances, prepayment penalties have been illegal since 2014:

https://www.nolo.com/legal-encyclopedia/when-are-prepayment-...


So what do people in Australia do when they move and have to sell their house, which will happen a lot before the 30 years is up? Are the buyers stuck with the exact same terms that the original purchasers set on the remaining principal, and then have to enter a separate mortgage for the part that's already paid off?

Or do there tend to be clauses that allow full repayment on transfer of ownership or something like that?


We generally can't get fixed term mortgages that are greater than 3 years.

Most of us have variable mortgages with less conditions placed upon them.


No generally there is no pre-payment fee. Although I'm not going to say it doesn't exist. I've only heard about it on the internet. The avg length of stay in a house is like 4-5-6 years anyway at which point you request a payoff amount and the buyers money is sent to pay off the note. You can also pay any additional principal amount you'd like and pay it off in full at any time. You can also refinance it at any time if the rate drops.

In the US, the standard mortgage is 30 year fixed. i.e. you pay the same rate for 30 years. Adjustable rate mortgages exist, but are less typical.

That's pretty unique to the US, I think. Canada has no comparable product and the difference between "fixed" and "variable rate" mortgages here is that fixed mortgages are fixed for five years.

Adjustable rate mortgages (ARMs) weren't even available in the US until 1982, Congress didn't allow them. They're still around, the type you describe is a 5/1 ARM. Fixed rate for 5 years, adjusts every year after that. 3, 5, 7, and 10 year ARMs are common. A 5/1 loan rate is about 1% lower than a 30 year fixed now. It doesn't make much sense to me to take the risk with rates as low as they are now.

Those used to be much more common in the US. The 2008 housing crisis changed everything, and variable rate mortgages are extraordinarily rare now.

Interestingly, I never saw a fixed rate mortgage for 30 years in my country. The top fixation period is usually 10 years, anything higher than that is unusual.

A typical value is 5 years.


> Those used to be much more common in the US

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.)


Main factor is that interest rates are so low (and have been for years now). With very low interest rates, it would be foolish to get an adjustable rate mortgage since it only has room to go up. Much better to lock in the very low rate for life. Thus, approximate nobody takes variable rate loans anymore.

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.


Not unique, standard in several European countries I’ve lived in too

Surprising, that seems very inefficient. As a bank offering a mortgage I have to set an interest rate for entire period? Naturally I’m going to be conservative to ensure profit.. which hurts the consumer. Variable or short term fixed rates seems much more logical.

That's the point of securitization, which is the point of the article. The banks aren't holding the mortgage. They immediately sell it off to some other financial institution who wants to buy what basically amounts to a homeowner bond that pays the prevailing interest rate. (There are some differences mentioned elsewhere in this thread, notably that the homeowner has an option to pre-pay, there's collateral that the mortgage holder can foreclose on, risk profiles are different for homeowners than corporations, etc.)

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.


It's interesting you think there necessarily are "losers".

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.


> 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.

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.


>who the losers are in this system.

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.


Patrick also links a good newsletter at the end that goes into the "who are the losers" question a bit: https://byrnehobart.medium.com/the-30-year-mortgage-is-an-in...

Interesting insights, my brain always goes to how to reduce inefficiency but there are many more things at play.

What percentages of conforming mortgages are sold off by the originators that wrote them, before the first payment is even due? If it is conforming, or close, there is almost no risk for the initial underwriter? I could be way off base, but that's mostly what the article is about, that the people offering loans arent the ones holding the risk.

Regarding risk for the initial underwriter, there are two main elements I think:

- 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!


The website is of patio11 on hn

https://news.ycombinator.com/user?id=patio11


Many banks don't care, they are going to turn around and sell the loan. Some banks don't even make money off of the loan itself, they break even or even lose money originating the loan and make money servicing the loan - collecting the payments.

It's a trade, the consumer exchanges certainty about costs for a higher fixed rate than they'd get otherwise.

If the consumer doesn't like that they can get a lower cost variable rate mortgage just as easily.


Which is why .gov holds like 50% of residential mortgages. Any losses can be eaten by tax-paying renters [by virtue of government purse] to subsidize failures of homeowners/lenders. Home owners can watch their asset [privately] appreciate while failures in the mortgage system get socialized onto landless class as well.

Government technically isn't holding the mortgages - Fannie/Freddie/etc. buy the mortgage, repackage them into securities, and then sell the securities. The flow analogy in the article is really good - mortgages flow through a lot of intermediaries and get traded on markets. (The exception is the Fed's purchase of RMBS, which actually is a quasi-government agency holding mortgage assets. It's more like 25%, though; the Fed holds about $2.6T in RMBS, while the total RMBS market is about $10.3T.)

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.


During prior to the 2008 crisis, one of the shady practices was that all mortgage brokers, realtors and banks were pushing adjustable rates on everyone which was a huge reason so many people lost their homes.

Didn't interest rate plummet during that crisis?

Eventually... But we have to remember that things moved in waves.

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.

[0] http://www.freddiemac.com/pmms/pmms30.html


I personally think they used this as one of the indicators of "sub-prime" because there were a TON of flippers in ~2004/05 (knew one guy who owned 40 houses with a group of 4 friends)

All APR to keep all the payments lower... they lost them all in 08/09.


That doesn't sound right. The rate is fixed till the renewable period, typically 5 or fewer years.

> That doesn't sound right.

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.


Assertion requires evidence. This graph disagrees with you:

https://fred.stlouisfed.org/series/MORTGAGE30US


> This graph disagrees with you:

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...


That is a chart of the interest rate of 30 year fixed rate mortgages in the United States.

What does that have to do with the ratio of fixed rate to adjustable rate mortgages?


That's the mortgage interest rate, not the percentage of 30-year fixed rate mortgages vs. ARM.

Categories > Money, Banking, & Finance > Interest Rates > Mortgage Rates

Unless you're not arguing against the last part of the parent comment...


Not in America. Here's a graph of the market share of 30-year fully fixed rate mortgages between 1996 and 2010: https://academic.oup.com/view-large/figure/114328487/hhu060f...

Point 2 is important for a bank if they hold the loan on their books. Normally, you as an individual don't worry about something being worth less unless you know you're going to sell it in the near future. You won't have a loss until you sell. Technically.

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.


In America, the majority of loans (especially after 2008) are fixed interest rate for the life of the loan. So even if the FED/RBA raises the benchmark rate, the mortgage rate and the note associated with it will not change.

