I am back from a trip to Norway and Denmark. The impetus for the trip was an invitation to speak to a group of alumni of the Business Institute in Oslo. My topic was property bubbles.
The morning of my talk, I took a walk along the beautiful path next to the Akers River. My mind wandered, and at one point I tried to recall the steps to this dance, which I had learned recently and only done a few times. My mind also wandered to my talk, and so when I gave it I used the opening 25 seconds of the dance while singing (details below the fold).
Anyway, a lot of the questions were good ones. My favorite was when a guy asked if Norway would be less subject to a bubble because its mortgage loans come with recourse. In most states in the U.S., you can default on your mortgage and owe the bank nothing other than the keys to the house. With recourse loans, after the foreclosure sale, you still owe the bank any deficiency between the sale price of the home and the outstanding balance on the loan. I agreed with the thrust of the question, because recourse loans make people think twice about making speculative home purchases. I certainly think that recourse loans change the dynamics of the housing market. Canada has recourse loans, and that may be one reason that they did not suffer the bubble-and-crash that we did.
In my answer, I also pointed out that the underwriting criteria shift when you have recourse loans. You can be a bit less concerned about the property itself as security for the loan and a bit more concerned with the borrower’s capacity to repay the loan (income and assets) and with the borrower’s conscientiousness (as typically measured by a credit score).
For all the Dodd-Frank legislation and all the mumbo-jumbo about shadow banking, it really would have been simple to prevent the financial crisis of 2008. Recourse on mortgage loans would have done it. In effect, recourse loans give mortgage borrowers more “skin in the game.” Instead, Dodd-Frank tried to envision giving mortgage brokers more skin in the game.
And, of course, removing government support for investor loans probably would have done it as well.
The 30-year fixed rate mortgage should be retired — for good. Despite continued proof that it fails to build up wealth for the most disadvantaged Americans, and that mortgage debt should not be a burden as homeowners approach their 50s and 60s, misguided advocates maintain that the 30-year fixed rate mortgage should be at the core of the U.S. housing finance system.
I have been telling friends that the tragedy of this year’s election is that in my opinion this is a time when we need to change course in many ways, and the Trump phenomenon reduces the probability of that happening. One example is housing finance policy, where Democrats are always looking for an excuse for government to intervene, and I think any reasonable evaluation of history would say that it would be better to go in the opposite direction.
I am willing to claim that the whole financial crisis of 2008 could have been prevented with just one innocuous reform: take away any government subsidies for investor loans.
Subsequent research has confirmed that in the regions with the most pronounced price cycles, significant shares of home purchases were by non-owner-occupants. Their mortgages were eligible for purchase by Freddie and Fannie. They were eligible to receive favorable capital treatment when packaged into securities that were rated as safe by rating agencies.
Investor loans do nothing to promote the goal of home ownership. They are riskier than loans to owner-occupants. Why did regulators allow Freddie and Fannie to buy them, and why did they allow them to be eligible for favorable capital treatment? Probably because the powerful mortgage lobby was at work behind the scenes.
Speaking of the mortgage lobby, Pinto is probably correct that we do not need the 30-year fixed-rate mortgage. Canada does fine without it. But don’t hold your breath waiting for any reform that might be guided by his point of view. That is one example of what the Trumplosion of the Republican Party has made impossible.
In this book compiled by the Heritage Foundation (long PDF), Ed Pinto writes (p. 33),
a home-purchase loan that qualifies under QM could have a 580 FICO credit score, no down payment, and a 43 percent DTI. A loan with these characteristics acquired by Freddie in 2007 had a 42 percent failure rate under the adverse conditions that prevailed between 2007 and 2012.
In case anyone thought that having the government set credit standards for mortgages would allow one to sleep at night.
At this point, I am completely pessimistic about the future of housing finance in America. There is a powerful lobby at work to maintain policies that subsidize demand and mortgage indebtedness. And the prospects for electing someone with ideological opposition to government involvement in housing finance are quite dim.
