"Life Cycle" Hypothesis of Saving: Aggregate ... - Arabictrader.com

Long-Term Financing in an Inflationary Environment 285
ment in the early years and underpayment toward maturity. The initial overpayment
can be quite large even with moderate inflation. To illustrate, with a real
rate of 5 percent and a rate of inflation of 10 percent, the nominal rate trebles
from 5 percent to 15 percent, and for a long-term mortgage (say 30 years) the
initial payment nearly trebles in real terms. Of course, these high payments are
made up by much lower payments toward the end of the contract, but this is no
compensation, at least for buyers who have cash constraints and can look forward
to more income as they get older. Many such people will be frozen out of buying
a house or at least one commensurate with what they can afford in terms of life
income.
Another problem is that high (and variable) inflation leads to high and uncertain
interest rates. This is especially serious when long-term mortgages are
financed from short-run deposits as has been the case for the United States. The
mismatch of maturities implies high risk of losses and probability of bankruptcy
which is precisely what happened to the Saving and Loan industry in the U.S.—
they lent very long and financed it with very short liabilities in a period of rising
interest rates.
To avoid this mismatch problem one must lengthen the duration of the liabilities
or shorten the maturity of the assets. Lengthening the liabilities has little
chance, at least in the U.S., as the S&L industry’s role has been that of offering
a liquid short-term asset. As for shortening assets, nothing can be done directly
since a mortgage, by nature, requires a long maturity. However, it is possible to
shorten the relevant measure of duration of the mortgage, by replacing the traditional
fixed long rate with a rate floating with a short-period rate (say a one year),
reset at the termination of each period (one year). From the point of view of
matching maturities this instrument has the same maturity as the short rate on
which it is floating. Each time the interest rate is reset the periodic payment is
recalculated using the new rate, the debt balance carried over, and the remaining
years to maturity.
This approach offers an effective but partial solution to the maturity mismatch
problem. It has been utilized fairly extensively in the U.S. under the name of
Adjustable Rate Mortgage (ARM), and in other countries with middling rates of
inflation, like the U.K. However, it suffers from two serious drawbacks. The first
and most serious is that the approach does not remedy or improve the major
problem of the tilting of the real repayment schedule. That problem depends on
the early (real) payments rising with inflation because inflation raises nominal
interest rates. With the ARM, the interest on which payments are computed is a
nominal market rate (though a short-term one) and will therefore also rise with
inflation, tilting the payment schedule just as much as a conventional mortgage.
Thus the ARM, though it may be of considerable help in solving the lenders