Episode 107: A Better Mortgage with Kevin Erdmann (Incentives Series pt. 9)

Shane Phillips 00:00:05
Hello! This is the UCLA Housing Voice Podcast, and I'm your host, Shane Phillips. This is episode 9 in our ongoing Incentives Series, supported by UCLA's Center for Incentive Design. Throughout this series we'll be exploring the misalignment between what we say we want our policies and processes to achieve, the behaviors and outcomes they actually incentivize, and potential solutions. This week Kevin Erdmann is back for round two, and we're zooming in from the big-picture effects of tighter lending standards to talk about a specific, very unique, and — so far at least — non-existent mortgage product: the fixed-amortization, adjustable-principal loan. I'll make just a few quick points by way of introduction. First is that for all the benefits of fixed-rate mortgages, and there are many, we pay a steep price for interest rate stability. Today the rate gap between a 30-year fixed-rate mortgage and a 5/1 adjustable rate mortgage is about one percentage point, which for a $500,000 loan equates to about $300 a month or over a 10% increase. From 1984 to 2015 the spread between a 30-year fixed and a 1-year adjustable mortgage averaged 1.7 percentage points. The second point is that we pay such a high premium in part because lenders bear the risk if interest rates rise, but borrowers don't bear the risk if they fall, because our mortgages typically don't come with prepayment penalties. If rates fall then we can always refinance, and that asymmetrical risk helps explain why we pay such a premium for long-term fixed rates. And third: it may not have to be this way. By giving up our ability to speculate on the possibility of falling interest rates, we could significantly lower the rates we pay without sacrificing stability in what we pay year-to-year. As I put it in the interview, we can trade away uncertain benefits of unknown magnitude for certain benefits of quite large magnitude. That's Kevin's pitch anyway, and I find it pretty convincing. Given it a listen and let us know what you think. The Housing Voice Podcast is a production of the UCLA Lewis Center for Regional Policy Studies, with production support from Claudia Bustamante, Brett Berndt, and Tiffany Lieu. You can reach me at [email protected] or on Bluesky and LinkedIn, and you can follow the show and share your thoughts on our Substack, uclahousingvoice.substack.com. With that, let's get to this second conversation with Kevin Erdmann.

Shane Phillips 00:03:05
All right, Kevin, welcome back. It has been a week since our conversation on mortgage lending standards. So I'm sure we were both fresh and ready to get even further into the weeds today. Sounds like we were both sick over the weekend in between too, but I think we're both mostly recovered. So welcome back.

Kevin Erdmann 00:03:22
Yeah, great to be back. Thanks for having me.

Shane Phillips 00:03:25
So today we are talking about an idea that you wrote about in 2021 that has really nothing to do with mortgage lending standards, but instead would be a completely new mortgage product. I just published a report at the end of 2025 proposing a new loan product that could make it possible for developers and landlords to share profits with tenants. So kind of off the wall mortgage ideas are right up my alley, especially right now. My original plan for this series was actually to do a short episode with you focused only on this idea, but then the series evolved and I realized we needed to talk about lending standards and so that's that earlier conversation. But I still wanted to talk about this idea partly because it sounds like it could really work, but also just because I think it's really creative and it's important to occasionally step back and consider totally different approaches. So the proposal is a fixed amortization, adjustable principal mortgage, which, at least to the non-economists and non-finance people, I think is not exactly self-explanatory. So tell us about it, starting with the problem it's intended to solve.

Kevin Erdmann 00:04:38
Yeah, I probably could use a little more P.T. Barnum because there's probably a better name to call it. Naming is probably not my strong suit. But yeah, it basically started with the idea that what borrowers really want is fixed cash flows. They want to know what their budget's going to be. They want to know when they get the mortgage that the payment is going to be $2,500 a month today, next year, five years from now, ten years from now. The way we've given them that is by fixing the rate on the mortgage, but fixing the rate on a loan creates a lot of risks for lenders and they have to charge us for those risks. So there's a spread on mortgages, fixed rate mortgages, that accounts for those risks.

Shane Phillips 00:05:26
Can you explain really quickly what you mean by a spread?

Kevin Erdmann 00:05:29
Yeah, yeah. So let's say you could get a floating rate loan or floating rate mortgage, let's say at 4%. And so that rate is going to change over time. And at the point where a floating rate mortgage might go for 4%, a fixed rate mortgage is probably going to be more like five and three quarters.

Shane Phillips 00:05:47
Just the gap between those two things. It's the premium you're being charged to have a fixed rate.

