Friday :: Feb 13, 2009

Greenspan and Managing Risk

by Mary

Atrios points out Greenspan's excuses about not being able to prevent the housing bubble were a little late especially when he was a key promoter of the innovative financial packages that blew up the financial systems. The speech where he talked about the wonderful innovative risk management packages, he also talked extensively about how it would be good for homeowners to take variable rate mortgages as long as they were willing to handle their risk. (emphasis mine)

One way homeowners attempt to manage their payment risk is to use fixed-rate mortgages, which typically allow homeowners to prepay their debt when interest rates fall but do not involve an increase in payments when interest rates rise. Homeowners pay a lot of money for the right to refinance and for the insurance against increasing mortgage payments. Calculations by market analysts of the "option adjusted spread" on mortgages suggest that the cost of these benefits conferred by fixed-rate mortgages can range from 0.5 percent to 1.2 percent, raising homeowners' annual after-tax mortgage payments by several thousand dollars. Indeed, recent research within the Federal Reserve suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade, though this would not have been the case, of course, had interest rates trended sharply upward.

American homeowners clearly like the certainty of fixed mortgage payments. [Ed: they sure got over that preference, didn't they?] This preference is in striking contrast to the situation in some other countries, where adjustable-rate mortgages are far more common and where efforts to introduce American-type fixed-rate mortgages generally have not been successful. Fixed-rate mortgages seem unduly expensive to households in other countries. One possible reason is that these mortgages effectively charge homeowners high fees for protection against rising interest rates and for the right to refinance.

American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks but are willing to manage their own interest rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home.

So Uncle Alan decided that the wonderful financial packages would magically manage the risk for the financial institutions and homeowners would magically know how to manage their own risk.

Well, that sure worked out well, didn't it?

Mary :: 5:04 PM :: Comments (1) :: Digg It!