Overall, I find the book painful to read. It shows the extent to which Dodd-Frank produced costly, counterproductive policies, based on misguided diagnoses.
Describing on a paper by Oscar Jorda and others, John Hamilton writes,
This “hockey stick” in mortgage lending was accompanied by a similar pattern in real house prices. These too had been largely stable for nearly a century. Since 1950, house prices have grown faster than inflation around the world.
My guess is that as of 1950, when the rise in mortgage credit began, there was too little mortgage borrowing. My guess is that since about 2000, there has been too much mortgage borrowing. In Minsky terms, we went from hedge finance in 1950 to speculative finance in the 1990s to Ponzi finance thereafter. Ponzi finance means that people get loans who cannot repay them except by getting new loans.
An idea that just will not die is that the government could have done a better job of bailing out mortgage borrowers. Larry Summers is one of the people who touts this idea without having any institutional facts at his disposal.
The key fact is that in the markets that experienced the strongest cycle, about 45 percent of homes were purchased by speculators. That means that the government faced the following choice:
1. Bail out these housing speculators. That would mean either that taxpayers or banks would reduce their mortgage amounts to the point where they could rent out their properties and cover their mortgages. Why this would be equitable or stimulative to the economy is not at all clear to me.
2. Have a bailout that was limited to owner-occupied homes. This would not have accomplished very much in the markets that had the strongest housing cycle. In addition, it was not easy to execute, for a variety of reasons. As I pointed out at the time, it involved creating new business processes that folded together loan servicing, loan origination, and security payments. Also, you face a trade-off. Give the borrowers too generous a bailout, and you generously reward the profligate. Give them too limited a bailout, and they re-default. Under the programs that were tried, re-default rates were very high.
I am reminded of this by a new paper by Patrick Bayer, Kyle Mangum, and James W. Roberts that documents the mindset of speculators during the housing boom. They found evidence that people who observed speculative behavior had a propensity themselves to speculate.
The presence of each neighbor that begins to invest in housing within 0.10 miles of a household increases that household’s probability of also investing in housing by 8 percent within the next year and up to 20 percent over three years. The presence of a flipped property that has just been re-sold, the other channel of contagion that we consider, raises the probability of that household investing by 9 percent and 19 percent over the same horizons, respectively. The magnitudes of both forms of investor contagion change over the course of the housing boom, especially the flipped property channel, the effect of which is greatest in the peak years, 2004-2006.
Tyler Cowen reproduces a chart from Sober Look purporting to show that house prices are now above their 2005 peak. Several commenters on Tyler’s post are skeptical, and so am I.
Consider figure 2 in this piece by San Francisco Fed economists. It shows the price/rent ratio, and while it has gone up considerably since the trough, it is nowhere near back to the peak. Their figure also shows that mortgage indebtedness is not in a danger zone, either.
Look, if you want to suggest that house prices in San Francisco and Los Angeles are hard to justify, I won’t argue with you. But at the risk of saying something that could look stupid later this year, I will say that most of the country is not yet in a housing bubble.
Joel Kotkin writes,
High housing prices are also rapidly remaking America’s regional geography. Even areas with strong economies but ultra-high prices are not attracting new domestic migrants. One reason is soaring rents: According to Zillow, for workers between 22 and 34, rent costs claim upwards of 45 percent of income in Los Angeles, San Francisco, New York, and Miami compared to less than 30 percent of income in cities like Dallas and Houston. The costs of purchasing a house are even more lopsided: In Los Angeles and the Bay Area, a monthly mortgage takes, on average, close to 40 percent of income, compared to 15 percent nationally.
Read the whole thing. Nearly every paragraph has something I could have excerpted.
Ryan Avent, Matt Yglesias, and Matt Rognlie have already each made a point that a lot of wealth disparities in the U.S. economy can be traced to the real estate market. Avent and Yglesias have made zoning regulations an issue.
