This seems like a good time to discuss something other than the flu, so I wanted to assemble into coherent fashion some thoughts that have been floating around regarding how we are approaching the housing component of our economic situation. One of the perspectives that I like to highlight is that we don't have to panic; we have the resources to respond how we choose, rather than being forced into policies.
In some areas of governance, there is a fair amount of uncertainty. But in our economic realm, we do not lack for information. Mountains of evidence exists pertaining to the likely ramifications of various policy options. If you prefer to skip the evidence, no problem, just scroll toward the bottom.
Our exchanges tend to break down in two bottlenecks. The first is the task of education, of sharing what the professionals in the field know with a broader audience. The second is the task of translating public opinion into policy, in other words, of defending the value of the reality-based world in the political world.
We are in a great position to push for evidence-based decisions as the last two election cycles have seen us capture both houses of Congress and the Presidency. But as is frequently the case, it's more difficult to defend the primacy of the facts in a particular case than to defend the concept of a reality-based world. The theory doesn't threaten entrenched interests. But its practice sure can.
Those of us who are not professionals in a given field are reliant upon people familiar with the details to share what's going on. It is the collective, aggregate sum of all of this individually possessed information that allows citizen engagement and democratic governance. Experts provide guidance; we all are responsible for creating the policy.
So far, there isn't anything new or particularly controversial here. These are core beliefs of a large, governable majority of Americans. What requires vigilance, though, is in implementing this concept in specific situations and then reflecting upon the success or failure of the actions.
Earlier this month, several Federal Reserve economists released an important and timely study providing some additional empirical backing and theoretical modeling for a lot of what we have known for years. The full PDF can be accessed here. I am going to quote some relevant passages from the introduction and then emphasize a few things more succinctly.
One of the most important challenges now facing U.S. policymakers stems from the tide of foreclosures that now engulfs the country. There is no shortage of suggestions for how to attack the problem. One of the most influential strands of thought contends that the crisis can be attenuated by changing the terms of “unaffordable” mortgages. It is thought that modifying mortgages is not just good for borrowers in danger of losing their homes but also beneficial for lenders, who will recover more from modifications than they would from foreclosures. Proponents of this view, however, worry that without government intervention, this win-win outcome will not occur.
[snip]
In this paper, we take a skeptical look at this argument. Using both a theoretical model and some loan-level data, we investigate two economic decisions, the borrower’s decision to default on a mortgage and the lender’s choice between offering a loan modification and foreclosing on a delinquent loan.
[snip]
We first study the “affordability” of a mortgage, typically measured by the DTI ratio, which is the size of the monthly payment relative to the borrower’s gross income. We find that the DTI ratio at the time of origination is not a strong predictor of future mortgage default. A simple theoretical model explains this result. While a higher monthly payment makes default more likely, other factors, such as the level of house prices, expectations of future house price growth and intertemporal variation in household income, matter as well. Movements in all of these factors have increased the probability of default in recent years, so a large increase in foreclosures is not surprising. Ultimately, the importance of affordability at origination is an empirical question and the data show scant evidence of its importance.
[snip]
We estimate that a 10-percentage-point increase in the DTI ratio increases the probability of a 90-day-delinquency by 7 to 11 percent, depending on the borrower. By contrast, an 1-percentage-point increase in the unemployment rate raises this probability by 10-20 percent, while a 10-percentage-point fall in house prices raises it by more than half.
[snip]
We then address the question of why mortgage servicers, who manage loans on behalf of investors in mortgage-backed securities, have been unwilling to make mass loan modifi-cations. The evidence that a foreclosure loses money for the lender seems compelling.
[snip]
It is natural to wonder why investors are leaving so many $500 bills on the sidewalk. While contract frictions are one possible explanation, another is that the gains from loan modifications are in reality much smaller or even nonexistent from the investor’s point of view.
We provide evidence in favor of the latter explanation. First, the typical calculation purporting to show that an investor loses money when a foreclosure occurs does not capture all relevant aspects of the problem. Investors also lose money when they modify mortgages for borrowers who would have repaid anyway, especially if modifications are done en masse, as proponents insist they should be. Moreover, the calculation ignores the possibility that borrowers with modified loans will default again later, usually for the same reason they defaulted in the first place. These two problems are empirically meaningful and can easily explain why servicers eschew modification in favor of foreclosure.
[snip]
Even though it may be in society’s interest to make modifications (because of the large externalities from foreclosure), it may not be in the lender’s interest to do so, whether or not this lender is an investor in a mortgage-backed security or a portfolio lender.
[snip]
Our skepticism about the arguments discussed above is not meant to suggest that gov-ernment has no role in reducing foreclosures. Nor are we arguing that the crisis is completely unrelated to looser lending standards, which saddled borrowers with high-DTI mortgages, or interest rates that reset to higher levels a few years into the loans. Rather, we argue that foreclosure-prevention policy should focus on the most important source of defaults. In the data, this source appears to be the interaction of falling prices and adverse life events, not mortgages with high-DTI ratios or otherwise relaxed risk characteristics.
