While the burst of the housing bubble recedes into the past, its echo continues to reverberate throughout the economy and in communities across the land. The U.S. housing market remains a mess. Home values have steeply fallen from their 2006 peaks, loan defaults have reached historic levels, and the implosion of the housing finance system may take years to rectify. The latest figures from the Mortgage Bankers Association report over 8 percent of all mortgages were at least one month late during the first quarter of 2009, which is the highest figure since tracking began almost 40 years ago. Additionally, almost 4 percent of mortgages were in foreclosure. Taken together, 12 percent of all Americans with a mortgage are in trouble and prospects look dim for improvement in the housing market until well into 2010.
The picture actually looks worse in certain markets and states. Standard & Poor’s Case-Shiller Home Price Index, a widely watched measure of 20 metropolitan areas, fell a record 19 percent over the last year. In Las Vegas, the drop was almost 33 percent. Woe to the family looking to move from Nevada, Arizona, California, or Florida for a job opportunity elsewhere.
Of course, these families and others have a right to expect their policymakers to help chart a way out of this muddle. Looking back in hindsight, it seems that too many irresponsible actors were allowed to operate without supervision. The challenge now is to craft a more responsible housing policy. This should necessarily include support for both rental housing and homeownership as well as transforming our housing finance system so it once again is known less for its profitability and more for its delivery of safe, sound, and appropriate mortgage products.
In the near term, policymakers will be expected to assist distressed homeowners and prevent mass displacements. The Obama administration’s anti-foreclosure plan debuted in February to generally positive reviews but it has been slow to take hold. What they dubbed the “Making Home Affordable” program strives to enable homeowners whose home values have declined to take advantage of falling interest rates and refinance their mortgages at better terms. And perhaps more significantly, it encourages mortgage servicers to modify existing loans by lowering monthly payments or writing down the principal. Advocates have argued that additional sticks are required to ensure that mortgage principals are lowered when appropriate. And they seem to have a point, as servicers appear to prefer modifying loan terms even when this isn’t enough to avoid foreclosure. Months after the initial rollout, there remains concern that the plan can reach enough homeowners to make a difference and do so before their household finances completely erode. The administration’s plan is likely to need additional revisions but they had the right instincts which was to put real money on the table, $75 billion, to make sure the servicers don’t stay on the sidelines.
Of course, the policy is still reliant on the performance of the broader economy. If massive job losses persist, people will not be able to stay current on their payments, even after their loans have been refinanced or modified. This means that stabilizing housing markets will depend on the quality and character of the economic recovery. But soon enough, policymakers will have to decide what a sustainable and responsible housing policy looks like for the future.
As they set out on this task, it would be wise for them to acknowledge the underlying cause of the housing crisis: a finance system that allowed for the inflation of a now-burst housing bubble. The previous demise of the stock market bubble redirected capital back into global markets via our housing stock and a seemingly insatiable appetite for mortgage-backed securities. Eventually these securities were sliced, diced, and sold in such a manner that it became difficult to assess their underlying value and risk.
The rise in homeownership rates, which topped out at a record 69 percent in 2004, was aided by a policy push — begun under President Clinton and continued by President Bush — to get more lower-income families into the market as homeowners. But we should not blame these new buyers for the upward pressure on home prices. Pervasive cheap credit and the advent of risk-based pricing (otherwise known as subprime lending) expanded the market and allowed more people to get into good homes through good loans. Unfortunately, a rise in predatory practices was also used to get good people into bad loans that they could not afford over the long term. Many well-intentioned advocates overlooked the dangers and risks posed by homeownership for certain families or the growing prevalence of predatory lending. A number of groups were paying attention, such as the Center for Responsible Lending, which has been dedicated to protecting homeowners from abusive financial practices. They were on the case, but the concerns they expressed to policymakers went mostly unheeded.
Instead, the watchdogs were told that lenders were already overregulated. In a February 2009 op-ed in The Wall Street Journal, former Texas Republican Senator Phil Gramm sought to blame the Community Reinvestment Act (CRA) for causing the housing crisis, since he claimed it forced banks to loan to risky borrowers. This is a weak claim lacking empirical evidence. CRA, which has been on the books for over 30 years, was never an excuse to make loans that would not perform. There were many ways to get an “outstanding” rating for the banks that were being assessed under CRA, and they could do so through safe, sound, and fair lending. These arguments ignore the reality that many loans were made by unregulated firms in the alternative banking sector not covered by CRA. The political attacks by Graham and others on the right have become a distraction from the real work of figuring out how to fix our housing markets.
The search for a responsible housing policy is likely to take us back to the future. Two of the greatest innovations in American finance are the 30-year fixed mortgage and the creation of mortgage markets with a high degree of liquidity. Fannie Mae and Freddie Mac were initially created to ensure that banks had access to sufficient capital to lend to home buyers. Their subsequent overreach has left them under government conservatorship. They will need to be replaced or reinvented to serve their original purpose. On his way out the door, former Treasury Secretary Hank Paulson proposed replacing Fannie and Freddie with highly regulated utilities. In exchange for a fee, these firms would purchase and bundle mortgages that would be backed by the federal government in case of default. Like other utilities, they would be governed by a public commission that would set the rules for operation, including establishing a fee structure to limit returns and standards to ensure only creditworthy mortgages are guaranteed.
