How Not to Deal with Today’s Housing Market

By Robert Lerman :: November 23rd, 2011

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The nation faces an economic paradox.  On one hand, a weak housing market is still perpetuating the nation’s economic woes, with millions of families owing more on their mortgage than their home is worth.  By some forecasts, the impending foreclosures will keep home prices low for several years, worsen personal and bank balance sheets, and slow economic recovery.  On the other hand, homes are increasingly affordable even without sizable income gains. Today, a family earning the median income can buy a medium-value home and spend only 16% of its income on mortgage payments (assuming a 5% down payment and a 4.5% interest rate).

Yet, avoiding foreclosures roundly trumps affordability in policy proposals. The Obama Administration is pushing Fannie Mae and Freddie Mac to allow underwater homeowners who have kept their mortgages current to refinance their debt at today’s low interest rates.  Alternatively, opinion pieces in the Nation and the Weekly Standard propose to require banks and others mortgage-holders to cut homeowners’ mortgage debt to levels closer to their homes’ market value. The New York Times’ Joe Nocera recently touted this approach, noting that we’ll have an estimated 6 million unneeded homes within six years.  Economist Martin Feldstein concurs, calling for spending up to $350 billion on “principal reduction” in return for homeowners waiving their right to walk away from their loans.

Moves like these can increase current homeowners’ net worth or disposable income, but their impacts on the housing market are uncertain.  Lowering interest rates eases monthly housing costs and can boost aggregate housing demand without government subsidies.  But, while government-backed principal reduction will alter the balance sheets of households and lenders, they won’t necessarily increase housing demand or reduce housing supply. If a family with a $200,000 mortgage on a house now worth $140,000 can’t or won’t pay its mortgage and then gets evicted or leaves voluntarily, housing supply and demand don’t change, even though the number of units readily available for purchase rises and one more family most likely enters the rental market. Marking down this hypothetical mortgage debt to $150,000 wouldn’t necessarily change supply or demand either: the family might still move and become a renter or might stay put, leaving vacancy levels unchanged.

The mark-down policy, if financed by government subsidies, would be highly inequitable.  Suppose the Wilson and Brown families each bought properties for $130,000 and each took out a $120,000 mortgage.  When the value of the homes hit $230,000, the Wilsons took out a new mortgage for $200,000 to pay off the original mortgage, buy a new car, and pay private school tuition while the Browns continued paying their mortgage.  When the home values fell to $140,000, the Browns still had positive equity in the home and no reason to abandon the property, while the Wilsons owed $60,000 more than their home was worth. Is it fair to the Browns of the world to provide a $60,000 subsidy to the Wilsons to keep them in their home? Beyond that, big subsidies to families with both high mortgage debt and high family incomes may not be fair either—a point few mark-down proposals address.

Paying down the negative equity of homeowners would also mainly help four states.  About 63 percent of the dollars would flow to homeowners in Arizona, California, Florida, and Nevada, where foreclosures are highest.  Yet, these four foreclosure-wracked states account for only 21 percent of the nation’s personal income.

So if government-backed principal reduction raises thorny equity issues without necessarily reducing the supply-demand imbalance, what’s a wiser alternative? My recommendation is to increase demand by helping low-income and young people currently renting or living doubled-up.  In our stagnant economy, fewer households are being formed, so demand languishes. With better information on their housing options, greater access to mortgages, and home ownership vouchers, many Americans could buy dwellings with very affordable monthly costs and help stabilize housing markets equitably.  Watch for more detail on these alternatives in my next post.

1Comment

  1. Jon Goldstein  ::  10:22 pm on November 24th, 2011:

    In the middle of the 3rd paragraph you contend that “housing supply and demand do not change, even though the number of units readily available for purchase rises…”. Seems to me that you are confusing stock and flow. The stock of houses didn’t change, but the flow (houses for sale) did.