On your #1, the biggest change is "private label MBS" (which did not get the GSEs' guarantee) largely vanished from the market (the high since the crisis was a twentieth of 2007's number). The supermajority of investors in pools of mortgages are buying GSE-issued securities, which are insulated from default risk, including the case where the lender seizes the collateral and can't liquidate it for the entire outstanding principal net of costs.

For 3) it's a bit more complex than what you described.

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...


Th article does cover these.

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).


>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.

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.


That’s not what lower liquidity looks like. The bonds sell just fine, you just have to lower the price to sell it, such that the effective yield matches the market rate.

Lower liquidity would show up as wider bid/ask spreads, which doesn’t happen in that case.


> We slice and dice mortgage pools to reflect this

There's no way to properly do this.

It's why 2008 occurred, and why it'll occur again.


Is the prepayment risk really much different from a callable commercial bond? Call protection is not universal in commercial or even agency bonds.

Does the prepayment risk even matter for most mortgages in the US since they are sold to the government sponsored enterprises?

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.


Yes. Fannie and Freddie sell those loans to investors, they don't hold them. They just insure them against defaults. But prepayments are still investors' problems as far as I'm aware.

The Gses bundle up the mortgages and sell mortgage backed securities to investors. The prepayment risk flows through to those investors. As an extreme example, some securities they separately sell the principle payments and the interest payments. So if you bought the interest payments on a bunch of mortgages you stop getting paid as people prepay.

The folks who bought the principle payments are very happy to get paid early.


No, not very different. But as I understand it, most commercial bonds are not callable, whereas most mortgages are pre-payable with no penalty.

Ironically it doesn't mention the elephant in the room. US Fed is now funding T2.6$ worth of mortgages [1]. US Fed began purchasing RMBS assets (essentially mortgages) in order to support the housing market as one of its responses to 2008 crisis [2]. It was meant to be a stop-gap measure, but it hasn't ended.

BTW this is a good overview of different parties involved in the mortgage supply-chain https://imgur.com/NYg7G4t

[1] https://fred.stlouisfed.org/series/WSHOMCB

[2] https://www.newyorkfed.org/markets/mbs_faq.html


Thanks for mentioning this.

I somehow didn't quite realize MBS purchases had resumed with the Fed's COVID response, for some reason I assumed they were only buying Treasuries.

Even though I've been trying to keep up with the Fed's activities, somehow I missed the part about current-decade MBS purchases (and it's a big part).


You're welcome!

If you are a numbers person I found H.4.1 weekly data release to be very useful [1]. It is reasonably accessible to non-expert like me so I dig into it once in a while.

The line item of interest here is "Mortgage-backed securities". As you can see from Jan 6th release; Fed funded B576$ worth of mortgages in 2021 alone.

I read remember reading somewhere that Fed now holds 1/3rd of all the mortgages. Can't dig up the source now.

[1] https://www.federalreserve.gov/releases/h41/20220106/


Wait till you find out the Fed buys corporate bond ETF's nowdays too...

Their reasoning was sound (liquidity mismatch), but I hope it stops there and doesn’t continue into buying equities like the Bank of Japan.

More about why the Fed stepped into the corporate bond market to provide liquidity in 2020: https://www.brookings.edu/wp-content/uploads/2020/10/wp69-li...


It's worth pointing out that the Secondary Market Corporate Credit Facility has ended, and the Fed has sold everything it has bought [0].

But of course the precedent has been set, which may be why you chose to use the present tense.

[0] https://fred.stlouisfed.org/series/H41RESPPAABNWW


Seems like if the economy were a bridge then it would be held together with blue tack and bubblegum at this point.

> to support the housing market

I.e. to keep housing prices high?


If government banned long term debt would the real estate market disappear, or would home and auto prices eventually level out at a much smaller amount reducing overall inflation, or would ownership just be for the wealthy and the rest would live in pottersville?

I guess home values would go down, but investment (improvements, remodeling etc.) would go down as well, so the old houses would be pretty shabby when sold. Newly built homes would be either substandard (what the Chinese derogatorily call "tofu quality", where walls aren't really that solid), or available to the wealthy only.

It is surprisingly expensive to build a (brick and mortar) house to 2021 security, energy-saving and quality standards, at least in Central Europe. We have a lot of cheaper housing from the 1960s-1980s, both block of flats and detached houses, but no way would such buildings in their original form be approved today.


Interestingly, I had a modern house built in eastern Europe (Latvia), and shipped to western Europe, very affordably. I had the foundation, roof and windows done locally but the frame, with insulation, was under 40k, for a ~140 sqm house.

For the curious: in 2019 the average house in the US was 213 square meters: https://www.rocketmortgage.com/learn/average-square-footage-...

A wooden house can be very affordable, but also tricky. The wood should be well dried. There was a wave of interest in wooden houses in 2015-6 AFAIK, which resulted in vendors shipping not-yet-very-dry wooden constructions to their customers.

If you only allow short-term debt (say, five years max) then to finance a modern house—even if you could buy it "at cost"—you would need to take out a series of "balloon" mortgages. Every five years you apply for a new loan and use it to pay off the old one. However, this is risky for the borrower since it assumes interest rates won't increase too much (vs. a 30-year fixed mortgage which you can refinance at any time if the rate improve) and that you will be approved for a new mortgage when it's time to pay off the current one.

Or you can save up $1000/mo. for 15+ years so you can pay for the house without taking out a loan… while also paying rent on top of that.


This would transfer the real estate from the people to huge rental companies that can buy real estate without 30 year loans. Probably it would also lower the prices a lot, though.

I'd speculate that in a world where a few huge real estate conglomerates own all the housing, lowering prices will not be what they will be doing.

The entire financial system in the U.S. is a manufactured product, if you really think about it. The USD has intrinsic value even if Americans don't lift a finger since you need US$ to purchase most goods on the commodities market.

If this link is broken, the U.S. would almost immediately fall into decline. The net spending power of most Americans would drop by a third to one half of what it is today, leading to social unrest. The U.S. government wouldn't be able to fund many of its programs, such as Medicare and the DoD would need to drastically cut its budget.


So what is better?

Mortgages seem to have some pretty nice features. They help encourage people to invest some of their income into an asset that generally appreciates rather than spend it all. It aligns incentives around upkeep and investment in the neighborhood and community. They offset some of the negatives of inflation.


