Judging Treasury’s housing report

By Felix Salmon
February 11, 2011
Treasury's long-awaited report on reforming the US housing market.

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I’m impressed with Treasury’s long-awaited report on reforming the US housing market. It’s a good length — it comes in under 11,000 words, which makes it shorter than, say, Michael Lewis’s Vanity Fair article on Ireland. It’s written in a very clear manner, laying out in a simple and honest way exactly what went wrong, and what Treasury is proposing. And although it might look as though providing three different options for reform is a bit of a cop-out, in fact they’re not as far apart from each other as you might think, and all of them would constitute a radical change from the status quo.

The message is clear: what we have right now is unacceptable, and we need to do something big; the main choice facing Congress is between a modest government housing guarantee, a tiny one, or none at all.

It’s worth reading the rest of the report, too, not just the section laying out options at the end. One very welcome theme running through the report, from the beginning of the introduction, is that an important part of “affordable housing” is giving people “rental options near good schools and good jobs” which don’t take up an inordinate proportion of total income. This kind of language appears all too rarely in papers on mortgage-market reform:

Today, renters often face significant affordability challenges. Half of all renters spend more than a third of their income on housing, and a quarter spend more than half. And for low-income renters, adequate and affordable homes are increasingly scarce. For every 100 extremely low-income American families, for example, only 32 adequate rental homes are affordable.

The report is also clear-eyed about two aspects of the US mortgage market which seem to be sacrosanct: the pre-payable, 30-year fixed-rate mortgage, on the one hand, and the mortgage-interest tax deduction, on the other. It notes that both are pretty much unique to the US, and cause significant distortions and risks: “tax incentives like the mortgage interest deduction can encourage investment towards housing over other sectors in the economy”, the report says, adding that investment in those other areas “may lead to greater long-term growth or job creation.”

There’s even a nod to the concept of covered bonds — look closely, it’s buried in a subordinate clause at the bottom of page 14, but it’s there. Such things are hard to understand, but they’re very attractive from a policy perspective. The problem is that banks don’t like them, and so it’s going to be hard to implement them given the lobbying power of the banking industry.

But banks are going to have to start putting a lot more of their balance sheets at risk in the housing market whatever happens, if any of the options in this report are adopted. The idea is to replace the current system, where the government guarantees nearly all the mortgages in the country, with a private system where government is involved only at the low-income end of the market or in the event of a major crisis.

If any of the choices are adopted, then mortgage rates will continue to rise — they’re already above 5%, and that’s a good thing, since the cost of a mortgage should reflect the risks inherent in it. It will be harder to get a pre-payable 30-year fixed-rate mortgage. But if you do get one, your monthly cost might not be much higher than it is right now, since as Dean Baker calculates, the headline price of your house is likely to be lower. The obvious cost of such a system, then, is that it would increase the number of homeowners with negative equity, and thereby increase, at the margin, the number of defaults and foreclosures that we’ll be seeing going forwards.

More generally, it’s far from clear that there’s enough private money at all which is willing to fund such a system. The main problem I have with Treasury’s report is that it simply assumes that if government support for the housing market is slowly removed, then private money will come in to take its place — at a higher price, to be sure, but at some price.

The big risk is that private money won’t come in, at any price, if there isn’t a guarantee — that the amount of private funding for the US mortgage market will be substantially lower than the demand for mortgage loans. The result would be a broken, non-clearing market, with people stuck in their homes because they can’t sell them, and the idea of a “market price” being somewhere between a purely theoretical entity and an outright joke.

That’s why my preference would be for Treasury’s third option, where the government guarantee remains extant, just with a lot more safeguards than it has right now, in a system where it’s priced rationally rather than well below market. Fannie and Freddie would go away, and be replaced by private mortgage insurers; the government would reinsure the mortgage insurers, rather than insuring the mortgages directly. And the government would only lose money after the private insurers had lost all of their money.

Are there private-sector players who would step up and insure mortgages in such a system, willingly providing a buffer between banks and the government? Treasury simply says that “a group of private mortgage guarantor companies that meet stringent capital and oversight requirements would provide guarantees for securities backed by mortgages that meet strict underwriting standards” — but it’s not immediately obvious to me who those companies might be. If such companies can be found, and if they’re well-capitalized enough to credibly backstop an enormous proportion of the entire US mortgage market, then this solution is I think a good one. But those are two very big ifs.

