Home Economics

By Hamiltonicus 

You could say housing is the beginning, middle and end of current U.S. economic woes.  The credit freeze touching off the 2008-09 recession stemmed largely from a mania for ‘subprime’ mortgage lending to homeowners with high default risk.  This mania originated in government policies pressing for more loans to low-income home-buyers and gained steam when lenders found they could sell off risky loans en masse in newfangled packages called mortgage-backed securities (MBSs).  These got bought by investors willing to risk non-payment of some loans in return for large-volume returns on those that paid off.  Financial houses were soon holding and trading huge positions on risks they knew nothing about.

Federal policy has for decades favored home ownership, giving income tax breaks to householders on their mortgage interest and local property tax payments.  The construction and real estate sectors have prospered correspondingly.  More recent developments fueled a buying boom starting in the early nineties.  Easy mortgage credit broadened the pool of buyers, pumping up demand and pushing sales prices upward.  A ‘wealth effect’ emerged as homeowners felt rich enough in their house values to buy lots of stuff with their credit cards and even take out second mortgages, giving them borrowed money to buy even more stuff.  The boom gained momentum in 1997, when Congress raised from $250,000 to $500,000 a tax exclusion for first-time home buyers on capital gains realized when they eventually sell for more than they paid.  What a great investment, even if you have to live in your house for two years to get the benefit.

Prices went through the roof.  Between 1992 and 2006, average home values rose an astonishing 125%.  As this bubble soared further and further from earth, it pulled much of the economy upward with it.  But danger lurked in millions of homes, mortgaged to the edge of their owners’ means.  Many mortgage borrowers did not understand the obligations they were undertaking.  Many loans were ‘back-loaded,’ with easy payments early in the life of the loan but sharp step-ups later.  Many banks failed to clarify terms in their haste to push loans over the counter and quickly resell the rights to collect on them.

Trickling delinquency reports became a rivulet and then a river.  Some financial houses with MBS positions faced massive losses, while others feared they might.  Credit froze as lenders sought to gather and hold their capital.  Business activity slowed.  Meanwhile, the music in the housing market stopped.  Foreclosures began to flood the supply side, nudging prices lower.  The low-hanging fruit of first-time buyers had been harvested and huge credit card debts cast a shadow over household borrowing.  As prices began to tumble, homeowners saw their nest eggs melt away before their eyes.  Some sold in panic.  Millions of families realized they could no longer borrow and spend but must instead save and save.  And we know what happens when everyone stops spending at once.

Where had all the easy credit from?  In the early nineties, the federal government launched a drive to expand home ownership among lower-income families.  It required that private banks direct parts of their loan portfolios to families whose low earnings and credit scores disqualified them from traditional mortgage eligibility.  This ‘subprime’ lending requirement was buttressed by new policies adopted by two vastly-profitable federally-chartered mortgage institutions known as Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation).

Created to promote home ownership by making lending more attractive, Fannie and Freddie sell loan guarantees to banks issuing mortgages and also purchase mortgages in volume, holding some on their books and packaging others for sale as MBSs.  Because the loan guarantees and purchases help direct mortgage lenders reduce their risks, more loans get made, at lower interest rates.

In support of the new low-income home ownership policy, Fannie and Freddie relaxed standards on loans they would guarantee and purchase.  A previously minor lender called Countrywide jumped in with both feet, pushing out subprime loans as fast as it could and selling them, first to Fannie and Freddie and later to others.  With loans jumping from $92 million in 1992 to $200 billion in 2004, Countrywide had become America’s largest mortgage issuer by 2004, largely thanks to its subprime portfolio.

Meanwhile, banks and other financial houses dove into the game of buying subprime mortgages and bundling them into MBSs for sale.  The risks of subprime lending seemed to disappear like magic.  Instead of being forced by federal policy, banks became eager to make subprime loans because the risks could be sold onward into the MBS market for instant cash that could be used to finance even more loans.  Fannie, Freddie, Wall Street and players from all corners soon emeshed themselves in a tangle of risky loans and MBSs.

Much of the buying was done with borrowed funds to boot.  Lenders continued to support the spree even as ominous default reports began trickling in.  Why?

Lenders believed that the federal government would furnish taxpapayer funds to keep Fannie and Freddie afloat, though no law required this.  That is exactly what happened when Fannie and Freddie began to teeter.  Uncle Sam poured in the funds, while taking ownership of Fannie and Freddie assets and control of their managements.  In parallel fashion, markets believed that loans to players in the subprime casino were actually safe because those players were ‘too big to fail,’ meaning that Uncle Sam would furnish bailouts rather than see go under with all attendant chaos.  This too came to pass, of course.

That was the beginning; now is the middle. Though the crisis-driven recession officially ended in 2009, recovery has been weak by historical standards. Three years into recovery, for example, unemployment has only recently dipped below 8%.  Fears of a ‘double dip’ cannot be gainsaid and housing remains central to the story.