I never understood that kind of US/Western point of view. I will give a trivial example: my grandparents purchased their house in year 19xx and both died in the same house in 20xxs. How's the price of house even mattered all their life? There were living there, it's not something external. Today, I specifically asked my parents if they knew how much their house cost. Nope, they didn't know. It's an irrelevant information for them. Cost it 10k or 10m won't change a thing - they live in it, it's not something external. So house-asset (why it's asset?) is something more US-specific I think. Also it ... bad?

A good financial planner will emphasize this point. Rents go up, but your mortgage doesn't. So you buy a house and eventually forget about the relatively small mortgage payments that have effectively become smaller due to inflation.

The modern world of people moving and upgrading every 5-10 years has really changed this dynamic for the negative.


Of course, part of that 'upgrading' is that homes in a lot of urban areas have become impractically expensive for anyone who wants enough space for a family... but you still have to buy in ASAP if you don't want to be left behind by further market inflation. So cue 'starter home' nonsense.

There is/was a fairly straightforward explanation for the fiscal stimulation of home ownership and in the 60s government was not very coy about describing it: home ownership ties people into their respective communities by giving them a very tangible piece of "skin in the game". When you own a very expensive (relative to your total net worth) piece of real estate, that gives you a real incentive to take care of your local community. This in turn improves the stability of the society as a whole, since the large group of homeowners is not in favor of any real upheaval which might threaten the status quo.

> that gives you a real incentive to take care of your local community. This in turn improves the stability of the society as a whole, since the large group of homeowners is not in favor of any real upheaval which might threaten the status quo.

“take care of your local community” and “[preserve] the status quo” are placed in fairly direct opposition often in daily life. unless you want for children to live in the home they were born in forever, no new infrastructure to be built, etc. who really wants the status quo anywhere to be maintained for 30 years? most people i know, most communities i’m involved in, crave more novelty than that.


I meant "preserving the status quo" as meaning "society remains roughly in the same shape", ie no violent upheavals, revolutions or other drastic changes that would disrupt the ability of an average citizen to keep making a living. Think overthrowing congress in favor of a military dictatorship, or a couple of states seceding and trying to take the nuclear weapons stationed there with them. In that sense most of the western world hasn't seen that much "real" upheaval in the past century despite massive technological changes. We still have democracies that operate on mostly the same principles as a hundred years ago, sometimes with many of the same political parties as a hundred years ago as well.

Relatively slow improvements to living conditions are fine, as that does not cause massive disruption for the average citizen and does not threaten whichever groups are in power.


I think there are pros and cons to population movement, its not all negative. There is now more supply and demand which creates a more robust market full of choices. Obviously a big negative is the massive price increases that either completely price groups out or burden other groups in large debt, but I'll leave my points at that.

Geographical mobility is far lower now than it has ever been. This is generally considered a bad thing: people are staying in places where they can only subsist on transfer payments, and growth industries in prosperous places are limited by labor.

Perhaps it's a US phenomenon.

In the US (and probably most places) a house is the most expensive asset that a person will own throughout their life.

It is reasonable to ask if a person's life would be better if they were able to extract some of the value from the house in exchange for other things. For example, I can borrow against the value of my home and afford to go on more vacations, or a nicer car. It could fund my retirement, even.

Another way of looking at it is as a component of an overall portfolio. Does it make sense for me to have 80% of my net worth in real estate when I can get a 30 year loan at 2% or 3% and diversify? HELOCs are another commonly used instrument.

I suppose some may argue that a few of the things I've mentioned are "irresponsible", but the truth is that it varies from person to person. When used intelligently, debt like this can be a win for both parties.


> It is reasonable to ask if a person's life would be better if they were able to extract some of the value from the house in exchange for other things. For example, I can borrow against the value of my home and afford to go on more vacations, or a nicer car. It could fund my retirement, even.

Isn't this a reverse mortgage?


Yup, that’s one common way to do it.

Here's one US-based example. Anyone in the US who is middle-class likely will have to sell their home or put it into a financial trust by the time they become very old in order to qualify for certain Medicaid benefits, which is the only affordable way to receive elderly care unless you're a millionaire. So from that perspective, thinking of the home as an asset can be important.

Medicaid in 49 states and DC has a 5 year look back period (California is 30 months/2.5 years) on transactions/disbursements with regards to intentional impoverishment. Something to consider when estate planning.

https://www.medicaidplanningassistance.org/medicaid-look-bac...


> Medicaid in 49 states and DC has a 5 year look back period (California is 30 months/2.5 years)

California is also phasing out the asset test, which will eliminate the need for a look-back period entirely (asset limit moving from $2k/$3k for individual/couple to $130k/$195k this July, planned for total elimination by July 2024.)


> Anyone in the US who is middle-class likely will have to sell their home or put it into a financial trust by the time they become very old in order to qualify for Medicaid,

In most states, your home is exempt (at least to certain far above median value, equity limit) from the Medicaid asset test, so, no, you probably won't.


You should. While it's true that your primary residence won't be counted as an asset in order to qualify you for Medicaid, they can and will place a lien on the property if you ever enter into a nursing facility (and maybe in some other situations). This allows them to capture the proceeds if the house is sold while you're living or (in some states?) from your estate when you die.

Older families should strongly consider placing their home into some kind of trust or transferring ownership to a descendant before this becomes an issue.


“Will want to because of potential downstream inconveniences of” and “will have to in order to qualify for” are...very different things.

That's true, but I don't think most people would put, "the state sold the house my mom has lived in since 1972 and kept the proceeds" in the "downstream inconveniences" bucket. It's a pretty big deal! The whole point of getting approved for Medicaid is that you won't have to go broke paying for your healthcare (at which point you'd qualify for Medicaid, anyway).

    >> certain Medicaid benefits
Assisted Living and Nursing Homes. Medicare makes you burn thru your assets before they start paying.

You get charged $5K/month until you are broke. Then Medicare pays the place 1/3 that price for the same care.

Largest wealth confiscation scheme ever seen. Inheritance? No, sorry.


Medicare is the standard retirement healthcare plan and all Americans are eligible if they worked a minimum of 10 years.

Medicaid is for the destitute so of course you need to spend down assets to access it.


According to the American Council on Aging, "In most cases, one’s home, home furnishings, and vehicle are exempt." (from the asset test).

Yes, from the asset test required to qualify you for Medicaid. But if you enter into a nursing facility, for example, then they'll place a lien on the property and collect if the house is sold while you're alive or from your estate when you die (assuming there's no living spouse).

You really want to have a plan for your primary home before this becomes an issue. The asset test is only one concern.