Kevin Erdmann 00:05:53
Yeah, it's the extra interest rate that they have to charge for the risk that the interest rate you're paying in the future won't match what the market rate is. So let's say you get a $100,000 loan and it keeps the math simple if we think of it as sort of like a perpetual bond. And at some point, you're going to pay them back $100,000. Your interest rate you're going to pay on it is whatever the market rate is at any given month. So this year, maybe you pay them $4,000 to pay the interest expense on that. And at the end of the year, the bank still has this loan on the books for $100,000. And then next year, maybe you pay them $6,000 and they still have a loan on their books that's worth $100,000 and it goes on and on like that. Once you fix the rate, so let's say the market rate today is 5% and they say, okay, we're giving you this loan and you're paying 5%. So you pay $5,000 to them this year for interest. And now at the end of the year, the interest rates 4%. Well, if you've already agreed to pay them $5,000, that's a valuable loan. They could take that loan and sell it to an investor. You sell it to another bank, and the bank would be willing to pay them $125,000 for it because that's how big of a loan you would have to make to somebody else. to get $5,000 a year from them. So now you're paying them the same amount of money for interest expense, but on the bank's books, they're $25,000 richer. And then when it goes the other way, if interest rates go up to 6%, now they're stuck with a loss. And if they're tracking the value of their assets, that loan really will only be worth $80,000 to them, because at that point, for them to borrow money to capitalize their bank, they would have to pay a higher rate than what it was when the loan got started. Once you fix the rate, then all the risk goes to the bank, because now their assets are changing value constantly. And then what makes mortgages obviously then worse for them, it's a bum deal for them because if the interest rates go up, they're stuck with the loss. So if interest rates go up to 6%, then they've got a loan that's only worth $80,000. But if interest rates go down to 4%, you're allowed to pay them back at face value and just pay them $100,000 and refinance at the lower rate. So for them, the deal is nothing but losing. And so basically what they say is, we're going to charge you 6% out of the gate. We're going to charge you as if this is a loan worth $120,000 because at some point, we know we're going to have to make up a loss on this when you refinance. In fact, in securities markets, the mortgage bonds that are traded every day out in the marketplace They aggregate a bunch of mortgages, and they have data on all those mortgages, and the investors in those securities, they look at the details of all those mortgages. How old are they? How many more payments do they have? What's their interest rate? For them, the math is all about how likely is this mortgage to be paid off early, because that's cutting off the winning scenario for them.

Shane Phillips 00:08:48
So the fixed rate mortgage, it provides that cash flow stability, that predictability that you know what you're going to spend as the borrower month to month, year to year, but you are paying quite a large premium for it. I mean, if we're talking roughly one and a half percentage points higher an interest rate than you could get if it was a adjustable rate floating rate mortgage, that's a very significant increase in monthly cost. And it's not just, you know, the bank being a jerk about it. It's the fact that they have the This downside risk that they have to compensate for because you're able to refinance if rates fall. So that's where we're at, where both the borrower is getting this cash flow stability, but they're paying more. The banks have to charge more, which probably limits the amount of business they can do in order to offer this product. So that's sort of the problem that we're trying to address or that exists with the fixed rate mortgage. So let's get into the fixed amortization adjustable principal mortgage. How does that work and how does it solve both of those problems to some extent?

Kevin Erdmann 00:09:51
This is basically just a floating rate mortgage, but the contract on what you're going to pay in cash over time is going to be preset. So let's say that the current floating market rate is 5% and you would start that contract out by saying, okay, I'm going to pay this mortgage off. as if it's a 30-year mortgage that is a fixed 5% rate. I know that every year from here on out, I'm going to pay 5% of the value of this mortgage each year plus whatever the principle is I would need to pay to have it paid off in 30 years. So at the end of the year, if the market rates 5%, then it just looks like a floating rate mortgage. You've paid a few thousand dollars off on the principal, you've paid back 5% interest, and then everything just continues like a floating rate mortgage. If the rate goes up to 6%, you're still going to keep paying the same amount, but now basically you owed the bank an extra 1% of the principal that you didn't pay them that year. And so it's basically like taking out a loan for that extra 1% and just tacking that onto the principle of the mortgage.

Shane Phillips 00:11:02
And in this scenario, that additional 1% is 1% of the total principle. So if, you know, during year, let's say five, you've got like $80,000 left on this mortgage or this loan, then it's going to be 1% of 80,000. It's not the original loan amount. It's the principle at the time or every year when this assessment happens.

