“It’s time to apply the same rules from top to bottom: No bailouts, no handouts and no cop-outs. An America built to last insists on responsibility from everybody.” Thus President Obama laid down the gauntlet in his recent State of the Union address. Yet he remains committed to subsidizing industries. And mortgage lending is high on his priority list. In his speech, he announced a plan that “gives every responsible homeowner the chance to save about $3,000 a year on their mortgage, by refinancing at historically low rates…A small fee on the largest institutions will ensure that it won’t add to the deficit, and will give banks that were rescued by taxpayers a chance to repay a deficit of trust.” Last Wednesday, February 1, Obama unveiled the specifics of this demand-side bailout, which would require congressional approval. Lawmakers should think about some likely consequences.
Let us digress for a while and look at the big picture. The U.S. housing market has been in a deep recession since the Great Financial Meltdown of 2008. This is despite the fact that interest rates for 30-year conventional, constant-rate mortgages lately have hovered slightly below 4 percent, the lowest level in at least a half-century. If a recovery has occurred, it has been modest and then only limited to high-income markets such as metro Boston and San Francisco. Federal Reserve Flow of Funds data released in December reveals disturbing indicators. The Fed concluded that U.S. households are sitting on $13.2 trillion in debt, slightly more than the current $13.1 trillion in total government debt and more than 85 percent of GDP. Since 2007, household net worth has shrunk from $66.8 trillion to $57.4 trillion, with $2.4 trillion of that decline alone occurring during Third Quarter 2011. What’s more, composite home value during this time dropped from $21 trillion to $16.1 trillion.
Other evidence also points toward a housing market that has yet to hit bottom. The Standard & Poor’s/Case-Shiller 10-City and 20-City Home Price Indices for November 2011 fell by a respective 3.6 percent and 3.7 percent from November 2010 and by 1.3 percent each from October 2011. That puts these seasonally-adjusted measures at their lowest levels since 2003. Accompanying the price declines has been the rapid growth in homes with negative equity; i.e., properties whose outstanding mortgage value exceeds current market worth. According to the Santa Ana, Calif.-based real estate tracking service, CoreLogic, 10.7 million homes, comprising 22.1 percent of all homes with a mortgage, were in this “underwater” condition during Third Quarter 2011. That’s slightly down from 10.9 million homes in the Second Quarter, but still staggeringly high. And the drop might not be sustainable in the near future. CoreLogic’s own Home Price Index showed a 4.7 percent drop nationally in 2011, the fifth straight year of decline. Bank of America senior economist Michelle Meyer projects house prices will drop another 7 percent through 2013 before rising again and achieving 5 percent annual growth during 2015-20.
Accompanying, and to a large extent causing, the fall in home values has been a sharp upswing in foreclosures. According to the Jacksonville, Fla.-based Lender Processing Services, which now handles more than half the nation’s foreclosures (and often too quickly, as legal documents from state attorneys general lawsuits suggest), foreclosures in October represented 4.29 percent of all active residential mortgages nationwide, the highest figure on record. Even more significantly, properties in foreclosure now account for a far higher share of residential sales. About 20 percent of all home sales during Third Quarter 2011 involved foreclosed properties, notes the Irvine, Calif.-based RealtyTrac, a category that includes bank repossessions, short sales and other transactions under duress. While that’s a drop from the 2010 figure of 30 percent, that doesn’t mean the end is nigh. The normal rate is about 5 percent. And much of the decline last year was due to lenders, in seeking to avoid further legal action, slowing down the processing and sale of properties already in the foreclosure pipeline. Bank of America’s Meyer expects foreclosures to total 8 million over the next four years before subsiding. This glut in “shadow inventory” should keep prices down for a while.