People sometimes take out a home equity loan, which is kind of like going in reverse with mortgage payments -- you are going more in debt, using the equity in you built up with previous mortgage payments. If the value of your home increases you have access to a bigger line of credit.

A common use for such a loan is to pay for renovations, which can further increase the value of a property. Another typical use is "home grown leverage" i.e. using a home equity loan to pay for some investment, which is commonly done with rental properties (often to make the down payment on another mortgage; the hope being that you can collect enough in rent to have money left over after making monthly loan payments). For a truly US-only use-case, people sometimes wind up having to use a home equity loan to cover medical bills after a major emergency or accident, though I think this was more common before the Affordable Care Act and will probably become even less common with surprise billing being mostly eliminated.


Even if I never move I can borrow against my house/asset. Sure, this can be abused. Don't blow it all on a vacation or a house remodel. But if an opportunity comes along to buy an income producing asset then debt is a wonderful tool. I'd rather have access to 100k of debt than not.

What if the cost of being in a position to access the 100k of debt is you have to pay 1k per year in additional property taxes, whether you use the debt or not. If property taxes aren't lowered to compensate for appreciated values, it starts to look bad for homeowners who live in their houses.

I live in the US and I've always found the idea of a house as something that is supposed to appreciate in value to be odd. Sure, it's great for you if it does, but I really don't think it should be an expectation. The only issue I can see when it comes to the price is if you want to move out after just a few years but the value has fallen. Hard to buy a new place when you're still on the line to pay the mortgage for your old place even after selling it.

The author actually address this a bit in the 2nd and 3rd paragraph. The US has added a layer of complexity on top of the plain vanilla mortgage. For the rest of world, mortgages are a way to pay for the house over time. However, in the US, they are into derivatives of the house price (pool them together, sell off the risk (rate of change of house price)), hence the title of the article: Mortgages are a manufactured product.

Edit: now that I think about it. The first level is just buying house with cash immediately. The mortgage is the next level of complexity, adding time dimension. The article is about the 3rd level complexity above that (securitization of the 2nd level)! Turtles all the way down.


Sure, but as a home buyer, what happened to your mortgage after you purchase your home only really matters to you as far as who the servicer is... you don't care or even know who owns the other parts.

US home owners use mortgages for the same purpose as people in other countries... to be able to pay off their home over time. How is it any different as a home owner in the US verse the rest of the world?


From the home owner perspective, the derivatives are nice because the borrower are able to get a lower mortgage interest rate, or a longer mortgage, or qualify for a mortgage when they could not before. The risk of non-payment is spread out, allowing less compensation for the risk.

Next two turtles are CDO-squared and CDO-cubed.

> How's the price of house even mattered all their life?

Assuming the standard US fixed 30 year mortgage, it mattered quite a bit. Their final payment was on relative terms, much less than their first payment. This effect over time made your grand parents wealthier by having one of the most expensive parts of living (housing) somewhat sheltered from inflation (taxes and upkeep not withstanding).

I live in a popular location, and the house next door just rented for 2.5x what I pay on my 10 year old mortgage. I like where I live and don't plan on selling, but the price I locked in years ago has absolutely mattered to my life.


> How's the price of house even mattered all their life?

Be thankful that it didn't. But if they have full ownership, if all their other retirement savings went away, the equity of the home could be leveraged for living expenses:

> This is an “if all else fails” enhancement that Vettese (and I) hope will not prove necessary. For many Canadians with substantial home equity, it’s nice to know that in a worst-case scenario, your home equity can be tapped. But, Vettese warns, “it should only be used to provide necessary income, not to enhance one’s lifestyle.” He also says it should not be considered until age 75. He notes that a reverse mortgage typically involves about 180 basis points higher than a HELOC would charge.

* https://findependencehub.com/retired-money-boost-retirement-...

If someone lives long enough that they are no longer able to take care of themselves, and it is not possible for them to live with family, then the equity could be used for paying for an assisted long-term elderly care facility.


> How's the price of house even mattered all their life? There were living there, it's not something external. Today, I specifically asked my parents if they knew how much their house cost. Nope, they didn't know. It's an irrelevant information for them. Cost it 10k or 10m won't change a thing - they live in it, it's not something external.

And if it is worth $100B, would it still be irrelevant? Would they still live in it, instead of selling and becoming mega rich billionaires?


If their house were 100B that means similar house nearby is also 100B and one still needs a place to live.

But why would they need to live nearby? Or have a similar house? Maybe as an empty nesters they can move to a smaller house and use spare change for other nice things?

If I walk into a room with 2 people and I offer one of them a million dollars to move to Cleveland, then one of them has something tangible and valuable that the other one doesn't. Older homeowners in markets that have seen a lot of appreciation are presented with this offer every morning when they wake up. Whether they take it or not is immaterial. It's a real offer that really exists.

In the US, you likely can’t afford the house you want. So you buy the house you can afford. Ideally, and this has been the case since 2014, the value of the house increases. So, now you say, “wow, looks like I can sell this house and get a better one”. And let’s say you do that. But the new house you just bought only has 3 bedrooms, and not 4. And maybe you have 2 kids now and need 4. So you hope and pray your new-ish house has gone up in value, and most likely it has, by a lot. So you sell that and buy a new one. You do this every 5-10 years. Once you hit retirement age, you sell the house and move into a long term care facility (aka “an old folks home”). These aren’t cheap though. Affordable ones are $5k/month, most are north of $10k. So what do you do? Well, you have the money from the sale of your house and hopefully some retirement funds. That’s why it’s kind of important that your house value goes up. It’s how you’ll survive when you’re older.

> the value of the house increases. So, now you say, “wow, looks like I can sell this house and get a better one”.

If the price of your house increases, the price of the better one increases even more. You can switch it if you saved or if you life improved. The price increase doesn't help, it hinders that change.


Not in my experience (3 houses so far, early 30s).

The way I’ve seen markets move is that certain price bands are more susceptible to fluctuations than others. For example, over the course of a 4 year period you might see the entry point for the market go from $400k to $500k, while the $500-$600k band sees a 30% increase, the $700-$800 band sees a 20% increase, and the $900-$1m sees a 10% increase.

So while the entire market is moving up, certain bands become more affordable if you can capitalize on a higher percentage band.


The other element is leverage. If you put 20% down (which is higher than average), you are levered 5:1. If all houses double in value, your equity goes up 5x. (Example: $100k down on a $500k house; price doubles to $1mil, your equity is now $600k; you can now easily afford 20% down on the higher price house, despite the fact that it is now $2,000k from $1,000k when you started the process.)