Past recoveries have usually been led by the housing sector: increased mortgage lending, new home starts, quick hiring for construction jobs, money in pockets, increased consumer spending.  Precious little of that has been happening this time around and the recovery has been correspondingly weak.  Taken by itself, the housing sector has remained in a recession that some even call a depression.

The biggest real estate bubble in American history is not coming back.  New home construction is down, construction and real estate employment down, mortgage lending down despite record low interest rates, sales down, prices down, down, down.  It’s been going this way nearly seven years now, blips and feeble policy interventions aside.  Roughly one quarter of all U.S. mortgages are now ‘underwater,’ meaning that the home’s value in today’s depressed market is less than the principal owed on the loan, taken out when prices were higher.

Instead of a wealth effect, the housing sector now imparts a ‘reverse wealth effect’: homeownership is making people poorer, not richer.  The pauperizing effect of an underwater loan leads some homeowners to default on their mortgages, throwing more properties onto the market and further depressing prices.  Others cling to their homes, hoping desperately for better times, unwilling to sell at prices too low to pay off their mortgages.  This home detention prevents many unemployed workers from relocating and helps keep joblessness rates at unacceptable levels.

Banks, along with Fannie and Freddie, have meanwhile tightened up big-time on lending standards.  Critics say they have overcorrected on previously lax standards at the worst possible time, especially since a lot of default risk was squeezed out of the market as prices and loan sizes fell back to realistic levels.  Though some think the market has now at last hit bottom, few expect prices to rebound quickly.

Could this era of U.S. economic woe be brought to an end through a housing sector rescue?  Would it be wise to stress a sector-specific intervention ahead of ones directed at the broader economy?  Does the fact that housing usually leads recoveries but this time has failed argue in favor of  a housing intervention or against it?  Are there interventions that would work or would it be better just to wait till people slowly find the money to start buying again?

The most ambitious proposals involve broad-scale re-mortgaging with substantial, though camoflaged, taxpayer support.  New mortgages would be issued to underwater and delinquent homeowners.  According to some versions, lenders would buy the homes at current discount prices and then re-sell them back to owners, with scaled-down principal papyments on the new mortgages to reflect lower current values and with interest payments at today’s low levels.  Lenders and homeowners would then split any future appreciation in home values.  With debt burdens lightened, homeowners would be freer to spend, thereby boosting recovery.

Two key questions are how this could be brought about and whether its benefits would outweigh its costs.

Initiative could perhaps come from banks themselves, who would gain relief from thousands of slow, expensive and distracting foreclosure proceedings.  Massive home acquisitions leave banks on the hook for property taxes, insurance, maintenance and fines for violating codes and ordinances.  They need to create whole new departments for tasks tangential to their core business. On the other hand, mass re-mortgaging at reduced principal and interest would whack lenders with immmediate write-downs on their assets.  Precarious bank balance sheets have so far kept the government along with Fannie and Freddie from nudging or somehow requiring mass re-mortgaging.

Fannie, Freddie and the government could grab the reins themselves because all have acquired substantial mortgage and MBS holdings over the course of the current crisis.  Fannie and Freddie got taxpayer money to buy up even more loans and MBSs than they had held beforehand, thereby mopping risk out of markets so mortgages might start flowing out again at reduced interest rates.  Their current holdings in this category total roughly $1.5 trillion.  Treasury holds another $1 trillion, acquired and parked there through the Federal Reserve’s ‘quantitative easing,’ another adventure in driving borrowing costs down.

As owners of mortgages and MBSs, the Treasury, Fannie and Freddie could presumably wire up a mass re-mortgaging program, though the details are far from clear.  President Obama has hinted vaguely that he might push some such approach if re-elected and some Congressional Republicans might even help.  Mitt Romney, Republican presidential candidate, offers even less specificity on the issue than does the president.

What downsides might there be?  One objection is that mortgage relief would create ‘moral hazard.’  If falling behind on your payments can qualify you for easier mortgage terms, why not do exactly that?  Relief advocates contend that this moral hazard is exaggerated: people will not voluntarily choose default that will destroy their credit ratings.

There is no free lunch. Terminating existing loans would extinguish the principal and interest income that mortgage and MBS holders expect to earn from them.  Mass re-mortgaging would therefore mean mass losses on MBSs.  There could be lawsuits.  Moreover, if MBS positions held by Uncle Sam, Fannie and Freddie shrink in value, the government has less money to meet its financial obligations, plain as that.  Shortfalls can be covered, some day some way, only from taxpayer pockets.  Meanwhile, pension funds supporting retirement accounts for millions of ordinary Americans also hold huge MBS positions.  Declining MBS values from mass re-mortgaging would therefore take money straight off the top of American retirement funds.

Mass re-mortgaging may be the only intervention capable of restoring the housing sector’s heartbeat.  It would mean a gargantuan wealth redistribution among ordinary citizens in hopes that mortgage relief is where all that money would do the most good.  If it’s tried, let’s pray it works.  Otherwise, we may be in for a long horror show where the American dream of home ownership becomes a new kind of nightmare on Elm Street.