Can Homeowners Arbitrage the Mortgage Subsidy?

There's something very attractive about being given the opportunity to buy something which you know the seller is losing money on. That's why a standard round of haggling in any bazaar will involve the seller explaining that he's losing money already at this price: in some kind of economic theory-land the buyer shouldn't care about such things, but in reality we always do.

Some people love to spot these things and effectively arbitrage them. Do gas stations make all their money from selling overpriced sodas and lose money on the gasoline? Then if you don't buy the soda, you're essentially taking free money from the gas station. Will a hotel lose money on its special offer if you don't order room service or other optional extras? Same deal. And in the financial world, there's a certain type of person who will take low-interest-rate-for-life balance-transfer offers from credit card companies, borrow a large lump sum on the card, invest that sum in a CD, and pocket the spread.

Sometimes, you can make real money from this kind of thing. And when the sums of money become mortgage-large, and the government is subsidising mortgages, then there might be a trade here. Or that's what Arnold Kling thinks, anyway:

My wife and I have owned our house free and clear for about twenty years. But I think we probably should take out a conforming mortgage and invest the proceeds in a municipal bond that matures in 2011. It looks as though on an after-tax basis we would come out pretty close to break-even over those two years. At that point, we can re-assess. If it looks like I am wrong about the outlook for interest rates and inflation, and rates are still at five percent or less and likely to remain so, then we will unwind our position (use the proceeds of the bond to pay off the mortgage). On the other hand, if I am right and interest rates are headed up in 2011, we can take the proceeds from the maturing bond and invest them in some nice high-yielding instrument. If nothing else, this strategy can give me some income with which to pay off the taxes that the government is going to make me pay to cover the cost of the subsidized mortgages that Freddie and Fannie are issuing today.

Kling's big idea is that the government is effectively subsidizing mortgages -- this is true -- and that therefore he, as a homeowner, should be able to get his hands on some of that subsidy. But it doesn't really work like that.

For one thing, let's actually do the math here. Say that Kling takes out a $100,000 mortgage on his house and invests it in a Maryland municipal bond. According to the Maryland muni-bond yield curve, munis maturing in 2011 yield on average 1.692%. But some bonds trade at higher yields than that: today, a hospital bond with a coupon of 4.25% sold at 102.789 cents on the dollar to yield 3%. If Kling put $100,000 into that bond at that price, he'd receive four coupon payments of $2,067, as well as $97,287 at maturity.

Meanwhile, let's say he takes out a 30-year mortgage in order to lock in today's artificially low interest rates for the maximum amount of time: the headline Chase rates are an interest rate of 5.125% and an APR of 5.225%. Plug those numbers into an upfront cost calculator, and you'll see that Chase is charging $1,120.35 in up-front fees, not including application fees, appraisal fees, or fees for obtaining credit reports. Call it just under $2,000 all-in. The mortgage itself will have a principal amount of $98,879.65, and get paid off at $544.49 per month.

Over the next two years, Kling will spend $13,068 in mortgage payments; add in the up-front fees, and the cost of having that mortgage for two years is about $15,000. At the same time, he's getting $8,268 in coupon payments on his municipal bond, which means that over the course of those two years, he's basically got a negative carry of $6,732.

Plugging Kling's mortgage numbers into an amortization calculator, we can see that when the bond matures, the balance on the mortgage will be $95,955. He can pay that off in full with the proceeds from the maturing muni bond, and still have $1,332 left over. But that still means that he's $5,400 in the hole -- which is way more money than he'll ever get in mortgage-interest tax relief or anything else he might be counting on in order to get "close to break-even". And in the meantime, of course, he has to consider the opportunity cost of making all those mortgage payments without anything like sufficient coupon income to cover them: think of all the other things he could do with that money. And we're not even starting to add up the amount of personal time and hassle that Kling's going to have to go through in order to set this whole scheme up; nor are we making any allowances for credit risk on that muni bond.

So what are the chances of any remotely sensible person trying to take Kling's advice and put on a freeload-off-the-government trade by locking in low mortgage rates? About zero, I think. There are many things to worry about when it comes to government intervention in the housing market, but this isn't one of them.