Kevin Erdmann 00:11:25
Yeah, so you can think of it as annual resets and then it's very easy to sort of do the math because however your payment interest rate compared to the market rate, then that's the percentage that you will change the level of principal. So effectively, if you're paying less than what the market would pay for that loan that year, then you're increasing the principal amount, but you're going to pay that off over the remaining amount of the amortization. If it's after year one, then you're paying that 1% off over the next 29 years. Effectively, the math is, if you were starting out, let's say you had a $1,200 a month payment, this would basically increase your payment to $1,212 the next year. Everything would just scale with the scale of the underpayment. Now, if interest rates went down, then your payment would go down slightly and the principal would go down slightly. And it would go on from there. As far as the bank's concerned, the $100,000 mortgage they originated at the end of every year is still worth $100,000 plus or minus whatever you've paid off or adjusted the principal before. But the face value and the market value for them are the same every day that they hold that on their books. And so all that valuation risk goes away for them.

Shane Phillips 00:12:41
Yeah, and we've been talking about this proposal, this fixed amortization adjustable principal mortgage in relation to a fixed rate mortgage, but it's important to also compare this to an adjustable rate mortgage because in this scenario, if interest rates rise and you have a typical adjustable rate mortgage, if interest rates go up by one percentage point from 4% to 5%, your monthly payment is going to increase pretty dramatically. Yeah, I think it's over 10%, 10 or 12%, something like that. And so you're getting a lot more stability for exactly the same rate change with this proposal you're talking about. And your principal does go up, but your payment only goes up very, very slightly, much less than it does with an adjustable rate mortgage.

Kevin Erdmann 00:13:31
Yeah, yeah. And the math just all sort of works out with the amortization because eventually, by the time you get to the end of the last few years, most of what you're paying is paying down the principal. When the principal's down to $10,000, adding 1% to that is just negligible. There's no point in the process where you're going to get big swings in what you have to pay in your monthly fee. It's really at these reasonable levels of rates that you could choose, the changes in the payment you're making are well within what we're used to paying with just because we usually bundle insurance and property tax payments with our mortgages and those change each year. This really wouldn't create any more volatility than we already have in the fixed rate loans.

Shane Phillips 00:14:14
And I wanna make clear here that a key feature of this would be relative to the fixed rate loan, you would be paying a much lower just kind of base interest rate. And so your monthly expense starting out certainly would just be lower than someone with a fixed rate. It might change over time in a way that a fixed rate doesn't, it might get cheaper or more expensive pretty marginally, but it's gonna start out quite a bit cheaper because that spread goes away.

Kevin Erdmann 00:14:44
Yeah, yeah. And in fact, once you start thinking about it this way, there's a lot of constraints on terms and mortgages that are really sort of arbitrary that we take for granted. And once you start realizing you could sort of play on the edges with these things, You could choose a 4% rate or a 5% rate, or you could choose a high rate if you're wanting to err on paying down the loan fast or whatever. The choice of what your payoff rate is up to the lender and the borrower. To me, the 5% rate seems like It historically has led to pretty stable results, but really even pushing the payment rate below that doesn't tend to lead to much instability. Partly what we do with these fixed-rate mortgages is everything else is getting more expensive over time. When you originate a mortgage, you might have an income of $70,000 and a monthly payment of $2,000. 15 years from now, when you're halfway through that mortgage and you're still paying $2,000 a month, by then your income is probably $110,000 a year. So it's really sort of odd that we've done this. We've engineered these products to be most financially stressful when they're originated, and then they sort of arbitrarily become less stressful over time based on arbitrary changes in inflation over the life of the mortgage. And we're paying for that. And I don't think anyone that buys a house is thinking, oh, you know, we wanted a house, but I'm really excited about taking a speculative position on future inflation rates. And in a way, the fixed rate mortgage is making us inflation speculators. And this is actually taking away that speculative part of it. The real dollars we're going to pay back are actually more stable over time with this type of product, whereas the real dollars after inflation that we pay back fixed rate mortgages actually fluctuate a lot depending on what happens to inflation over time.

Shane Phillips 00:16:38
I want to talk about this speculation aspect of it because I think this is really key to sort of the trade-off here. If you bought a home with a fixed rate mortgage or refinanced your home with a fixed rate mortgage in late 2021 at under 3%, then you came out very well because interest rates increased so much. And so, as I understand it, really what you're giving up is the opportunity to capture that specific kind of benefit of keeping a very low payment, even as the cost of purchasing a home increases pretty dramatically, or specifically the cost of getting a mortgage for a home. And that's, you know, that is a cost, you are giving up something there. But in exchange, you are getting effectively the lower interest rates of an adjustable rate mortgage combined with the payment stability of a fixed rate mortgage. Is that right? Yeah, yeah. Yeah. And I think of that as you're sort of trading away this prospect of uncertain benefits. You're getting this really steep discount effectively on the house that you bought of unknown magnitude in terms of, you know, if rates rise and you've got that fixed rate, but you're trading away those uncertain benefits of unknown magnitude for really certain benefits of quite a large magnitude.