In Canada, the price for the detached home that you want increases faster than the townhouse you could afford, so the plan of buying a starter home to help buy the home of your dreams is not really sensible anymore. It requires your other wealth/income to increase to compensate for the different appreciation rates of the house vs townhouse, or for you to move further and further from your current location, which will probably negatively affect your income or at minimum, your quality of life.

Your grandparents are the exceptional case (in the US, anyway). The vast majority of homeowners here change homes multiple times in their life (IIRC, once a decade or so).

One of the big advantages of a system like the US (unlike, say, Japan, where homes are a depreciating asset) is that it increases mobility. If your home is worth less than the day you moved in, you're kind of stuck there -- every move represents a capital outlay that is just going to evaporate over time. In the US system, a home is a little like a fixed-income asset. Even if it only appreciates at the rate of inflation, you can treat it as a stable store of wealth.

Even if you purchase one home in your entire life, it's still a positive in this system. As others have pointed out already, you can borrow against that wealth, or, in the case of your grandparents, pass it down to heirs. Accumulating wealth is better than not accumulating wealth.


increases mobility for home owners whilst everyone else is locked out of a rising market. I'm not convinced this is a good trade off.

This has a lot more to do with zoning and urban planning that it does with the mortgage as a financial product.

On the majority of lots in most cities it's very difficult (or illegal) to build new housing. That's a regulatory constraint that has nothing to do with how the house is financed.


Did they care about what they were leaving to their heirs? What happened to the house after they both died in that house? Did the kids keep it? Sell it?

Even if you never use it as an asset in your life, it is still an asset.


I think 2 things here: people today seem much more likely to relocate due to work and other preferences...in 2018 the median duration of holding a personal property is 13 years, hardly a lifetime. But lets say that someone buys a house and owns it for a lifetime...eventually that will be passed down to the kids or whomever, and they may want to liquidate in order to move somewhere else. Although in 2008 and also today much of what was/is happening in complete speculation, which upends the market for many people.

Nit: "personal property" traditionally means any property except for real estate. Using it to mean "real estate" is confusing.

Further nit: while it is true that there are two types of property, real and personal, there are also several different uses of property, such as investment use, business use, and personal use. So one can refer to personal-use real property, such as a residence, versus business-use real property, such as an office building.

It seems TFA doesn't address commercial mortgages at all.


> How's the price of house even mattered all their life?

Depends on the way the financial sector works where they live; in the US, if they ever applied for credit for anything while owning the house, it, and their debt:asset ratio, probably would have played a role in the terms they were offered, and that may have been largely transparent to them, because a lot of the information flow supporting that decision doesn't go through the people applying.


Home equity loans are an obvious one. Or cash out refis.

If you have 1m equity, you could for example take out 500k at 3% interest and buy a dividend stock paying 6% and effectively double your yield on that equity (plus added risk from the debt, though).

Or use the equity to buy a rental property.

But most people aren't too finance savvy so you're right that it may not affect them in practice.


>500k at 3% interest and buy a dividend stock paying 6%

Just curious, what dividend stock do you think will pay you 6% without very high risk?

The closest I can think of to what you're describing is BP stock but with the recent rise isn't hitting 6% anymore. (I-Bonds are capped at 10k + 5k per year and typically aren't that high.)


In the US, you are taxed for the value of your house each year. As it goes up in value, so does your property taxes. It's hard not to be aware of its value :)

In practice the market value of a house and the assessed value of a house (used to determine real estate taxes) are not as tightly correlated as one might assume.

That varies widely from one location to another. In California for example, your statement is mostly inaccurate due to the effect of Prop. 13, which severely limits annual increases in assessed value for current owners.

Presumably you inherit it and that is part of their plan to impart wealth to the next generation.

Housing is, unfortunately, not a human right in itself apparently. So we got care about it.

I don't think you're wrong. But there is another side to this argument.

Owning makes you responsible for things beyond your control. If the factory in your town closes, you're underwater no matter how smart you were about picking it or diligent you were about maintaining the house.

Similarly you can't really do what you want with it. You better keep it cream and beige coloured! And that's all you can buy. No one builds small homes or castles. Just identical units. Everyone must have a lawn, it must be one of three shades of green and cut correctly etc.

It also forces you to care about things you don't really care about: you have no problem with minorities living next door, but what if it effects your house price? The same for infrastructure your town needs. You know we need a free medical clinic but what if poor people hang around when you're showing the place?

It has the same effect on services: tax rates MUST be lowered because you can see them before buying. Internet speed is irrelevant because no one knows how bad it is until they move in. So no one has workable internet. Americans schools are famously underfunded for this reason too.

It gives you a big incentive to veto all future housing development too. That's given us a very big housing shortages in many places.

The ownership model also makes people much less mobile, limiting their income and productivity, not to mention cementing inequality and effecting nation gdp etc.


> Similarly you can't really do what you want with it. You better keep it cream and beige coloured! And that's all you can buy. No one builds small homes or castles. Just identical units. Everyone must have a lawn, it must be one of three shades of green and cut correctly etc.

Don't ever buy in a HOA area! That is the nightmare you describe.

No HOA in our neighborhood, so while all the houses were the same shade of beige with the same lawn when the developer built the area, over the years as people have repainted and redone yards it has become wonderfully colorful with each house having unique character.


It honestly baffles me that America has them. The US (I'm a Brit) is meant to be about individualism, personal rights, property rights etc. But these are all the bad bits of communism (except for actually killing people).

The only logical reason for this I can see is people being terrified they'll lose 50k because their neighbours paint their house black and let the lawn turn to scrub.


How does it work in the UK? Many areas I visited in the UK have very uniform looking houses (all brick walls, nothing really sticking out, very pleasing to the eye). I assume there must be some strict rules to follow...

In the UK, there are very tight laws for changing your house. But they're set nationally. I think they're ridiculous. It's very hard to get permission to build something in a residential area (with some tightly defined exceptions for 1 story extensions not visible from the front or sheds etc).

Weirdly you can do what you want outside of that. So I can't build a turret on my house. But I could paint it pink and replace my front lawn with cactuses or cover it in junk cars.

No one can make me do anything to make it look nice. But I'm stopped from doing much to make it bigger or look better than the neighbours.

There are "listed" buildings (where you cannot change almost anything). But they're rare and you know you're buying Shakespeares cottage and gave to keep it exactly as is. And in a lot of areas you need permission to cut down trees over a certain size.


