Kathleen McCaffrey, Associate Editor
Ideology: Libertarian | Writing from: Berlin, Germany
In 2007, it became obvious that the United States had a tremendous financial problem triggered by a gross amount of mortgage delinquencies and foreclosures. It has been accepted by many economists that the ongoing “subprime mortgage crisis” can trace it origins to many policies from the 20th century in both the private and public sectors. (As Peter Schweizer explains in his latest book, government housing regulations first saw their radicalization during the Carter Administration and the cheap money policies of the Fed in the 1990’s unleashed a flood of lending – helping expand the real estate bubble.)
Yet the ramifications of these “easy money” policies, like the 80% of US mortgages issued to subprime borrowers as adjustable-rate mortgages, have shown their most destructive consequences on financial markets since 2007. Securities backed with subprime mortgages lost a sizeable portion of their value and caused a large decline in capital over a variety of industries in the world.
Long story short: the government took it upon itself to rectify this crisis utilizing bailouts, and stricter regulations. Barney Frank proclaimed last year that “the private sector got us into this mess” but “[the] government has to get us out of it.” For the past two years, the government has been fretting over high-risk mortgages, or ones with slim down payments given to people with bad credit, and wagging its finger at those who did not live within their means on Main Street and Wall Street alike.
Fair enough, we can all agree that this issue is in dire need of an effective solution for the financial security of our country. However, we will not be getting a permanent one if these high-risk loans are still available – and they are, from the Feds.
As the Washington Times reported this week, “[loans] insured by the Federal Housing Administration (FHA) have become ‘the new subprime,’ and these loans are exposing taxpayers to the same kinds of soaring default rates and losses that brought down Fannie Mae and Freddie Mac as well as destroyed many banks and the private market for mortgage loans. While private lenders learned a lesson from the mortgage crisis and are shying away from easy-money loans, the FHA has stepped into the breach. The agency has provided backing for 37 percent of all mortgages used to buy homes this year.” While the private sector has “wisened up” to 20% down payments, the FHA requires only 3.5% minimum.
The Washington Examiner reported, “In September, delinquencies among U.S. commercial mortgage-backed securities surged to 3.64 percent, up from .54 percent last year. The Mortgage Bankers Association projects that foreclosure rates will keep climbing through until late next year, particularly among Federal Housing Administration loans, 8 percent of which were in foreclosure or delinquent at the end of June, compared with 5.5 percent in early 2006.In 2008, it insured 21.5 percent of all new mortgages, up from fewer than 6 percent in 2007. Yet despite all those failing loans, FHA so far this year has backed nearly 2 million mortgages worth at least $328 billion.”
Whitney Tilson, manager of an investment firm, concisely explained that this means “the FHA’s portfolio is exploding and the taxpayer is now on the hook for 100 percent of the losses.” Edward Pinto, a former chief credit officer at Fannie Mae, “estimates that 20 percent of the FHA’s entire portfolio of $725 billion mortgages will end up in foreclosure – a rate recently borne out by estimates FHA provided to Congress.” According to Pinto’s prediction, the agency will require a “bailout” within the next three years. Of course, Barney Frank, the Chairman of the House Financial Services Committee, backs this program regardless.
How can we expect the government to “get us out of this mess” when it can’t even bring itself to discontinue a practice that got us into a crisis?
Well, this is sort of a “damned if you do, damned if you don’t” scenario. Home prices need to be stabilized, even artificially, because falling home prices continue to erode both household and bank balance sheets and lead to more foreclosures because and further price declines. Defaults are far more frequent in homes with negative equity, so there is an incentive for the FHA to step in and take up some of the lending, which banks are not doing anymore, as a way to stop house prices from falling. If these loans help keep home prices flat, it helps mitigate defaults elsewhere in the economy, which helps the economy turn around because it helps banks and households get their balance sheets back to healthy and start lending/borrowing again. So long as the FHA stops this sort of lending once home prices start rising again, this is not a serious concern. The FHA and government are probably going to incur a loss from doing this, but the net loss is almost certainly less than costs of allowing home prices to completely tank. Until banks start lending and home inventories turn over at a normal rate again, the FHA’s liquidity is a necessary evil.
Dear Mark,
I must admit that I find your logic somewhat perplexing.
1) If, in fact, the government’s loans to the housing market are necessary to “stabilize, even artificially” home price declines, why should the government not step in and start buying up real estate ad nauesum? Without even touching the problems associated to expanded government ownership, might I simply suggest that this would be a bad investment on behalf of the American people? The fundamental value of residential real estate is ultimately derived from the willingness of individuals to pay to live in a particular location, not the intrusion of some transient authority to restore “liquidity” (your word). If, in fact, fundamental values are falling, I see no reason why government purchases would do anything in the long run other than cause the government to lose substantial sums of money while prolonging an already painful price adjustment process.