Kevin Erdmann 00:18:03
Exactly. Yeah. With the fixed rate mortgage, you're sort of like buying volatility. So if interest rates go way down, you're going to win big. If interest rates go way up, it's probably because inflation is going to go up. And since your payment doesn't have to rise along with that, then you win big there. And in scenarios that aren't volatile, where the interest rates sort of stay similar to where you started, then you're basically just losing slowly over time.

Shane Phillips 00:18:28
Because of that spread.

Kevin Erdmann 00:18:29
With every payment, yeah.

Shane Phillips 00:18:31
Yeah. All right, so I think an important point I want to discuss here is, as I initially read the description of your proposal, it seemed like you were saying that if I took out a loan and interest rates went up from 4% in the year I got that loan to 5% in year two, my principal would increase by 1%. And if rates stayed at 5% into the next year, year three, then my principal would not be adjusted up or down because rates didn't change. That sounded a little off to me because as I said, if I've got a 30 year fixed rate loan, my monthly payment is 12% higher with a 5% interest rate compared to a 4%. but I read your paper a little more carefully and now I think I understand it better. And what's really happening here is basically you're always comparing the present day interest rate with the rate you got when you took out that loan, right? So if I was issued my mortgage with an effective 4% rate and the prevailing interest rates or inflation increased to 5%, my principal would increase by 1% for each year that prevailing rates stayed at 5%. So it's going to be a recurring thing. I would also be lowering my loan principle through monthly payments, but that would be the effect of just the interest rate changes. And similarly, if rates fell after I took out the loan, then my principle would be adjusted downward every year for as long as rates stayed below that initial level. Is that correct?

Kevin Erdmann 00:20:06
Yeah, yeah. Once you start thinking about how these terms that we think of as embedded in the fixed rate mortgage, partly why the terms have to be so detailed on a fixed rate mortgage is because of that balance sheet risk, like the need to refinance. The only reason there's a need to refinance is because the market value of that mortgage is different than the face value of it with the bank. And so it's an accounting event for them if that loan gets paid off. It's something they have to deal with and treat as an event. But really, refinancing becomes sort of no big deal with this sort of mortgage because the face value and the market value are always same for the bank. They don't care if you want to add or subtract $5,000 to the principal. any given day. It doesn't add any risk to them. You can play around with everything about it. It would be difficult to create a fixed-rate mortgage where you're playing around with the amortization and stuff because the bank doesn't want to keep extending a mortgage that's got, say, a low rate that's a loser for them. They're not willing to play around with the terms. But with this loan, since there's none of those risks, One thing you could do, for instance, is you could start with, say, a 25-year amortization, and then you could say, you know what, if rates go above the market rate where we're increasing the principal, instead of increasing my payment, let's just add payments to the end of this mortgage, which the bank's happy to do because there's no balance sheet risk for them in that, and maybe there's a limit to that guardrail. So maybe when it gets to 30 years, then we say, okay, now any increases from there will go to the payment amount. So it gives you all these margins that you can play with really at very little risk to all the stakeholders involved. We did a lot of these in the COVID period. We did these, let a lot of people take a year off on making their payments. That sort of thing would be easy to do with this sort of loan because it doesn't involve all these valuation complications. So you could even sort of sell a mortgage product where part of the product is, you know, as long as say that your loan to value is below 80% or whatever, part of what they could sell with the product is, hey, if you get laid off, you can pick a year anytime in the next 30 years where you say, you know what, I can't make payments this year. Just add the entire payment to the principal.

Shane Phillips 00:22:25
And they can do that without having to charge a premium for it because you are paying for it with the higher principal.

Kevin Erdmann 00:22:32
Exactly. And you're paying at the market rate, so they're not taking the risk that they're extending a loan that's not worth anything to them.

Shane Phillips 00:22:39
Yeah, I guess you're actually not paying a higher principal, you're just gonna pay the interest for that year, but it's the actual market value of that interest, and so they're happy to take that and have another year of you making payments, essentially, right? Yeah. Well, I wanna talk really quickly about this refinancing aspect of it too, because when you refinance your home because interest rates have fallen, you should be doing that because you are kind of compensating yourself for the premium you've been paying for your fixed rate mortgage. And if you don't exercise that option, then you're kind of leaving money on the table, just handing it over to the bank, essentially. But every refinance has a cost and you don't know when interest rates are going to bottom out. And so, I mean, I refinanced my house twice. from 2017 to 2021. And I ended up, you know, the second one was at the right time, but there was a cost to that, you know, half a percent of the value of the house, 1%, whatever, you know, it depends, but it's a significant cost. And people are doing this, you know, year after year, I'm sure there are millions of refinances every year on average, or at least hundreds of thousands. And those are just kind of like wasted money at some level that you would not need to spend if you had a product like this for your mortgage instead.