In some respects, this would be consistent with President Obama’s view of the essential role credit plays in our economy. In his first address to a joint session of Congress, he argued that “the flow of credit is the lifeblood of our economy.” This makes finance a public good that has large benefits for society as a whole. We certainly have seen the positive externalities that are created when people have access to responsible credit and are able to access the loans that finance the purchase of homes, education, and other goods and investments. What we need to avoid is a repeat of the scenario where too many bad home loans make their way on the books of too many banks. And if finance is a public good, we will need to take steps to protect it, just like we protect the air we breathe and the food we eat.
A first step will be to recognize that the future housing finance system will necessarily be nested within broader reforms to the financial sector. When the administration’s initial plans to do this were released in June by Treasury Secretary Timothy Geithner and White House Economic Advisor Lawrence Summers, they sought to identify a series of principles that could drive future policy. At the top of the list was to more effectively manage systemic risk. This makes sense since we have learned the hard way that our concern should be both with the safety and soundness of particular institutions, as well as that of the entire interconnected system. This will necessarily entail stronger oversight, higher capital requirements, and other rules to increase transparency and accountability. But Geithner and Summers also argued that a new round of consumer protections was needed, taking into account how consumers make decisions and how they behave. The time seems right for this type of increased regulation of financial services. In fact, I would argue that it will be required as a necessary step to restore integrity and trust back into our financial system. These are basic human values that we have allowed to be driven from the marketplace. We should demand a new set of rules that help usher them back in. The administration’s blueprint for a new consumer financial protection agency seems to move in this direction by identifying a set of principles that will drive future product regulations, include transparency, simplicity, and fairness. What would fairness in mortgage lending entail? Let’s start by banning the practice of “yield spread premiums” where side payments are made when borrowers are steered toward higher-priced loans than lower-priced loans that they would otherwise qualify for.
Consumer protections should be at the heart of the system and not an afterthought. Making the transition from a rule-based regulatory regime to a principles-based framework will have real ramifications for developing a sustainable homeownership policy. If this means the housing finance system becomes a low margin business, with limited profit opportunities, so be it. In the near future, we should expect that the housing finance system provides fewer incentives for “innovation” but delivers more “value.” There is no shame in getting back to basics and relying heavily on the old standard 30-year fixed FHA mortgage. Even on a hot summer day, plain vanilla ice cream can taste mighty good.
Shoring up the housing finance system is a necessary step, but so is the recognition that homeownership is not for everyone. Accordingly, we need to ensure that there is a sufficient stock of affordable rental housing and consider alternative ownership models, such as shared equity homeownership. In exchange for a public subsidy, families give up a portion of the home appreciation. This makes buying the home easier for the family and preserves affordability for the community over the long term. At the same time, the owner is placed within a community-based support system, such as a land trust or limited equity cooperative, which can mitigate the risks of homeownership. Shared equity housing has the potential to provide an attractive balance of affordability, access, and the opportunity to build up home equity. It has been modeled in a number of the communities across the country and is ready for prime time. In recent years, even as successful experiences were accruing, it lacks a funding source that could be tapped at the community level. But the influx of stimulus dollars flowing to localities from the federal government in the guise of increased CDBG allocations has boosted resources. Local decision-makers should be taking a good look at the potential of shared-equity projects to stabilize their housing markets and offer increased opportunity to their residents.
But even if alternative ownership models proliferate, mortgages should not be available on demand. Savings and a reasonable down payment must be part of the equation, along with checks to verify steady or sufficient income. This does not mean that families with low incomes and few resources should be shut out of the American dream. It turns out that there are responsible ways to make homeownership work for a wide range of families.
Researchers at the University of North Carolina have studied the outcomes of an initiative of the Center for Community Self-Help, which began partnering in 2004 with Fannie Mae and the Ford Foundation to deliver nearly 50,000 loans to lower-income borrowers. They found that when compared to a similar cohort of borrowers who obtained subprime mortgages, the Self-Help borrowers had a much better track record for staying current on their payments. The subprime borrowers were nearly four times more likely to be delinquent on their loans. The impressive results of this program can serve as a how-to guide for policymakers looking to stabilize future housing markets. The Self-Help model works because it recognizes that home buying is a complex process that works best if it includes consumer safeguards, accountability, and well-tailored financial products — not to mention considerable support to homeowners when they get into trouble.
Finally, responsible homeownership should be considered in the context of a national strategy for housing policy. This means boosting rental housing in tandem with homeownership and exploring alternative ownership strategies. As the country recovers from a debilitating recession, brought on in part by excesses in the housing market, it is exactly the right moment to make sure housing policy is at least two-sided (if not three-sided to allow for greater exploration of shared-equity models). The time is also right to revisit the effectiveness of the mortgage interest deduction. In a time of scarce resources, isn’t subsidizing second homes and mortgages of up to a million dollars a bit much? A more responsible policy, as proposed by Barack Obama during the campaign, may be to replace the mortgage interest deduction with a refundable tax credit available to homeowners who do not itemize on their tax return. This credit will be equal to 10 percent of mortgage interest and it will be capped at $800 ($8,000 of interest). While the first budget produced by the Obama White House did not include this provision, it did propose capping itemized deductions (including mortgage interest) at 28 percent. While this proposal is unlikely to make much progress this year, perhaps it is a signal that they are serious about tax reform. If they are, they should be expected to revisit the inequitable manner in which the benefits of the mortgage interest deduction are distributed.