April 11, 2008
This morning, CBO released a new study on policy options for the housing and mortgage markets. The paper discusses the potential for federal intervention to ameliorate the situation, by encouraging and removing impediments to private mortgage restructuring or by providing federal financial support. (It does not, however, address the question of what regulatory changes might be warranted over the longer term, either to address the problems that led to the current situation or to support any wider federal role in the financial markets.) CBO finds that:
- The current economic situation is quite fragile, largely as a result of the difficulties in mortgage markets and other financial markets. Much of that fragility arises from falling house prices, which affect consumers through their housing wealth and lenders through their loss of collateral. It is exacerbated by the growing complexity of financial instruments and entities, which may make it difficult for participants to know what risks they are assuming, and by the leverage of both borrowers and financial market intermediaries, which means that it is difficult to prevent liquidity and solvency problems from spreading throughout the financial markets.
- Foreclosures are an expensive way to resolve delinquencies. A large number of foreclosures is also likely to reduce the demand for houses, as potential purchasers conclude it would be better to wait until prices stop falling. Thus, excessive 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 by reducing household wealth, could reduce consumption spending, increasing the likelihood and severity of a recession. While actions could be taken to limit the risk of such a downward spiral in housing prices, it is not feasible for policy interventions to stabilize house prices at current levels since such prices are strongly influenced by the significant inventory of unoccupied houses for sale.
- Significant impediments stand in the way of private market resolution of the difficulties in the mortgage market. In order for large numbers of mortgages to be restructured, procedures must be developed to secure the agreement of the institutions that hold second mortgages. Because most mortgages are securitized, resolution procedures also have to respect the limits of securitizing agreements. Without committing resources, the Congress could provide a standard for mortgage restructuring that might assist agreement among the first and second lien-holders and simplify the decisions lenders have to make. Legislation could also change the treatment of mortgages in bankruptcy, which would help borrowers and might increase the pressure on lenders to voluntarily restructure loans outside of bankruptcy; such a change, however, might also lead to higher interest rates on future mortgages.
- Direct federal provision or guaranteeing of credit to mortgage markets could help avoid foreclosures and ease the downward pressure on house prices, helping the market to adjust in an orderly manner. It would also shift part of the cost of mortgage losses from current lenders and investors to taxpayers. The number of borrowers that could be assisted by such steps would depend directly on the amount of mortgage insurance subsidy that the government provides. With the range of refinancing fees embodied in most recent proposals, the federal subsidy would probably average less than 5 percent of the loan principal. Given that scale of subsidy, CBO expects that perhaps several hundred thousand borrowers would benefit from expanded FHA refinancings over the next few years. Generating higher levels of participation would require substantially deeper subsidies, which would in turn significantly increase the federal budget cost.
The paper updates and expands upon the discussion of the housing and mortgage markets in an earlier CBO analysis of policy options for addressing the general weakness of the economy (Options for Responding to Short-term Economic Weakness, January 2008). It expands upon that earlier work in a number of ways. First, it discusses in depth the market developments and failures that led to the current situation. Second, it discusses options for influencing the mortgage markets, especially those that might help arrest the downward spiral of house prices. Some of those options would require a federal commitment of funds, in the form of either credit guarantees or direct subsidies. Finally, it considers the advantages and disadvantages of establishing a new agency to assist in the restructuring of mortgages. The study was written primarily by analysts in CBO's Macroeconomic Analysis Division, with Kim Kowalewski coordinating and leading the effort.