There are a lot of financial-sector players who have every incentive to claim that such private-sector companies will never appear, and that a broader government guarantee, like the current one at Frannie, is sadly necessary. As this debate moves to Congress, it’s going to be crucial to be able to examine such claims impartially, and to decide whether Treasury’s optimism regarding the future risk appetite of private capital is justified. Any bright ideas as to how to do that? Because I can’t think of anything offhand.

21 comments so far

to me a paradox…
we have an economy that is struggling and for many Americans “a struggle”…
a few years, more than that to privatize the mortgage market…
will lead to what, less Americans able to afford their own home, more able to afford?
I would hope we have learned a lesson over these past four years in that less is better and more comes with a risk…
optimism difficult for me at this time for I say affordable housing will be a bigger issue now and later…
thank you.

Posted by chapapet | Report as abusive

Renting is cheaper (and less risky) than short-term home ownership. Renting is more expensive than long-term home ownership. After all, you need to pay the landlord to take the risk of ownership off your back. And even if the landlord owns the property for the long term, he still faces vacancy risk and “bad tenant” risk. Moreover, the landlord likely has better uses for his capital (and thus will demand a higher rate of return) than you do. So moving to a rental society is NOT the answer to “affordable housing”.

Instead the solution has to be some combination of:
(1) Smaller/cheaper properties.
(2) Larger/extended households living together.
(3) Lower sale prices, especially in areas where the “values” are above the cost of construction.

Posted by TFF | Report as abusive

As a European living in the US I consider mortgage interest tax deductions to be unfairly regressive policy.

Many poor Americans struggle with most of their income going on rent. The wealthy can also opt to spend most of their income on a mortgage, however knowing that their existing wealth can cover other living costs, get a fat check back from the IRS, AND get to keep most of any capital gain.

Posted by vk9141 | Report as abusive

It’s not just the people at the low end of the spectrum that pay thirty percent or so of their income on housing, but the majority of people that do.

Posted by Soothsayer | Report as abusive

It is clear that government interventions have effectively created a Ponzi scheme out of the housing market. The only reason that house prices in many areas are as high as they are is the Greater Fool Theory where people are certain that someone else will pay that much or more for the house in the future. Most of these markets have house values that are far greater than the replacement cost of physical development of a lot and construction of a house.

The mortage interest deduction is clearly regressive and tends to discriminate against seniors who often don’t have a mortgage at all. It creates a disincentive to using the house as a savings tool by paying off the mortgage quickly.

Similarly, higher interest rates due to lack of government backing would simply allow house prices to equilibrate to true market values. It appears that, similar to democracy, the US government wants “market pricing” until they figure out that it means asset prices may decline at which time the full faith and credit of the US government is thrown into the breach to maintain asset values at any cost.

I live in Upstate NY where house prices are sufficiently cheap and tax rates high that the property taxes are actually currently a bigger deterrent to buying a more expensive house than mortgage interest rates. We are currently paying more in property taxes than in mortgaage payments.

I say, let the housing market go back to being a market driven creature with bank financing of mortgages and minimal involvement of the government. I think the system would stabilize and we would all be better off. It is clear that government intervention at the current scale is even more destabilizing than lack of government intervention. However, good regulation and enforcement to ensure clear mortgage practices and to prevent fraud is necessary.

Posted by ErnieD | Report as abusive

I’m mostly on the side of EmieD here, with the caveat that your model really only works in low-growth/slow decline areas like Upstate. Where there is rising income/rising population you will get bubbles forming. These should be kept regional (not nationalized) and draw scrutiny by regulators.

Second problem: it seems Treasury understands that bubble prices were unsustainable, but they have failed utterly to work out a plan for all the millions of Americans who will lose money or their house as it continues to deflate. When people realize these prices will never ever come back (as will happen under 1 and 2) what will they think?

Debt slaves are not happy voters. Just look at Egypt.

Posted by LadyGodiva | Report as abusive

LadyG, the only alternative I see is to significantly inflate the currency in which those debts are denominated. That doesn’t cure the federal government’s problems (the twin entitlement monsters that promise to eat the nation), but it goes a long way towards curing the imbalance between debt and income in the consumer sector.