Kevin Erdmann 00:23:54
Yeah. Yeah. I mean, in a lot of ways, this product would actually shrink the finance sector because they wouldn't need to get paid for those risks and all of that.

Shane Phillips 00:24:04
Yeah. Don't tell the brokers about this proposal. Yeah.

Kevin Erdmann 00:24:06
Yeah. And all that underwriting activity having to do whether it's tactical refinances or cash out refinances, all of that would be much easier. You could just have a set of guardrails that really, at any time, if your loan-to-value is below a certain threshold, especially below 60%, 70%, 80%, there really just is no collateral risk for the banks, and there's really no reason why people shouldn't easily be able to make adjustments when life changes require them.

Shane Phillips 00:24:36
Yeah. One thing I think people might hear when you describe this proposal is, you know, if all I know about these adjustable principal mortgages is that if interest rates rise after I take out my loan, then my principal is going to increase by that percent every year. And that might sound like a pretty bad deal. If I take out a loan with a 4% interest rate on day one, my mortgage payments in the first year only lower my principal by about 1.75%. So if rates rise like they did in 2022 by like four percentage points, then I would be stuck with a mortgage that's actually getting bigger over time. Because every year for as long as rates stay elevated, I'm paying off less than 2% while the principal is rising by more like 4%. Even granting that 2022 was a very unusual year and so that kind of occurrence would not be a common one, that does sound pretty bad on the face of it. But the real reason I bring this up is because I think it's easy to let yourself do this calculus without accounting for that premium we're paying on fixed rate mortgages. So can you maybe talk about that a little more, just how this all balances out?

Kevin Erdmann 00:25:48
Yeah, it is. It's tempting to sort of think of it through the lens of the life cycle of the borrower. And then our intuition is to sort of think about the possible downsides.

Shane Phillips 00:26:01
Yeah, you can list 10 advantages, but the one unusual, rare, bad event is the one that everyone's going to want to talk about.

Kevin Erdmann 00:26:09
Yeah, yeah. The negative scenarios. And you're right. The recent interest rate markets have been very strange historically. You don't tend to see real rates moving like they did in 2021 and 2022. Historically, where you would have seen this maybe get some borrowers into trouble would have been like the late 70 s, early 1980 s inflation spike, and then the spike in interest rates when the Fed raised rates to beat inflation. There, you would have had a few years where very recent borrowers would have had a spike in principle that might have sort of eaten into, pushed loan to value up to where they might be in negative equity or something. So historically, that's where it would run into problems. Other than that, there really aren't scenarios where it creates sort of dislocating problems. But at the time, the mortgages we have now were problematic because the interest rate risks of the lenders, Fannie and Freddie ran into problems during that time. Banks were going out of business when they didn't have their interest rate risk hedged and rates were going all over the place. But I think the main thing I would say is that Historically, changes in interest rates are mostly related to changes in inflation, and real rates don't really tend to move more than a percentage point or two over time. When rates are being changed by inflation, then generally, actually the norm is that incomes and prices all across the board are going up with that inflation. In those scenarios, your income is probably going to match the changes over time that you're going to end up paying. Again, what we're doing now is we're speculating on forward inflation, and this is removing that speculation so that in nominal dollars, you might see your payments go up if there's a spike in interest rates for a while because of inflation. But in real dollars, compared to what your income and the expense of everything else is, this actually brings the mortgage more in line with what everything else in the economy is doing.

Shane Phillips 00:28:12
And you're not actually saying that this would replace fixed rate mortgages or the existing adjustable rate mortgage products, right? This would just be another option. And so if in late 2021, if you wanted to refinance into a fixed rate mortgage or buy a home with a fixed rate mortgage, you would still be able to do that. Even if this was on the market, you would just have this additional option and be able to choose between them. You know, I think in late 2021, a lot of people would have chosen the fixed rate mortgage and been happy to pay that premium because they felt like this is probably not going to be sustained. But I think that is an important point to make, that this can exist alongside what is there now. It doesn't require eliminating them and replacing them.