2.) Even if I were to admit that government support could stabilize home prices, would it not make sense to approach the task with prudent standards? If, as you put it, “defaults are far more frequent in homes with negative equity,” why would the government even consider lending with only 3.5% equity in a falling market? This seems preposterous if not absurd.
The current FHA loan mechanism represents one thing and one thing only: a redistribution of wealth from the American taxpayer to the special interests favored by current FHA programs. Furthermore, if we are to accept that the “evil” banks took full advantage of poor, unqualified borrowers in selling them homes that they could not afford, the ongoing FHA fiasco is serving only to propagate a deleterious system.
I unfortunately agree that we are “damned if you do, damned if you don’t.” However, I’m pretty sure that we’re a lot more damned if we do.
Tony,
-I’m not defending the FHA, or these plans. I’m saying it makes sense in the broader scope of the entire recovery. There are certainly more or better ways of stabilizing home prices, but the losses from this program are marginally more acceptable in this regard.
-Home prices need to be stabilized because, at its root, this recession is a balance sheet recession. If home prices continue to drop, and assets continue devalue, then more households cut back spending and choke off demand, hurting a recovery.
-Also, if prices continue to go lower, because of the law that effectively says banks have to accept short sales in foreclosure, it also means that banks’ balance sheets will be hurt by this as well. The banks have to increase loan loss provisions as LTVs increase, choking off the amount of money that they are lending, and take capital losses on any asset write-downs which also restricts lending as they approach their minimum capital requirements. Less lending means less economic activity, which also hurts demand and prolongs the recovery.
-Also, falling home prices put downward pressure on inflation in an economy with high unemployment that is risking deflation. Deflation increases the real value of debt, defraying necessary attempts to de-leverage and further delays households resuming a more normal level of demand. This would also increase the length and depth of the recession.
- Additionally, spates of foreclosure accelerate losses in home price, so if the the new loans default less than the current group of sellers, that goes a long way towards stabilizing prices.
-So, falling home prices = bad. As such, an imperfect program that may incur $100B (Zumbrun and Desmond’s number)in losses stinks, but not as much as when weighed against much larger losses stemming from another round of bank bailouts, and lost tax revenue from persistently higher unemployment. As such, increasing liquidity in the housing market to help it find a floor makes sense on the aggregate.
-In this regard, propping up the prices until traditional lending and purchases come back enough to justify those prices makes sense. Think of it like training wheels, and you take them off when the private market justifies the prices you’ve held the market at.
-Also, believe it or not, the 3.5% equity purchases in many cases represents an increase over current owners. A lot of these FHA mortgages are for short-sales, foreclosures, and people who are close to foreclosure and are motivated sellers. So the people buying in often represent a lower level of default on the margin than the current tenant, or help banks turn a physical asset at a motivated price into cash which can be lent. Replacing a sub-prime borrower on the edge of default (or already has) with a different sub-prime borrower isn’t ideal, but is still a net gain on the margin.
-Additionally, most of these FHA loans are replacing securitized loans which often cannot legally enter into a work-out plan (whereas FHA loans can be more easily). So again, while the losses are likely to be there with the new tenants, they are likely to be less than the ones with current owners because the new ones will avoid default more often. It isn’t like a lot of people are thinking now is a good time to sell into the market; most homeowners that are in good shape financially are waiting out the dip in home prices.
-I’m not sure why you put quotes around evil, because you aren’t quoting me. I said the FHA’s added liquidity to the market was a necessary evil, not that the banks were. That was “perplexing”. I never suggested anybody took advantage of anyone, though I’d imagine we can suggest the banking industry as a whole was incredibly short-sighted. I attribute that more to misaligned incentives rather than any sort of over-arching malice.
-To sum up, I don’t particularly like the FHA program, but I think you just have to tack it onto the overall cleanup cost of this mess with the TARP and ARRA, and all the special Fed lending facilities. On the margin, it makes sense to keep the line moving in home sales, moreso than letting house prices tank. This program does that. Will it ultimately justify the costs to the FHA? I don’t know. But I see how it could, and in that sense I’m not as livid about this as the author or you.
Dear Mark,
I should first note that all of your points are very well taken.
I agree with many of your earlier comments, and I must admit that I am of the same mind as you when you say “falling home prices = bad.” It is a very unfortunate circumstance that has harmed many individuals and the economy more generally. I wish that it were not the case.