Posted by TFF | Report as abusive

“If you build it, they will come” I am by no means an expert on the mortgage industry. However, I truly believe that if the system were to be changed so that it was driven by the private market we would have no problem luring private money into the market. I think that is a non-issue. Investors want to make money and there is plenty to be made in the U.S. housing market. However, as with any other market, namely the credit card industry, the government must have good regulation and enforcement to ensure that the entrepreneurs don’t use predatory lending practices or fraud. In addition, if the government wants to help “lower income” families then I think tax breaks are in order for only “low income” home owners. These tax breaks should not apply to the wealthy home owners or landlords who do not need it. This would increase the qualifications of low income families for home loans by helping to ensure less risk. In other words, the mortgage industry needs low income owners because they make up the majority of the middle class, and there is plenty of money to be made for the lenders, but the lenders will require less risk and that can only be provided by the government lessening the tax burden for the low income home owner as opposed to the government actually funding the loan. Of course the wealthy folks will cry foul, but they are benefiting because they are the ones making money off of the home loans, which would not be possible without the tax breaks for the low income families.

Posted by Blackbird1996 | Report as abusive

Blackbird, you could achieve that goal by replacing the mortgage interest deduction with a 15% tax credit on the first $5k of interest.

That, combined with the standard deduction (since those households would otherwise not itemize), would put most lower-income households ahead of where they are now. Of course the wealthy wouldn’t benefit nearly as much from the tax credit as they do from the deduction against their 25%+ tax rates, and the $5k limit would limit them as well.

Posted by TFF | Report as abusive

It’s a catch22 situation. The problem is that the mismatch between the existing housing stock and the market equilibrium housing stock looks substantial. I.e. a lot of people who live in houses cannot afford it under free market conditions. And the demand for the huge 2004-2007 type houses is simply not there when you have to pay the real market price. Accordingly, moving towards free market will cause the problems Felix correctly mentions. However, also the alternative “something less than a complete exit” will not work – it will simply drag out the adjustment process. Housing market in the US “worked” not because of immigration as some might think (that mattered probably for cheap apartments only) but of ever-increasing subsidies. Not high subsidies, but increasing subsidies. And that is a policy which is pretty difficult to continue. So, better to do it fast, experience a 10 year housing market slump, and finally, tear down all the excess housing stock…

Posted by tk2 | Report as abusive

tk2, that’ll be hell on the construction industry. If you rip off the bandage, we won’t be building ANYTHING for a decade.

Then again, we probably shouldn’t be building right now given the present oversupply on the market. Even with subsidies, vacancy rates are clearly on the high side.

Housing does gradually depreciate. Any idea what the natural tear-down rate is? Likely higher in an environment where it costs more to renovate a home than you can hope to get back in a sale.

Posted by TFF | Report as abusive

@ tk2: “the demand for the huge 2004-2007 type houses is simply not there when you have to pay the real market price”

If there is no demand, then the market price falls, which is exactly what has happened.

If this Geithner plan is some sort of plan to eventually demonstrate that the private sector is incapable of running the mortgage industry any better than the government-backed entities, then it’s up there with the Republican ‘starve the beast’ plan of wrecking government in order to show that government doesn’t work.

It’s also redundant; just ask a shareholder in Bear Stearns, Lehman Brothers or Merril Lynch.

Posted by Diggadave | Report as abusive

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Posted by travelperu220 | Report as abusive

“strict underwriting standards”

Ah, that pesky devil is always hiding in the details, whot?

Posted by melior | Report as abusive

“For every 100 extremely low-income American families, for example, only 32 adequate rental homes are affordable.”

I would love to know how many of the people who read this passage either in Felix’s post or in the original document and thought… “wow how can we increase the supply of affordable housing.” A strategy that has been an almost universal failure.

The only thing I want my local, state, and federal goverment spending tax dollars on is trying to boost the earnings power of the 100 extreemly low income Americans… what I don’t want to see happen is a big effort to build 68% more units of affordable housing so that all 100% of extreemly poor people can go on living that way.

Posted by y2kurtus | Report as abusive

The “new urbanites” are to blame for the shortage of affordable housing. Thirty years ago, the slums at the heart of our cities offered affordable housing for all. But now? Rich and educated people are moving back into the cities, buying, renovating, and upscaling the existing housing supply. And for the most part they aren’t interested in rubbing shoulders with the poor.

The ultimate NIMBYs… They love the idea of “affordable housing” in the suburbs (a ridiculous idea, since living in the suburbs is inherently more expensive than living in a denser urban area) but freely build luxury condos in the downtown.