Kevin Erdmann 00:28:55
Yeah, that's true. Another point I'll make in terms of how this affects expenses over the long term. Our intuition is to think of ourselves as a borrower and think about what can happen over the life of that loan. But you can also look at it cross-sectionally. At any point in time, interest rates are what they are. A certain number of mortgages get originated So there's X trillions of dollars of mortgages that are made in a given year, and there's a certain amount of interest expense that's paid on those mortgages that year, and there's this extra amount that gets paid for the prepayment risk because the fixed rate mortgages have to have a higher interest rate to cover that. So in any given year, you can see that there's extra money paid out to trade off this risk. Next year, whatever interest rates are going to be, however these mortgages worked out for the people that initiated the mortgages last year, next year, interest rates will be what they are. There will be a certain number of mortgages originated, and there will be an X number of dollars paid out for the lenders to take this risk. Every year from now into the future, cross-sectionally, in the aggregate, we pay extra money for the right to have a fixed-rate mortgage, and that goes away with this type of mortgage. That's money that in the aggregate, cross-sectionally, doesn't get paid. Maybe there are a few households that would pay more in really worst-case scenarios over the life of their mortgage than otherwise, but those are Over a 30-year period, probably not very many of them, considering the 1.5% or 2% gap that has historically been paid for this, and the movements are going to tend to be sort of randomized over time, so that on average, just people will be much better off.

Shane Phillips 00:30:40
Yeah, something that occurred to me is these people who bought homes in 2020, 2021 and got a really low interest rate. As I said, if you got a fixed rate, that worked out really well for you, but it is important to also consider that there's a cost to that. at the kind of housing market or society level where just taking myself for example, because I have such a low interest rate on my house, the duplex that I live in, and at the same time, I also have the benefit of Prop 13, which I hate, but. but it is what it is. Like my property taxes are essentially fixed for all time. And so both of those things are really pushing me toward, even if I someday move out of this house, I will probably try to hold onto it and rent it out because I'm just giving up a lot to get rid of this mortgage and that effective subsidy from Prop 13. And, you know, I'm sure there are hundreds of thousands, if not millions of people in a similar boat in California, and that is keeping home ownership opportunities off the market. And that's not something that like I could choose to just quote unquote, do the right thing and sell the house when I'm done with it. But that's not going to make a difference in the aggregate. We actually need a system level solution to this problem. And it seems like a product like this, if it were to proliferate, would effectively solve that without even, you know, really pushing anyone. It would just many people would willingly move in that direction. I want to ask a question that did not occur to me, I did not put in my notes, but I'm wondering what effect this might have on prices. Because when interest rates go up, that tends to decrease prices because essentially people buy homes based on what they can afford to pay. And when rates go up, the same payment every month will not cover as large a mortgage. And so it seems like If this were a commonly used mortgage product, then prices might not fluctuate as much because you wouldn't really need to worry about the interest rate right now. And you could just kind of take it on faith, reasonably so, that it's all going to kind of balance out in the end. Is that a reasonable interpretation? And maybe that gets to a question I did write down about the kind of timing problem that we have with housing, where there's like a good time to buy, there's a bad time to buy. And it seems so arbitrary and outside buyer's control, but it's just something we accept as a normal way for the housing market to work. And I don't know that that necessarily has to be true.

Kevin Erdmann 00:33:11
Yeah, absolutely. I think it really does reduces a lot of those stresses and a lot of those arbitrary cyclical changes. You know, something that's sort of related to this that I think we can see operating in the market today, the new home builders, many of them are offering what they call rate buy downs, where the going rate on mortgages is, you know, 6% or whatever. And they're offering if you go through their mortgage company, they might offer three or 4%. So they're selling you the house at an elevated price. and taking the loss off the mortgage. The reason that that's effective for them is that by putting you in a fixed rate mortgage where the payment is starting out at 4%, they actually are pocketing a profit on that because by giving you the low rate now, they're making it so you're not going to refinance tactically when the rates go down. So the investors buying those mortgages from them aren't requiring very much of a spread for that risk, because they're basically refinancing for you out of the gate and they're paying for it by overcharging you for the house, because the market conditions now sort of allow that to happen. And so in a way, you can see the problem with fixed rate mortgages sort of playing out through that marketplace. And the only reason that's working for them is because there is this premium you have to pay to get out a fixed rate mortgage that they avoid by giving you the low rate right out of the gate.

Shane Phillips 00:34:33
Mm hmm. Mm hmm. And I think it's also something they can do because there's a lot of confidence that rates are going to go down rather than up. Right. Or or even hold steady.

