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Chapter
1Problems in the housing and mortgage markets have now spread to a broader array of financial markets. At this point, the nation faces a serious disruption to the functioning of its financial markets that could substantially impair economic activity in the near term. Since the end of the unusual housing boom from 2003 to early 2006, delinquencies and foreclosures on mortgages have risen, particularly on subprime adjustable-rate mortgage loans (ARMs), reflecting a retreat of house prices from unsustainable levels, the use of lax credit standards to make the loans, weak local economies, and in some cases, higher interest rates on ARMs whose interest rates had reset as scheduled in their loan contracts.1 (Subprime loans are made to borrowers with low credit scores or other impairments to their credit histories.) The problems are not limited to subprime ARMs, however. Delinquencies have also risen for prime ARMs and on so-called alt-A mortgage loans, which are often made on the basis of little or no documentation of the borrower’s income and may include low-downpayment loans, loans that are not for the owner’s principal residence, interest-only loans, and loans whose balances rise over time. Because most mortgages are resold as mortgage-backed securities (MBSs), the rise in delinquencies has caused the value of MBSs to decline, in some cases quite sharply.
The problems in mortgage markets have spread to the wider financial markets for several reasons. Although highly uncertain, the number of bad mortgages and, consequently, losses on MBSs are expected to be large. The use of complex instruments to fund subprime lending, such as collateralized debt obligations (CDOs), also has made it difficult for participants in financial markets to identify the magnitude of the exposure of other participants to losses.2 Moreover, a number of financial institutions borrowed heavily to finance their mortgage holdings, further increasing their risk exposure.
Those losses on mortgage assets, and the resulting contraction of the availability of credit to businesses and households, pose a significant threat to the pace of economic activity. Given the elevated uncertainty about their exposure to risk, financial institutions have tightened their lending standards and pulled back from all types of risky lending, preferring to conserve capital to guard against potential losses. Following a period in which the risk premium (the higher return required to compensate investors for assuming the risk of default) had been unusually low, the price of risk has risen, in some cases significantly. That pullback has extended to short-term lending between banks. In response, the Federal Reserve and some foreign central banks have intervened to provide large infusions of liquidity (that is, short-term financing) to keep financial markets from freezing up. Moreover, large numbers of foreclosures could trigger a downward spiral of house prices that could take them below what would be justified on the basis of normal relationships to income and production costs. Such a downward spiral would exacerbate the problems in the financial markets and could reduce consumption spending by reducing household wealth, increasing the likelihood and severity of a recession.
Policymakers have already taken steps to help the housing and financial markets cope with the aftereffects of the housing boom. In the wake of continuing weakness in those markets, though, additional actions have been proposed. (See Box 1-1 for a discussion of current federal housing policy.) Some of those actions would involve lenders (seeking to promote the modification of troubled mortgages), while others would expand the role of the federal government (providing or guaranteeing credit to mortgage markets). Such actions could help reduce the number of foreclosures, attenuating one source of downward pressure on house prices—although they would not address more important influences on prices. Many policy options, moreover, would significantly shift the risk involved in mortgage losses from current lenders and investors to taxpayers. (Policymakers are also considering new supervisory guidelines and regulations for financial institutions to address weaknesses that contributed to the problems in financial markets; this paper does not address those potential changes.)
The government currently supports homeownership through various channels. The effects of that support in normal times are to increase the number of people who own their homes rather than rent and also to increase land prices, the average size and price of houses, and the proportion of wealth that is in the form of housing (as opposed to other forms of investment). There are also distributional consequences that favor homeowners relative to renters.
The federal government, through the Department of Housing and Urban Development (HUD), undertakes activities that reduce mortgage rates. The Federal Housing Administration (FHA) provides mortgage insurance on loans made by FHA-approved lenders that meet certain requirements. The Government National Mortgage Association (Ginnie Mae) provides liquidity to the secondary mortgage market by guaranteeing investors the timely payment of principal and interest on mortgage-backed securities backed by federally insured or guaranteed loans—mainly loans insured by the FHA or guaranteed by the Department of Veterans Affairs. Other guarantors or issuers of loans eligible as collateral for securities guaranteed by Ginnie Mae include the Department of Agriculture’s Rural Housing Service and HUD’s Office of Public and Indian Housing.