Given such indicators, it would be hard to avoid concluding that the housing market remains mired in recession. Karl Case, emeritus professor of real estate economics at Wellesley College and co-originator of the S&P/Case-Shiller Index, goes further, declaring, “It’s a complete depression.” Pick your term, but the downturn has occurred in spite of the federal government’s unprecedented steps to stabilize the market since the summer of 2008: The Treasury Department under President Bush seized severely undercapitalized secondary mortgage giants Fannie Mae and Freddie Mac and placed them under conservatorship. The Federal Housing Administration (FHA), which insures mortgages against the risk of default, accounted for roughly 30 percent of all mortgage purchase obligations during 2008-11, up from about 4 percent during the housing bubble of 2004-07. Congress raised loan limits on FHA mortgages, thus expanding possibilities for Fannie Mae and Freddie Mac purchases and government-backed securitization. Congress under Bush enacted a highly generous tax credit for first-time homebuyers, twice extending it under Obama before letting it expire. The Federal Reserve purchased $1.25 trillion in mortgage securities to keep mortgage rates down. And the Obama administration created the still-operative Home Affordable Modification Program (HAMP) and Home Affordable Refinance Program (HARP) to make it easier for troubled homeowners to refinance.
The best that can be said of these efforts, as National Legal and Policy Center has noted on several occasions, is that they have averted short-term disaster. Unfortunately, they also have laid the groundwork for a worse disaster in the future. We now are redirecting ever-larger portions of the nation’s assets into promoting homeownership, in the process potentially replicating the 2008 collapse. Putting taxpayers at even greater risk are the affirmative lending mandates contained in the new Dodd-Frank legislation and because of the fact that roughly 90 percent of all new mortgages, whether explicitly or implicitly, now carry a federal guarantee.
The recession has produced a surge in vacancies as well as foreclosures. A Government Accountability Office report released this December concluded that the number of non-seasonal vacant homes in the U.S. rose by about 50 percent during 2000-10 (April), from a little under 7 million to 10.3 million. The study cited local market population declines and high foreclosure rates as the main culprits. Despite an overbuilt market, federal policy encouraged people to buy more housing than they could afford. Many buyers already were homeowners who bought a more expensive property. Others were owners who refinanced with “cash out” mortgages in excess of what the home was worth. Still others were black and Hispanic first-time buyers, who, despite limited credit histories and down payment capability, received loans due to threats against lenders via the Community Reinvestment Act.
Government intervention, in lieu of a full economic recovery, can do only so much to reduce excess inventory. The problem, however, is that people won’t spend money needed for a full recovery if they think homeownership isn’t worth the initial investment. In a background paper published by Yale University last year, “Wealth Effects Revisited, 1978-2009,” Professor Case, along with S&P Home Price Index co-founder Robert Shiller (Yale) and John Quigley (University of California at Berkeley), concluded that the long-run wealth effect of homeownership is more pronounced than it is of stock equity. Looking at data from several states, the authors observed that the more expensive home is, the more likely its owner is to boost overall consumption. The implication ought to be clear: As the rapid economic growth during the middle of the last decade was fueled by artificial credit stimulation, the resulting recession is a by-product of credit contraction. By ramping up housing demand through cheap credit and lowered underwriting standards, we risk an even deeper housing recession.
The banking, building, real estate and other housing-related industries, not to mention their supporters in Congress and elsewhere, are determined to see housing lead a full-scale recovery. For many months they’ve been pressuring the Obama administration to put forth something Big and Bold. Now the administration has responded. On Wednesday morning, February 1, President Obama rolled out a comprehensive proposal titled, “Plan to Help Responsible Homeowners and Heal the Housing Market.” Speaking to an enthusiastic audience of some 400 persons at the James Lee Community Center near Falls Church, Va., only blocks from NLPC headquarters, the President summarized the basics of the plan, the heart of which would make it easier for an estimated 1 million “underwater” homeowners with good repayment records to refinance their mortgage at today’s low interest rates. The program’s cost, an estimated $5 billion to $10 billion, would be fully covered by a portion of Obama’s proposed Financial Crisis Responsibility Fee, a fee which includes the pending (and nearly completed) $25 billion settlement against major banks initiated by all 50 state attorneys general. Privately- as well as publicly-held loans would be eligible. Participating homeowners on average would save about $3,000 a year. And they would only need a FICO credit score of at least 580, a threshold virtually all borrowers meet.