Kevin Erdmann 00:34:42
Well, if lenders think rates are going to go down, then the odds of you refinancing go up and they have to charge you a higher rate today to give you a fixed rate loan because they don't think that they're going to be getting that rate for very long. Oddly, in market conditions where lenders think rates are going to go down, that actually increases today's mortgage rates because it increases this risk.

Shane Phillips 00:35:06
Mm-hmm. So we've made pretty clear the benefits to homeowners here, home buyers, but you also write about how this mortgage product would benefit lenders and financial markets. I get the argument about lowering their downside risk and how it allows them to offer a lower interest rate and less refinancing. These things all seem good, but at kind of the financial market level or the macroeconomic level, what's the advantage here and why should it matter to the average person?

Kevin Erdmann 00:35:38
You know, a lot of financial distress has been caused by interest rate risks, because when interest rates change, the assets that financial sector holds, you know, their values changes. And then it puts a lot of institutions in dire straits when they haven't a whole bunch of activity in the financial sector is just creating hedges and bets and just all these engineering tricks to protect yourself from interest rate risk.

Shane Phillips 00:36:07
That was essentially, this was what caused the failure of Silicon Valley Bank, right?

Kevin Erdmann 00:36:12
Yeah, I think so. Yeah, yeah.

Shane Phillips 00:36:14
Maybe not exclusively, but my understanding is that was a big part of it.

Kevin Erdmann 00:36:17
Yeah, because the rates changed so quickly in 2021 and 2022, yeah. And mortgages are a big, within that asset class of assets that have interest rate risks, mortgages are a big part of that. And there's just tons of people that that's their job, is to try to engineer their institution in a way that they are covered in 10 different scenarios going forward. And when that gets removed from their things to worry about it, it actually just frees up, you know, basically right now they all have dollar bills and they from day to day, they go, you know, here's a dollar bill. Well, is that, is that a dollar dollar bill or is that a 95 cent dollar bill? And, and well, here, I got a guy, he's going to go tell me what that dollar bill is. Right. And now this just makes it so they're just – it's like cash. We're walking around. This is – here's a loan. It's a $100,000 loan, and it's worth $100,000. And if you want it, you pay me $100,000, and we don't need a backroom of 50 people trying to figure out what this thing's really worth.

Shane Phillips 00:37:15
So last time we wrapped up by talking about what it would take to fix mortgage lending standards, like what needs to change, who's responsible for making those changes. So I wanna ask the same question here to close this conversation. What would need to happen for this kind of mortgage to become a standard offering to U.S. homebuyers? And you mentioned maybe you need to PT Barnum this up a little bit. I think, You mentioned in the last conversation the Ninja loan, which I'd forgotten about, but that means no income, no jobs or assets. And as bad as those loans were, they at least do have a cool name. I feel like what you're offering here is currently the Fixed Amortization Adjustable Principal, aka FAP, mortgage. So I don't think that's going to work for us. Name is not everything, but maybe that's one starting point. But beyond that, what needs to happen? How do we make this a standard offering in the US?

Kevin Erdmann 00:38:15
You know, I think probably a lot of it, what would affect people's approach to this is that even just arms themselves have been sort of associated with, you know, risk taking and people taking out a loan that has more risks going forward because it has a lower starting payment. And so I think partly the intuition to keep a focus on fixed rate mortgages is in a way to sort of force borrowers to sort of take on loans that have sort of unfavorable terms because it sort of keeps them from overbuying or overborrowing, right?

Shane Phillips 00:38:52
And for the listeners, I think you said ARM, and that stands for Adjustable Rate Mortgage.

Kevin Erdmann 00:38:57
Oh, yeah, yeah, yeah. And, you know, before 2008, there were all sorts of these loans that looked a little bit like what I'm talking about here, you know, interest only loans where you weren't paying any amortization or even negatively amortizing loans, which are sort of like what this loan does when your payment rate's lower than the market rate. And of course, a lot of those loans were going to speculators or people that were bad underwriting risks. And so all those terms are all sort of tied up with this idea of recklessness. I think the key here would be, I think probably one reason we wouldn't see this loan developed today by private bankers is just that it would run into a bunch of rules that are intended to keep people from doing negatively amortizing loans and things like that, that this loan type would end up sort of falling under those definitions. I think probably what you would need to do is set up some guardrails in terms of the repayment rate can't be less than 4% or 5% or whatever. If your repayment rate is above X%, then you're free to play around with these sorts of terms.

Shane Phillips 00:40:05
When you say you would need to do this, is this something that, you know, federal agencies would primarily be responsible for that they could do on their own? As I asked last time, is it something that would require Congress to act in some way? FHA, Fannie Mae, would they participate in this presumably in some way? Or is it something that could just happen entirely privately?