My remaining issue, however, is as follows:
- The fundamental value of residential real estate is derived from the willingness of individuals to pay rents to live in a particular location
- I believe that, over the past several years, a dominant bubble mentality allowed prices to diverge from fundamental levels
- Real estate values are presently readjusting (and in some locations largely readjusted) to levels consistent with fundamental demand
If I understand your argument correctly (that increasing liquidity in the market will ultimately stop the decline in real estate values), it would have to be the case that prices are appropriate in light of my logic above. Is it your view that prices never diverged from fundamentally justified levels? Or perhaps you are arguing that fundamentals are irrelevant? If I am to follow that thread to its ultimate conclusion, I am left with the prospect of a downward spiral in home prices without floor. Could you perhaps point me to a location in which prices are spiraling downward? I am always seeking to find real estate on the cheap.
I do take issue with some of your specific points (there is currently no evidence of deflation and plenty of reason to believe that inflation is forthcoming; mortgage servicers generally have the capability to modify securitized mortgage loans, contrary to your suggestion), however I principally disagree with the suggestion that the government can somehow stay the fall in real estate values (almost calling to mind the battleship Yamamoto at Okinawa). Frankly, I believe that the best outcome of such a program would be to prolong the despair.
Perhaps you might agree with me on one key point, however? As soon as economic circumstances recover and home prices cease declining, the US government should immediately and entirely end this FHA program? If we can agree on that, I might be inclined to agree to disagree on the rest.
Kathleen,
Excellent piece, and great points.
Policies like this are what I think are going to lead us into a double-dip recession.
Tony,
-I agree that the program should be phased out.
-I do believe that prices can move from fundamentals. My point is that, even though fundamentals probably suggest lower prices, those fundamentals in the future are likely to rise in the future; we can either let prices drop now, or hold prices up until the economy recovers and fundamentals rise to current levels. The latter is expensive, but probably not nearly as expensive as the former. We’ve already seen a substantial decline in home prices since 2007, and it might be wise to hold home prices at current levels until the fundamentals sidle up underneath them and are able to support where they are now. Part of the reason fundamentals would suggest a lower price than we currently have is because mortgage lending (and liquidity in the market) is low so when banks get back to lending more the fundamental price will increase just by virtue of opening the market to more people who are willing to purchase the houses at current price.
-There is most certainly a huge deflationary risk at the moment. Based on the Taylor rule, the Fed should have interest rates at -5%, but instead is at 0%. So, effectively, we have contractionary monetary policy by virtue of the zero bound. We also have nearly 10% unemployment and a U6 of 25%, meaning there is a ton of downward pressure on wages, rents, and prices. Core CPI is flat, and demand isn’t likely to kick up anytime soon. I appreciate that the Fed is massively expanding their balance sheet, but without banks lending the money supply has actually been decreasing. There is a huge deflationary risk, and actually a one-time blast of inflation might actually be helpful getting the economy back on its feet.
Dear Mark,
I’m glad that you agree that the program should be phased out. I believe that means that this argument reduces to a relatively esoteric economic critique, which presumably takes down any reader interest to approximately two.
That said, I guess I’m still not quite following your logic. If I allow that the government can affect home prices, why proceed with an FHA program that essentially underwrites low quality borrowers and risks incremental default? Why not just buy up significant quantities of real estate? Would that not be more direct and effective? Frankly, why not just buy substantial amounts of every asset with falling values, including stocks, bonds, CDOs, etc.? If we’re focused on the health of the banking system, it seems like maybe the government should agree to just take some sub-prime structured securities out at par. That could be pretty effective at boosting equity levels. Would you support such a program?
All of your points on the Taylor Rule are well taken. My statistics on the money supply diverge a bit, though. My read is that 3, 6, and 12 month annualized rates of increase for currency are 3, 4, and 10 percent, for M-1 are 10, 11, and 17 percent, and for M-2 are -0.4, 1, and 8 percent. I introduce the decimal on the one negative number if only because it would have rounded to zero otherwise. I guess one cut of this data suggests that the money supply was basically level over the last quarter, though every other cut suggests significant recent increases. Not to mention that declining production levels would seem to indicate that this money is chasing fewer goods than previously, and velocity is invariably going to expand as economic activity begins to recover. I’m also a bit bemused when you say that “core CPI is flat,” as if energy is inconsequential. I just don’t see it, I’m sorry.
http://money.cnn.com/2010/02/26/news/companies/Fannie_mae_results/