HOAs are typically planned ahead of time by the investors/builders/etc. as part of a planned neighborhood. This is entirely imposed by capitalists. Another classic "communism is when capitalism" #6432368.

I don't think the author is implying something is wrong with mortgages. I think article is just a concise, informative explanation of how the mortgage industry works.

Land value tax and appatments. The vast majority of people will rent, the rent will be stable, and it will mostly not go to do-nothing lanloards.

Mass ownership of appreciating assets is a very unstable situation, and also unclear what it even means. It is better to increase wealth through public goods.


also unclear what it even means

It's very clear what it means - inflation. Consider a farmer in Zimbabwe who buys a used truck for 10000 Zimbabwe dollars to bring his produce to market. A few years later, he sells his truck for a million Zimbabwe dollars. He is a millionaire! But he still is a farmer and needs a truck to move his produce. Another used truck would set him back 5 million Zimbabwe dollars.

It can't go on like that. At some point the chunk of money that shelter takes out of the monthly paycheck can't grow further.


In my area, homes have doubled in the past 4 years since I bought my house. its great, seeing the neighbors sell their home for what seems like crazy money, except, while I could do that, I would then need to buy a home. Only way it makes sense, is to sell and move somewhere much less costly, but right now, even remote places are crazy expensive.

It depends on if you are trading up or down.

If you are trading up, the house you are buying is more expensive than the house you are selling. In this case you want a down market. Yes, you get somewhat less for your existing house, but you more than make up for it in what you save on the new house.

If you are trading down, the opposite is true. A hot market has increased the value of the house you are selling more than the house you are buying.


Sorry I mean it is unclear what the price of ownership being correct means.

Yes I absolutely agree, the greater extent "homeownership is a middle class right", the more housing price rising just is an across-the-board inflation. To the extent that the poor / non-whites are not involved, it is stealing from them.

This is why fixed asset ownership is just a rotten scheme, inflation or theft, nothing good comes from it.

"store of value" is highly overrated. Public goods and infrastructure are what materially derisks the future. Not some bidding rat race.


The biggest driver, arguably, of elevated home prices in the past 2 years has been [real ] interest rates that are effectively negative against inflation. The result is buying of property under fixed rate loan to short the USD.

That's not true. Most homes are still being bought to live in. The supply of SFH in decent places is just always too puny to meet housing needs.

Cashing out comes with the hassle to move, and is less attractive during pandemic. Rich people that want to decamp boost up demand in the select few popular remote places. That was the 2020 story.

Recently I am less sure exactly what's going, but yeah, single family homes are the worst!


People have always wanted to buy homes to live in. I'm talking about the large increase in prices in the last 2 years. [negative real] Interest rates are definitely a big reason for the asset appreciation.

Even if that is the case, SFH for being stupid not interest rates for being low is the proper scapegoat.

The rest of the inflation is due to pandemic-related supply side dysfunction, and fossil fuels which are even more subject to random things like OPEC whims.

Raising rates to bring down SFH prices and not reforming the SFH system would be colossally stupid.


Land would appreciate significantly less if housing and zoning regulations were eliminated. While there is value in being near a city core, land isn't a strongly constrained resource. Meeting the onerous requirements to build a home near this city core continually grandfathers in present-day land owners with buildings from the early 1900s while requiring entirely different standards for the next generation.

We have intentionally sabotaged the ability for our youth to afford houses under guise of safety while simultaneously grandfathering in our own shitty run down structures that were built under much looser requirements. The result is land with a shitty old structure can be worth almost as much as a new one, under this restrained and captured supply.


A bit off OP's topic, but in California ADUs (Accessory Dwelling Units) are now legal in all residential zoning districts. This effectively opens up the urban core for homeowners that wish to develop out their property.

A smart first time owner will take advantage of this and effectively create an additional 1 or 2 living units (Primary residence+JADU+ADU) that can cover the new mortgage.


There was just a Chronicle article on this https://www.sfchronicle.com/bayarea/article/San-Francisco-AD...

Honestly, I agree with one of the quoted people that ADUs are just a political hack to get a half-measure by the NIMBYs.

Even if we converted all the garages it would an extremely inefficient way to construct more housing. There was talk of trying to do financing for poor people to do the conversions, but insofar that that works I think it is likely to push up construction prices because ADUs are so inefficient.

(Conversely, the externality of decreased parking is quite good. I don't want to neglact that.)

If we really care about housing and equity for the poor, we should allow poor homeowners to trade in for a new condo if the entire block agrees, and then redevelop it at a massive scale. Far more housing, still equity for them, and once you bootstrap the process no one even need be displaced out of the neighborhood. Win-win


Some counterintuitive things:

- the floor rent is too damn high, but the land rent is two damn low

- Ownership is very hard to price, but the existance of the instutition of ownership is a choice! By raising the land rent the price of ownership shrivels up, and that clamps down on the risks from this volatile and ill-defined problem.

- Rent is just better, what is bad is rent paid to owners, integrating the flow into the stock. Rent that cycles right back around as citizen divdend or gov services stays as a flow and is good. (And what ever evil inclinations states might have, profits are not one of them in the fiat era. (States == federal government in this case. State, local, and invididual departments could still be money grubbers.))


> the rent will be stable, and it will mostly not go to do-nothing lanloards.

I see you've never rented before.


I am renting right now with a shitty do-nothing landlord, and in a dispute over maintainence --- the boiler is leaking and smoking up my apartment. I am under no such illusions.

Landlords maintain power through the restriction of supply. They don't need to actively do it, the single-family-home complex does it for them.

Land value tax (+ land use regulation reform) demolishes that. Appartment management, divorced from land speculation, will become the boring low-margin business it deserves to be.


I am skeptical of the claim that real estate generally appreciates over time, at least in real terms (inflation-adjusted). Yes that has been the trend for a long time and especially in popular areas, but there is no reason to think the trend will continue.

Current residential home prices in the US are far above their 100 year inflation adjusted trend. A few standard deviations above IIRC, and far above where they were in real terms at peak of the 2000s housing bubble. That's not adjusted for interest rates though, which explains some of the deviation.

So homes have appreciated strongly in real terms in the last decade, but it's likely they will revert to the mean from here (whether it be quick or more drawn out).

However you're correct that historically homes mostly follow inflation, and aren't appreciating in real terms. It's only in the modern era where that trend has changed, probably due to more investor involvement and Fed trying to stimulate growth aggressively.