In addition, two privately owned government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, provide capital to the mortgage markets by purchasing conforming mortgages, securitizing them, and charging a guarantee fee to investors. Although there is no explicit government guarantee of those securities, it is commonly perceived that the government would prevent a default. That implicit guarantee makes the cost of funds to the GSEs lower than it otherwise would be.1
The tax system is a major source of support for homeownership. Owner-occupied housing receives more favorable tax treatment from the federal government than most other privately held assets.2 Much of the income generated by assets owned by businesses is subject to corporate or personal income taxes. However, the value of the services generated by owner-occupied housing is excluded from taxable income. Even so, owners may deduct certain expenses, such as interest paid on mortgage and home-equity loans and property tax payments. Most capital gains from the sale of an owner-occupied house are also tax-exempt.
The tax advantages for investing in one’s home have been estimated to increase homeownership by between 2.5 percent and 5.4 percent, depending on people’s income. Furthermore, those advantages have been estimated to increase the amount of housing purchased by homeowners by between 5 percent and 21 percent, again depending on owners’ income.3 The study from which those estimates are derived assumes that additional land and other inputs for housing are available at no increase in cost, so none of the increase in purchases is absorbed in higher prices for houses and land. Those conditions seem more likely to exist on the outskirts of cities and in rural areas than in developed neighborhoods within large metropolitan areas, where limits on further development often exist. How much of the tax advantage is absorbed in higher prices inside metropolitan areas is disputed.4
1. Congressional Budget Office, Federal Subsidies and the Housing GSEs (May 2001).
2. See Congressional Budget Office, Taxing Capital Income: Effective Rates and Approaches to Reform (October 2005).
3. Harvey S. Rosen, "Housing Decisions and the U.S. Income Tax," Journal of Public Economics, vol. 11, no. 1 (February 1979), pp. 1–23. Rosen reports the amount by which taxing homeownership like other investments would reduce the rate of homeownership and the amount of housing purchased. The estimates in Table 4 under Regime 2 have been converted above to increases from the tax advantage.
4. Dennis R. Capozza, Richard K. Green, and Patric H. Hendershott, "Taxes, Mortgage Borrowing, and Residential Land Prices," in Henry J. Aaron and William G. Gale, eds., Economics of Fundamental Tax Reform (Washington, D.C.: Brookings Institution Press, 1996), pp. 171–198. Also see Donald Bruce and Douglas Holtz-Eakin, "Fundamental Tax Reform and Residential Housing," Journal of Housing and Economics, vol. 8, no. 4 (December 1999), pp. 249–271; and Jane G. Gravelle, The Flat Tax and Other Proposals: Effects on Housing, CRS Report for Congress 96-379 (April 29, 1996).
Whether additional policy interventions in the housing and mortgage markets are advisable depends in part on their objective:
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If the objective is to assist homeowners in distress, some of the policies seem likely to succeed, at least to some degree. Many policies intended to help homeowners may produce significant benefits for lenders as well. Avoiding some unintended effects will be virtually impossible because it is difficult to distinguish among homeowners who were victims of their poor judgment or of predatory lenders, those who overstretched their finances for purchasing investment properties, and those who exploited poor underwriting standards.
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If the objective is to avoid foreclosures and abandonment of properties, intervention might break a downward spiral in which foreclosures put houses on the market, pushing down house prices and producing more foreclosures. Although many analysts believe that house prices remain too high relative to people’s incomes, such a spiral, without intervention, could reduce prices even below their long-run ratio to incomes and production costs.
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If the objective is to arrest the decline in house prices, however, the policies are less likely to succeed. Perhaps the most important short-term influence on house prices is the elevated number of unoccupied houses for sale (the inventory overhang). That overhang is likely to remain until house prices fall enough to stimulate additional home sales. Put simply, none of the policies can (or presumably should) guarantee that house prices will stabilize in the near term. Furthermore, attempting to avoid (as opposed to attenuating) the market’s necessary adjustments may not only be unrealistic, but even if it were to succeed, might ultimately serve only to delay the recovery of financial markets and impair the pace of economic activity.
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Finally, if the objective is to stabilize the overall economy, the policies under discussion will probably have only a limited effect because most of them are likely to exert only a modest influence directly on the housing market. (The Congressional Budget Office discussed policies more specifically related to general economic stimulus in a January 2008 paper, Options for Responding to Short-Term Economic Weakness.) They might affect the economy indirectly, through their effects on consumer and investor confidence, though that is harder to predict.
The percentage of homes with subprime ARMs entering foreclosure was a record 5.3 percent in the fourth quarter of 2007, up from 2.7 percent at the end of 2006 and 1.6 percent at the end of 2005. At the end of 2007, more than 13 percent of subprime ARMs were in the process of foreclosure.
CDOs repackage assets such as mortgage bonds, buyout loans, and other debt (including other CDOs) into new securities.
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