Posted by TFF | Report as abusive

“The main problem I have with Treasury’s report is that it simply assumes that if government support for the housing market is slowly removed, then private money will come in to take its place — at a higher price, to be sure, but at some price.

The big risk is that private money won’t come in, at any price, if there isn’t a guarantee — that the amount of private funding for the US mortgage market will be substantially lower than the demand for mortgage loans.”

If the only reason we have the mortgage market we have today is because the private market is funded by Fannie & Freddie (in their confusing role as private entities propped up by the government) – then what kind of market is that?

And how stable has this mortgage market been? Catastrophically unstable – because the lack of accountability led to highly irresponsible lending practices that contributed to the mountain of leverage the led to the collapse of our financial system. I hope we’ve learned that people who want mortgages actually need incomes that support the loan.

The system is broken and must be changed.

Posted by MainStreetMuse | Report as abusive

Why, in principle, should there tax breaks or subsidies for low-income, or any, home owners? In principle, there should not. Why is house ownership is a Virtue to be encouraged? (But let’s acknowledge the need to buffer the effect of removing the exemption on existing mortgage owners who took risk that made sense under old assumptions.)

To be equitable, why not allow tax breaks equally for mortgage payments and rent payments, at least up to some maximum dollar amount?

Buying a house is, in part, an investment that carries risk, and, like any other investment, it should be entered into by those who can afford to take the risk, or, at the very least, by those who understand that it is a risk. I’m in favor of progressive taxation, but it seems to me that the way to help lower-income citizens is not to encourage and subsidize an investment and attempt to make it risk-free (which investments, by definition, are never supposed to be), but rather to extend to the same consideration to renters that we extend to mortgage holders.

Posted by samadamsthedog | Report as abusive

“To be equitable, why not allow tax breaks equally for mortgage payments and rent payments, at least up to some maximum dollar amount?”

The mortgage *INTEREST* is only part of the ownership cost for a home. Maintenance is just as expensive, at least after a few years when the balance gets paid down, and property taxes are another large chunk. If you make rent payments wholly deductible that would tip the balance much farther in the OTHER direction than it presently tips towards homeownership.

Moreover, the standard deduction for married-filing-jointly is $11k. You only benefit from deductions in excess of that figure, severely limiting the benefit to lower-income households.

Finally, we already charge zero income tax on the first $50k of income for a family of four. How many more tax breaks do lower-income households need?!?

I don’t think the mortgage interest deduction is a major factor supporting home values. Far less significant to the housing market than Fannie/Freddie guarantees. Phase it out over a few years and nobody would notice except for a handful of wealthy people who really don’t NEED the deduction in the first place.

Let’s do what we can to increase the tax base (and lower rates) instead of further exempting the small fraction of the income that is presently available for taxation.

Posted by TFF | Report as abusive

The simplest solution to the problem is to require at least 10% down and make amortization illegal.

Homeowners would more rapidly build equity, the IRS would take in more money because the size of mortgage interest deductions would drop and mortgage risk would drop.

As homeowners build equity faster, it would create a wealth-effect spending climate in which the homeowner would actually be wealthier rather than just feel wealthier, which would stimulate the economy more safely and effectively than expensive, tax-funded, stimulus packages.

The federal government could fund it independently because ’10% down, simple interest’ loans would be comparatively low risk… much less risky than letting banks amortize loans as recent history has dramatically and unequivocally proven.

A new federal mortgage entity to directly fund such simple interest mortgages would produce a fairly reliable income stream which the federal government could use to pay down its own debts.

If you want a mortgage system that safely and reliable meets America’s needs, then keep Wall Street bankers out of it. They only operate in their own interest.

Posted by breezinthru | Report as abusive

Interesting suggestion on banning flat-payment amortization, but when wages are going up and payments remain flat, homeowners ALREADY grow wealthier the longer they own the house. You are simply looking to accelerate that process.

It wouldn’t have made a huge difference in our situation, but we would have needed to cut back on retirement contributions when we purchased. Not sure forcing young people to use their home as their ONLY piggy-bank is a good move.

Large downpayments definitely make sense. The risk to the bank on a 20% downpayment is much less than the risk to the borrower. Moreover, if you can’t accumulate a 20% downpayment over five years of renting, you CLEARLY do not have the financial flexibility to safely afford the house. It isn’t just “having a stake in the deal” but also proving that you can reliably put large amounts of money aside.

Posted by TFF | Report as abusive
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