But it's important to note, even if a home appreciates only at the rate of inflation, usually the buyer only puts 20% down, so from their perspective they are earning 5x the rate of inflation in equity.

Pretty lucky to those that lived in 10% interest rate times that were able to buy all sorts of property cheap and refinance at low rates later.


Its important to realise that homes now != homes of the past.

Modern homes are typically an improved product, better features, and also better environmental facilities. Thus they should be increasing beyond inflation.


Laptops today are much better than laptops of the past. Should they cost much more than in the past (beyond just inflation)?

The problem is that people need houses to live in now. I can’t suddenly not need a house to live in simply because I feel very strongly that the trend of real estate appreciation won’t continue forever.

If you want to learn more about mortgages and the "behind the scenes" slicing, dicing and preparing, please check out "The Compleat Ubernerd": https://www.calculatedriskblog.com/2007/07/compleat-ubernerd...

It's a series of posts from a lifelong banker about all of these details, from the 2007 timeframe. Super interesting deep dive.


The worst part of this whole system is the complete opacity about what company will actually service the mortgage after you finish signing. As it turns out, some companies provide a much better and more modern servicing experience than others (for example: Chase versus anything Cenlar).

Other than a crappier website, what difference does the servicer make?

How your servicer handles property taxes and escrow can have a material effect on a household’s cash flows. Often time this is a very negative effect.

A servicer's records are probably your best defense against a robosigned foreclosure.

>educate them on the most complicated and high-stakes financial decision they’ll have to make in their lives,

I disagree with this hyperbole (part of the overall tone of the article). I think taking on full-time college tuition at age 19, or having kids, are both far more complicated and consequential financial decisions.

Taking out a mortgage to purchase, let alone re-finance, an owner-occupied residence is something a lot of people do, perhaps more often than they buy a new mattress. If you have the minimum down payment and good income & credit report, it's not a big deal, and since there are a lot of legal protections all around for owner-occupied properties, it's straight-forward and low risk to the one taking out the mortgage.


Indeed. Although, most of the time when someone ends up in one of those other 2 scenarios, long-term finances are not their primary objective ;)

Is Stripe going to revolutionize the financing of residential homes? :)

Any ideas on what forms other hoke financing products might take?

I'm confused about this part:

>A mortgage has a quirky little subcomponent called a Mortgage Servicing Right (MSR). Every month, it needs to collect money from the borrower and send that money… somewhere. This implies, minimally, a mailbox where you can send checks, someone to open the mail, and a phone number with a CS representative who can answer questions like “What is my current balance?” and “Did you get the last check I sent you?”

I thought mortgage payments were mostly done electronically now?


I don't think there are any Mortgage Collectors that do not allow you to send a physical check that needs to be processed. Of course they'll encourage you to set up AutoPay, bank transfers, etc, since it makes their job easier with no benefit to you (same can be said about "paperless").

Paperless and autopay online is absolutely a benefit to me, I have all of my records in a folder in my email and never forget a payment or make it late.

Sure, but that still means someone has to operate the website, and they still need to operate customer service when it doesn't work.

Mortgage brokers make crazy money in the U.S. Generally around 2% of the loan amount so they're making $6,000 on a $300,000 loan.

At the particular mortgage broker that I have inside knowledge of, their worst loan officers are closing 5 loans per month and their best are closing 30 or more which gives them an annual salary of between $400,000 to over $2 million.


This is more of a tangential comment, but I absolutely love patio11's blog. As someone who is generally interested in fintech and financial services but does not have the time to read deeply into it, this blog is a treasure mine.

I wonder why fixed interest rates are so prevalent in some countries (like, apparently, the US) while in other countries the standard is to tie the interest rate to a reference rate (like EURIBOR in the Eurozone)?

Here in the UK, as far as I can tell, your lender can't sell on your mortgage. It's a contract between you and them. I wonder how many countries do allow that.

It is generally possible under English law to assign rights under a contract, just not liabilities. It's also possible for the mortgage contract itself to contain a provision permitting transfer by the bank. Mortgage-backed securities (which generally involve the selling of mortgages to an SPV) are certainly a thing in the UK.

For retail mortgages there are presumably regulatory considerations as well, eg, the mortgage probably has to continue to be serviced by a regulated entity. It's not uncommon for the original lender to sell the rights to the mortgage but continue to service it.


Yeah, as a Canadian all of this seems pretty alien to me. To get my mortgage, I went to a specific bank, signed a contract with their logo at the top, the amount I owe / pay shows up in my online at that bank, and I send money every month to that same bank. If a different entity came up and told me to pay them instead, I's assume it's a scam. I'm surprised scammers in the US haven't tried that yet.

Also, as a Norwegian, risks related to refinancing in the case of a falling interest rate don't exist. Mortgages are floating-rate by default. If you enter a fixed interest rate contract, you are on the hook for the entire interest difference of the duration of the fixed rate contract if you terminate the contract.

10 year fixed rate contract, loan of 1 million and the rate falls from 3% to 2% on the second day of the contract -- if you terminate the contract now, you owe the bank 1% of the sum of whatever your loan balance would have been during each of the next 10 years.

To be fair, you get the opposite deal if the interest rate rises.


In the US you can go directly to a bank to get a mortgage, but I'm not sure why one would want to since you can't comparison shop that way.

Better to go to a broker who shops your loan among dozens of lenders to find the best terms. You typically end up with some entity you've never heard of (not a known bank), who will hold the loan for a month or two and then sell it off to someone else.


They can use the mortgage as collateral for their own loans, and I am not really sure how that is any different...

Even if you can’t sell the mortgage itself, I’m sure you can sell on the “economics” of the mortgage - just like you can invest in gold without actually having a vault at home

They might not be allowed to sell the servicing rights, but they almost certainly can sell the risk and returns.

I wish we had 30 year fixed-rate mortgages in Aus

What do you have?

I don't know about Australia, but in Canada mortgages are amortized over (usually) 30 years at first issuance, but they are on (usually) 5 year terms.

This means you'll renew your mortgage roughly five times before it is repaid, at the prevailing rates at that time. There's no such thing here as a mortgage with fixed interest rate over 30 years like, as I understand it, there is in the US.


>This means you'll renew your mortgage roughly five times before it is repaid, at the prevailing rates at that time.

This sounds a lot like ARMs aka balloon mortgages. Mortgage brokers ramming these everyone's throats played a big role in the 2008 melt down.