Kevin Erdmann 00:40:26
I think it would be hard for it to happen privately under the current regulatory regime for the reasons I stated. There's a lot of rules about how you treat amortization schedules and stuff that I think this would sort of accidentally fall into those baskets and sort of be labeled as a predatory loan. But you know, that really just comes down again to what do you start the prepayment rate at? And really, honestly, you know, historically, you can get to pretty low repayment rates, where you're sort of pretty regularly adding to the principle, but it takes quite a bit to get it to add up to a principle that would actually cause your payments. to rise at, say, faster than the rate of inflation, at least in the historical, you know, where I can backtest it. So I actually don't think there's that much danger. Partly what happened before 2008 was that the borrowers that were going for those sorts of loans happened to also be risky borrowers, right? So we sort of have this association between the two. But I think if this was a standardized product with guardrails around how low you could make the repayment rate, There's really no reason to see them as dangerous, and I don't see why the federal agencies wouldn't be able to offer something like this as a product, but I'm not an expert on sort of the governance details of what their rules say they're allowed to do or not do.

Shane Phillips 00:41:49
Yeah, and I can I can definitely see maybe a starting point is, as you say, set a sort of conservative minimum repayment rate that you're pretty confident most borrowers would want to go above anyway, because they want to pay it off in 30 years or whatever. And if you find over time that that's sort of a limitation and you do more research and look at the experiences of the people who have been borrowing already, you might find you could lower it a little bit. But it seems like starting somewhere might be the best approach and not trying to get it absolutely perfect, but being a little more on the cautious side to begin with, and then opening things up a little bit once you've got more experience and evidence.

Kevin Erdmann 00:42:31
Yeah. Really, when you think about it, the new home builders that are doing these rate buy-downs, those are actually a pretty risky proposition for the borrower because let's say that their menu price on the house you're buying is $330,000. But really, when you get into negotiating, they're going to give you $30,000 of free upgrades or whatever. Instead of that, they're giving you this rate buy-down. They're saying that you're buying the house for $330,000, but you know that if you were to resell it tomorrow, you probably aren't going to get more than $300,000. The buyers that are taking on those rate buy-down mortgages are actually taking quite a bit of risk. They're really, in fact, going in with, you know, much lower equity than what the paperwork says. And to get the payoff from those rate buydowns, just like the people that took out mortgages in 2020, they have to stay in that house, you know, in a year, less than 30 years that they move out of that house or pay off that mortgage. They're not getting the benefit. You have to live with that mortgage to get the full benefit of that low rate.

Shane Phillips 00:43:35
And you're sort of banking on rates staying high. If rates rapidly fall, then suddenly you've paid a bunch of money up front for a low interest loan that, you know, two years later you were able to get on the open market without any premium.

Kevin Erdmann 00:43:51
That's right. So anyway, as you have me thinking about it, I realized that this is a perfect scenario where there are specific mortgages being made right now that have a certain risk. that we're creating, that this mortgage, as far as I can tell, in every case would be, you know, if market rates now are 6% and there's people buying new homes and they're paying down the rate to 4%, if you did one of these loans and your repayment rate was 5%, Then you're buying the house for $300,000, and whatever you're adding to the principal over time maybe eventually adds $30,000 to it, but you don't have to take a $30,000 loss if you have to sell the house next year. That risk is spread out over the course of the mortgage. To me, in every scenario where people are doing the rate buydowns, if they could get a mortgage like this, where the repayment rate was lower, but they're paying the floating market rate, which is going to be lower than what the rate that they're buying down from is, I don't see any scenario where they could possibly be worse off than what they're getting with those rate buydowns now.

Shane Phillips 00:44:54
Right. Super, super interesting. All right, Kevin, I really appreciate you being game for two hour plus interviews back to back. This has been a lot of fun and I'm glad we got to kind of look at the macro at some level and then talk about a specific product that could also improve people's lives and hedge against some of these risks at the same time. So thank you again for coming on the Housing Voice podcast.

Kevin Erdmann 00:45:18
Absolutely. Always a pleasure.

Shane Phillips 00:45:24
You can find our show notes and a transcript of the episode on our website, lewis.ucla.edu. Talk with us and other listeners at uclahousingvoice.substack.com. You can find our show notes and a transcript of the episode on our website, lewis.ucla.edu. Talk with us and other listeners at uclahousingvoice.substack.com. The UCLA Lewis Center is on the socials and I'm on Bluesky and LinkedIn at @shanedphillips. Thanks for listening, we'll see you next time.