The proposal would encourage homeowners to refinance their mortgages either through lowered interest rates or more rapid equity buildup. Here is an example:
Lower the interest rate. A borrower takes a 30-year, $214,000 loan in 2006 at 6.5 percent. The outstanding current balance is $200,000, but the home has a market value of only $160,000. By refinancing at 4.25 percent, this owner would reduce monthly payments from $1,350 to $980, or by $370.
Build up equity. This same borrower refinances with a 20-year mortgage at 3.75 percent. By applying the monthly savings solely toward reducing principal, the home would have positive equity within five years, even with the market value remaining at $160,000.
The President’s housing initiative has other elements as well: 1) a Homeowners’ Bill of Rights, which would lay out a “single set of standards to make sure borrowers and lenders play by the same rules”; 2) a pilot program to transform foreclosed owner-occupied properties into rentals; 3) create one year of loan forbearance for borrowers looking for work; 4) pursue joint agency investigations into mortgage origination and servicing abuses; and 5) rehabilitate neighborhoods and reduce foreclosures. These measures, like the mortgage financing program, would be funded by the pending mortgage settlement, raising the total cost of the initiative to about $17 billion for some 3 million beneficiaries. Yet even without these additional activities, the president’s main proposal, mortgage refinancing, should invite a high degree of skepticism.
First, while the stated cost of the program is $5 billion to $10 billion, the true cost likely will be a lot more. The Obama administration intends the program to benefit only “responsible” homeowners – i.e., those not delinquent on their payments and who have a FICO credit score of at least 580. It would apply only to “underwater” privately-held loans. But that still would cover a lot of ground, especially if house prices continue to fall for another two years, as Bank of America projects. What’s more, the administration, as an incentive, is willing to have the government pay all closing costs associated with refinancing, which would amount to about $3,000 per mortgage. That’s on top of the $3,000 the new bank fee would provide in annual payment savings.
That’s just the start. Eligible borrowers would have to secure some kind of refinancing. And given that mortgage lenders, as an industry practice, avoid making conventional loans in cases of negative equity, the program would necessarily involve a further dramatic, and congressionally-mandated, FHA expansion. Brookings Institution Co-Director of Economic Studies Ted Gayer explains:
Private lenders are reluctant to offer a new mortgage to an underwater borrower, so presumably this plan would offer a government-backed loan, such as an FHA loan. This would require legislation, as FHA does not give loans to underwater borrowers, even if they are current on their existing mortgage. The tax on the “largest financial institutions” (which would also require legislation) would be used to fund the increased credit risk exposure to FHA.
All of this would come at a bad time for the Federal Housing Administration, created in 1934 and made part of the new U.S. Department of Housing and Urban Development (HUD) in the mid-Sixties. FHA may well require a bailout, the first in the history of its lender-paid single-family loan insurance program. Ed Pinto, a senior fellow at the American Enterprise Institute and former chief credit officer for Fannie Mae until the late Eighties, estimates that as of last October, about 17 percent of FHA-insured loans were in some stage of delinquency. About half of this portfolio – about $117 billion – was “seriously” delinquent; i.e., more than 60 days overdue. University of Pennsylvania-Wharton School Joseph Gyourko, author of the recent American Enterprise Institute paper, “Is FHA the Next Housing Bubble?,” notes that the agency’s exposure has grown from $305 billion in fiscal 2007 to more than $1 trillion today. Making this even more alarming, FHA capital reserves are a mere 0.24 percent, well below the statutory minimum of 2 percent, despite three premium hikes under President Obama. In lieu of a rapid recovery, Gyourko argues, FHA could need a bailout of anywhere from $50 billion to $100 billion.