So what does this mean?
First, it means it is good that our leaders are taking the situation seriously. Before about 2006-2007, people warning about problems in housing were ignored (or worse). And it's revealing that economists with multiple Fed branches are declaring openly that they are not saying government has no role to play.
Second, however, it means there is not insignificant disagreement about how to address our situation. Perhaps my favorite line is on the first page
The views expressed in this paper are solely those of the authors and not necessarily those of the Federal Reserve Bank of Boston, the Federal Reserve Bank of Atlanta, or the Federal Reserve System.
If that standard boilerplate ever applied, it is now. For these authors add to the evidence heap that some efforts of both Bush Administration and Obama Administration officials, as well as Congressional legislation, do not represent the most effective set of options for dealing with our housing situation. [Required disclaimer, I emphasize 'some', precisely because other actions have been great; what is wanted is more of the good stuff and less of the ineffective policy] Now, we do have to consider political circumstances; that's what being pragmatic is all about. One of the most important aspects of being pragmatic is focusing on what works. Across most issues, there is little public resistance to the set of solutions that work best. Another part of pragmatism is dealing with entrenched interests who don't care about public opinion. But here, understanding what works in housing is important, too, because over time, that kind of lobbying depends upon public confusion and secrecy.
What works in housing is addressing the 'interaction of falling prices and adverse life events, not mortgages with high-DTI ratios or otherwise relaxed risk characteristics'.
That's a fancy way of saying we need a social safety net, not a bank safety net. Most problems occur not because the interest rate homeowners pay on their mortgage is 7% instead of 5%. After all, mortgage rates have been low for years. Rather, most problems occur due to job losses and medical bills (the 'adverse life events') combined with the slippery slope 'of falling prices'. Put succinctly, here's what the evidence suggests would be the best bang-for-the-buck in the short term. Note, of course, that there are deeper systemic issues we need to address down the road, but that won't help anybody going through foreclosure in the next 24 months (or their neighbors, friends, family, etc). Related policies like environmental cleanup, subway systems and other transportation access, local parks, and better schools increase property values, but those obviously aren't short-term solutions to foreclosures.
For Adverse Life Events:
- Universal unemployment insurance (PDFwarning)
- Expanded food stamps (even CNNagrees)
- Single payer health insurance (93 Representatives at last count)
For Falling Prices:
- Allowing homeowners to stay in their homes as renters (ie, the Dean Baker plan)
- Allowing bankruptcy judges to regain control of the process (frustration over which drove Senator Durbin to make a very interesting remark recently)
- Meaningful first-time homebuyer grants. We've spent decades eviscerating entry level work and career advancement options. Long-term fixes to this problem won't address current foreclosure issues, but one logistically simple mechanism that blends the equity of helping those at the bottom and the efficiency of stabilizing housing is to transfer a large amount of wealth to people who do not currently own a home. The $7,500 loan last year and the $8,000 grant this year are interesting half-measures in that they're nice handouts to people who are going to buy anyway, but not nearly enough to help renters living paycheck to paycheck or small home owners looking to upgrade to bigger homes.
I am purposefully avoiding advocating a figure here because it's not at all clear that we should stabilize housing prices with taxpayer dollars. Basically, that's a transfer of wealth from renters and small property owners to larger property owners. But, if we decide this is valuable policy, then we should have a transfer payment large enough to impact the affordability of owning for the working poor and recent college grads and the affordability of moving up for those selling the starter houses to these groups (in other words, a policy that as closely as possible balances the benefits of the payment and the benefits of the price stabilization). Just as an example, if we simply took the $300 billion allocated to Hope for Homeowners and gave it to first-time home buyers, that would mean we could pump $60,000 each into 5 million transactions. For the $700 billion credit line that is TARP, we could pump $70,000 each into 10 million transactions. If we're going to be spending this kind of money, we should do it in ways that disperse the gains widely among buyers and sellers in ways that are permanent, rather than effectively subsidizing banks for programs that don't even prevent default and foreclosure down the road.
I am fundamentally optimistic about our potential future because we have options that are technically fairly easy to implement and conceptually fairly easy to understand. For whatever combination of reasons, these kinds of solutions have not fully made their way into the halls of our Congressional and Administration leaders. Even within the Fed, there is an increasing openness to disagree with the leadership, as evidenced by Kansas City President Hoenig's increasingly public opposition (PDF warning).
It's not too late. The more evidence we amass, the stronger the case for doing what works, and the stronger the political payoff to the party leaders that jump on board. But as each month goes by that we allocate increasing amounts of taxpayer money to corporate bailouts and mortgage refinancing and so forth, that leaves fewer resources available to use toward ends that are more effective at creating the shared prosperity that makes America great for investors and workers, renters and owners, young and old. Dare I venture, even Democrats and Republicans.