I have instead focused on what I call the four forces: New Commanding Heights of health care and education; bifurcated family patterns; globalization; and the Internet. Maybe real estate regulation is a fifth force?
My question would be how much real estate regulation has changed over the past fifty years. If zoning regulation has only gradually changed, then it would not be a fifth force.
Tyler Cowen points to a WSJ story about a start-up that will buy your house and flip it, so that you don’t have to spend time selling it.
In securities markets, we differntiate between brokers and dealers. A broker brings together buyers and sellers. A dealer buys from sellers, holds securities in inventory, and sells to buyers out of this inventory.
One challenge with trying to be a housing dealer is that it adds another transaction in a market where transaction costs are artificially high. Some jurisdictions have transfer taxes. You might have to pay for an extra title search. Another home inspection. Etc. Also, while a security still accrues interest while it is in inventory, an unoccupied house does not generate rent.
From an NYT blog post,
With the right financial vehicle, Mr. Rampell said, such a fund could invest to co-own houses in, say, pricey Palo Alto, Calif., making it easier for prospective home buyers to make down payments and reduce their mortgage burden. “They could own 10 percent or 15 percent of your house, so you don’t have to borrow as much,” Mr. Rampell said. “I think there’s a lot of room for more of those kind of new asset classes.”
Pointer from Tyler Cowen.
1. This is not the first time someone has proposed such an idea. In the early 1980s, with sky-high interest rates, somebody came up with the Shared Appreciation Mortgage, where you would get a lower interest rate from the lender in exchange for which the lender would get a percentage of the appreciation in 10 years or when you sold your home, whichever came first.
2. So what is the asset, exactly? I think of it as a second mortgage, with a variable interest rate that depends on the rate of appreciation of the property and on the size of what I would call the “discount,” because the third-party owner is going to pay less than $10,000 for a 10 percent share of a $100,000 house. Why? Because the third party does not get to live in the house and enjoy the implicit rental income. In the extreme case where a third party has 100 percent of the equity but for some reason pays the full $100,000 price. In that case, in exchange for giving up all the equity, the “buyer” would be living in the house rent-free!
3. There are no magic tricks in mortgage finance that make housing affordable to people who cannot save enough for a reasonable down payment. The only way to make housing affordable is for the price of homes to come down to where people can afford them. That’s true even in California, although folks there go through periodic episodes where they refuse to believe it.
the real place where the tax code provides a subsidy for owner-occupied housing is not by allowing mortgage deductibility, because if you or I were to borrow to buy other assets — for instance, if we bought a portfolio of stocks and we borrowed to do that — we’d be able to deduct the interest on that asset purchase, too. If we bought a rental property, we could deduct the interest we paid on the debt we incurred in that context. What we don’t get taxed on under the current income tax system is the income flow that we effectively earn from our owner-occupied house, what some people would call the imputed income or the imputed rent on the house. The simple comparison is that if you buy an apartment building and rent it out, and you buy a home and you live in it, the income from the apartment building would be taxable income, but the “income” from living in your home — the rent you pay to yourself — is never taxed. This is the core tax distortion in the housing market: the tax-free rental flow from being your own landlord.
Pointer from Timothy Taylor. The interview covers other topics, all interesting.
He goes on to say that it is unlikely that people would accept being taxed on a made-up number representing this “rental flow from being your own landlord.” However, people do accept being taxed on the appraised value of their property, which is arguably also a made-up number. It seems to me that you could tax homeowners on a made-up “appraised rental value” just as easily. Or just tax them a percent of the appraised value, as is done now.
Let’s go with the notion that the goal is to tax owner-occupied and investment property identically. Then my thought is you should just exempt landlords from paying tax on their rental income. But I find the whole notion of how the tax system should and should not work to give me a headache. Even if you start with the idea of a consumption tax, do you want to include the use of housing as consumption? Presumably you do, and then you are right back into these conundrums of rental vs. owner-occupied, are you not?