The Obama administration wants to avoid the day of reckoning by expanding FHA’s focus on low-risk borrowers, thus further usurping the role of private mortgage insurers. Raphael Bostic, HUD Assistant Secretary for Policy Development and Research, views a high profile by FHA as necessary for market stabilization. He states: “Providing access to credit for homebuyers of all income ranges and in all communities, and stabilizing our housing market, has been FHA’s mission for nearly eight decades.” Expanding this “access” may prove very expensive if there is another major economic downturn. President Obama’s proposal would substantially raise the level of exposure of an already exposed agency.
Second, the program amounts to a redistribution program, only instead of wealthy households, the source of funding would be banks and servicing operations that hastily approved the rising tide of foreclosure documents (i.e., “robosigning”). While $5 billion to $10 billion might not seem much to the five banks on the verge of agreeing to a reported $25 billion consent decree with attorneys general in all 50 states, the settlement extracted from those defendants – Ally Financial, Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo – would make it all but impossible for them to foreclose if they are in the process of negotiating mortgage modifications. The proposal would prop up home values via lawsuit. Even though the beneficiaries would be reasonably current borrowers with negative equity, there is no reason to believe that many of those borrowers won’t wind up in default. About a third of all permanent modifications under HAMP, for example, went into default within six months.
Third, the program further undermines the sanctity of a contract. By “encouraging” lenders to renegotiate mortgages with borrowers who bought homes well beyond their means, the federal government would be providing distressed borrowers with the equivalent of an amnesty. And like other types of amnesties (e.g., immigration), this one, once granted, would raise expectations of another one down the road. Lenders, fearful of being forced to make loans that can’t be repaid in full, would curb mortgage lending to all but the most creditworthy borrowers, save for FHA or VA loans. And federal and/or state prosecutors always can up the ante, insisting that the existing pot of funds is insufficient to “stabilize” the housing market. Markets can’t function smoothly if the terms of a contract can be renegotiated at the whim of government.
Advocates of the Obama approach believe the new initiative amounts to little more than the proverbial “good start.” An ad hoc group calling itself Campaign for a Fair Settlement issued a statement last weekend indicating it was “deeply concerned” about the rush to complete the settlement, lest it shortchange troubled borrowers. National Association of Consumer Advocates President Ira Rheingold made a similar point: “Does it go far enough? No. Does more need to be done? Absolutely. Is it a step in the right direction? Yes.” Columbia University Business School Professor Christopher Mayer, a supporter of the Obama approach, opined, “Based on the numbers alone, this is pretty modest.” And Rep. Zoe Lofgren, D-Calif., urged late in January: “The president has a ‘We can’t wait’ agenda. We’re asking [him] to use the authority that he has to obtain the principal-reduction plan that we have urged. He has the authority. Let’s use it.” President Obama, for now, hasn’t accommodated her wish. Future editions of his plan just may.
Actually, the requirement for congressional approval may be the saving grace of the housing proposal. And Republicans, who hold a majority in the House of Representatives, aren’t likely to be won over. House Speaker John Boehner, R-Ohio, for one, wants no part of it. “We have done this at least four times, where there is some government program to help homeowners who had trouble with their mortgages,” Boehner remarked. “None of these programs have worked and I don’t know why anyone would think this next idea would work.” Rep. Darrell Issa, R-Calif., chairman of the House Oversight and Government Reform Committee, is willing to be flexible on interest rate reductions, but in a way that “doesn’t require some shirking of the original agreement” requiring repayment of the whole debt.
But the issue isn’t just whether the programs will work – a successful bailout, after all, is still a bailout. The real problem is that we are in the process of socializing the risks of homebuying for all but the wealthiest segments of our society. One of the prime justifications for housing socialism is that housing is “too important” to be left to the vagaries of the marketplace. But “vagaries” is another way of saying “risk.” By supplanting banks as a source of risk evaluation, government is making it unprofitable for banks to underwrite mortgages. The Obama plan would make it easier for high-risk borrowers to stay in their homes. That may be a good election strategy, but won’t work in the long run as economics. The main, and unspoken, stumbling block to avoiding future housing market meltdowns is the assumption that homeownership is a moral entitlement. That assumption, in fact, is what created the current crisis in the first place.