I don't know enough about what a "balloon mortgage" is to comment on that, other than to say that the 2008 mortgage crisis was not as severe in Canada as it was in the United States.

So, to the extent that mortgage terms were a factor in the crisis, and I don't know whether it was, I wouldn't say that this kind of mortgage was disproportionately worse.


"Balloon mortgage" was just a nickname they gave to ARMs at the time. In the US, 30-year fixed had been the bedrock of home mortgages for decades. Most home buyers didn't really know what ARMs were and brokers bent over backwards to misrepresent them. Many brokers also stopped offering fixed rate loans because ARMs paid out WAY higher commissions. There were a lot of lambos in Hialeah those years.

Lenders were equally complicit in this mess. They were approving borrowers for obscene amounts of money by calculating qualifying amounts using ONLY the initial ridiculously low interest rate of the ARM. Thus, purposefully not accounting for the inevitable rate hike. Most lenders also looked the other way when brokers were very obviously fudging loan applications to qualify borrowers for more money.

When those balloons finally popped (2-5 years from loan inception), home owners saw their monthly payment rocket up to unsustainable levels. This is what kicked off the wave of foreclosures (and why you often hear idiots, even right here on HN, blame the home buyers for the entire housing bubble).

Then there was the whole bundling of these ticking-time bomb mortgages into securities that got magically AAA rated and pushed into people's retirement funds. And also how banks insured these shit securities to protect themselves from what they knew was about to happen. But that's a whole 'nother story that goes beyond the mortgage aspect of it all.

Sorry for the history lesson!


2 or 3 years fixed interest terms are common and 1-5 years fixed terms are available. FI loans cannot be closed early without incurring some penalties (economic costs). But the most popular loans are what are called Variable Rate Loan over 25-30 years. The interest rate can vary through the term of the loan based on the interest rate movement by Reserve Bank of Australia. These loans can be fully paid anytime. Split loans are common too where a portion is fixed and the other portion is variable. Another unique feature in Australia for Variable rate loans is a so called offset account. This is a normal bank account attached to the loan and any money here offsets the loan balance. So people can save any extra money over the minimum repayment in an offset account to reduce interest payment (as it is calculated on the difference of loan - offset). The money from offset account though can be withdrawn anytime providing tremendous flexibility.

Spiders, mostly.

AFAIK long term fixed rate mortgages only exist in the US. Every other country has the equivalent to ARM only. This is why the rising of interests rates could be devastating to lots of home owners who budgeted based on the existing rates. I wonder what will happen.

Slightly off topic: What should I read if this is all super interesting but Byrne Hobart is a smidge over my head?

> Private capital buys all the other risks.

What about the Fed? It is not private capital.


The Fed operates as both a public and private entity, while the Board of Governors is a governmental agency, the the Federal Reserve Banks are set up like private corporations. Whether that makes the actual capital private, I am not sure, but I think it is a noteworthy fact.

There's a lot to add to this article in my opinion:

Many lenders refinance loans because lenders also need to finance their activities and refinancing through securitization is a profitable way to do so, that goes for student loans, business loans, private loans, car loans, ...

Mortgages are no exception, what is different about the US compared to Europe is that the capital market to buy packages of loans is more developed because unlike the EU, the US is a unified financial and legal system under federal governance.

What happens in a mortgage is not that much different than a car loan, you use some cash and borrowed money to pay for the car and the lender expects you to repay that money (and interest) in fixed installments. Should you fail to pay the loan then the car is repossessed. The lender will want to make sure that your monthly salary is enough to cover the payments and that the car is valuable enough to recover the principle of the loan should something happen.

Incidentally, this is why banks don't like to give entrepreneurs mortgages because entrepreneurs don't have stable income (usually).

The moment you borrow that money, it becomes a liability for you but it becomes an asset for the bank/originator; after all you are going to pay the originator cash for 25 years.

Now in the US, your originator can sell this asset onwards to a loan aggregator (Fannie Mae; Freddie Mac) to realize profits today rather than hold the mortgage forever but obviously the loan aggregator has some standards it wants you to adhere too. (note: the EU doesn't have these types of loan aggregators due to the lack of synchronization between their national financial markets)

In theory the originator can make more profit by holding the mortgage, but since his money is locked up for 30 years in the mortgage; many of them don't have enough cash on hand to just lend the money and wait 30 years for it to come back so it can be lended out again.

The loan aggregators on the other hand buy mortgages from all originators and can put them together into a package that is safe and diversified enough so that the repayment performance is predictable enough (ignoring pre-2007 when rating agencies succumbed to customers' pressure to rate pretty much anything as safe and caused the huge financial meltdown when borrowers started to predictably default) and sell it onward to pension and sovereign wealth funds.

These aggregators, or GSEs as patio11 calls them, are private companies but by now they are government owned because they all collapsed in the financial crisis and since they underwrite pretty much every mortgage in the US, they had to be saved as otherwise the mortgage originators would also become illiquid and then you can only buy a house in cash (which would have pretty much destroyed the entire housing market in 2008).

The 60 basispoints though, is the fee for packaging the loans. It's not an insurance like patio11 says.

Operational work like support, collections, negotiations about late payment and administrative work ("Servicing") is outsourced is just because no loan aggregator wants to deal with that and a pension fund DEFINITELY doesn't want to deal with that and like any outsourced service that is well-understood, they prefer to pay as little as possible for this part. This creates natural market pressure for consolidation.


2008 calls, if you didn't know this already I guess this is a good re-hash.

A non-trivial percentage of Hacker News was 8 years old in 2008. :)

hn was so young back then.. but i wonder how much of us are 8 years old now ?

It has always annoyed me that the financial services industry attempts to referred to mortgages, loans and other financial instruments as "products". By definition, they are services. The many papers you get when signing a mortgage is about the closest thing you could refer to as a "product". I think they do this to attempt to create a sense of finality and inflexibility in what they are selling. "It's a product" makes it seem like a fixed thing that cannot be changed, when in fact, it definitely can be.

I work at a structured credit manager. I'm not sure how much the semantics matter, but from our perspective, a mortgage (or other loan) is an asset that we can buy with a certain yield and risk profile. This an abstraction to be sure, but the way we use mortgages makes them more of a product.

(we don't do much in the RMBS area specifically)


It’s a service for you the consumer, but those loans are packaged and sold as investment products

The Big Short (great movie) had a good scene on the productization of mortgages.

https://www.youtube.com/watch?v=xbiDrzTd8fE




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