A Good Start on Mortgage Finance

According to this story,

The Department of Housing and Urban Development said Friday that the reduction to the annual mortgage insurance premiums borrowers pay when taking out government-backed home loans has been “suspended indefinitely.”

…Borrowers with larger home loans would have seen an even bigger drop in their premium rate.

The premium cut was an abominable last-minute policy of the outgoing Administration. Fortunately, the Trump Administration canceled it before it could take effect. [Update: Today’s WaPo editorial agrees with me.]

The worst aspect of the policy would have been the special rate cut for large mortgages. Offering particularly cheap loans for large amounts is nothing but a gift to young professionals pushing their way into cities where housing supply is fixed.

If you want to make housing more affordable in San Francisco or Brooklyn, you have to address supply. Subsidizing demand without increasing supply simply serves to drive up prices and squeeze out the lower middle class.

Freddie, Fannie, and so-called Privatization

The WaPo reports,

Steven Mnuchin, President-elect Donald Trump’s nominee to lead the Treasury Department, said Wednesday that privatizing Fannie Mae and Freddie Mac is “right up there on the top-10 list of things we’re going to get done,” setting off a buying frenzy among investors.

I am very leery of this. My preferred approach for getting the government out of the mortgage market is the following:

1. Immediately stop any government support for cash-out refinances, second mortgages, and investor loans. Restrict support to owner-occupied purchase mortgages or refinances that lower the rate and term of the mortgage without the borrower taking out equity. Leave all the other mortgages to the private sector.

2. Gradually lower the maximum loan amounts for government support. As you do this, the private sector will have to fill in. If somebody steps up to issue mortgage-backed securities, fine. If instead what emerges is a model with banks holding the mortgages they originate while using long-term funding methods, then that is fine, too.

If you were to suddenly “privatize” Freddie and Fannie, you might end up restoring the status quo prior to 2008, with these institutions enjoying “too big to fail” status. They can use that status to borrow cheaply in credit markets and behave like hedge funds. I can remember when they were doing exotic things involving securities denominated in foreign currency that had nothing to do with their supposed “mission” of helping housing. These exotic transactions did not cause the firms to blow up then–because they blew up on credit risk instead.

I really detest the model of privatized profits and socialized risks. If you are going to privatize Freddie and Fannie, then you have to figure out a regulatory scheme to avoid socializing the risks. It’s not easy.

California’s Housing Shortage

Mckinsey folks estimate it at 2 million. Pointer from Alex Tabarrok.

The market clears, of course, but at a price point that is very high relative to income.

Presumably, this is a supply problem. You do not cure a supply problem with mortgage subsidies or rent controls.

They have several suggestions for how to fix it. First,

In California cities with populations of more than 100,000 people, we conservatively estimate that there is capacity to build 103,000 to 225,000 housing units on vacant land that has already cleared the multifamily zoning hurdle (Exhibit 8). One-third of this opportunity is in Los Angeles County. This estimate applies only to vacant and already-zoned urban land capacity and does not account for whether it is economically feasible to build housing onthis land.

Los Angeles County is a big place, and the vacant parcels seem to be all over the map. That leads me to worry about transportation issues. And it leads to their second recommendation.

We estimate that by increasing housing density around high-frequency public transit stations, California could build 1.2 million to 3 million units within a half-mile radius of transit. . . in our “high case,” 34 percent, or one million units, would be in the Bay Area; 8 percent, or 245,000 units, in the Sacramento area; and 30 percent, or 903,000 units, in the Los Angeles area.

An interesting paragraph about the disincentive to approve new housing appears in a footnote:

One reason for this is the small share of property tax that is allocated to the city from a residential development. The city must provide municipal services for the development, yet a large share of the development’s property taxes flows to non-city entities such as the county, the school district, and special-purpose districts such as fire and water districts. In addition, affordable units built by non-profit organizations are exempt from property tax, since such units qualify for the “welfare exemption” outlined in the state constitution. For a given parcel, local governments would often rather approve developments that generate more revenue, such as retail projects, than housing. This “land-use fiscalization” is commonly cited as a barrier to residential development in California.

On the permitting process in general, there is this:

California stakeholders could study other systems to get a fact-based view of “what good looks like”—for example, a robust, participatory, and transparent land-use process where outcomes are measured in days or weeks, rather than years or decades.

The report strikes me as very good.

Along similar lines, see Richard Epstein.

Another piece, recommended by Steve Teles, is David Schleicher’s City Unplanning.

Each time a community board approves a new development, the city could provide a time-limited property tax rebate to residents in the board’s district equal to a percentage of the “tax increment” created by the development (the tax increment is the increase in tax revenues caused by increasing property values18). The payments would head off local opposition to new development

Mortgage Loan Limits, Housing Demand, and Supply

Tobias Peter writes,

In the mortgage business, the drumbeat for the government to support more leverage is a constant, occurring in both a buyer’s and a seller’s markets. But it is the latter that has potential for dangerous buildup of risk. The latest fad is raising the conforming loan limit, which, since 2006 has been set at $417,000 in most areas, but allows for a higher limit in certain high-cost counties.

Of course, one reason that there are high-cost counties is because there are higher loan limits. Remember that the general pattern of government policy is to stimulate demand and restrict supply. Where this combination of policies is most blatant, in cities like New York and San Francisco, you see prices soar. More mortgage credit, which is supposed to make housing “affordable,” has the opposite effect.

For high-cost counties, one idea might be for the Federal government to try to encourage cities to break the logjam by offering a subsidy for every new housing unit that is fully approved in terms of permits within the next six months. I am not saying that I have that concept fully worked out, and of course it is not a first-best libertarian idea.

In any case Keeping the loan limits fixed, and getting rid of the alternative for “high-cost counties,” would be steps in the right direction.

The Affordable Housing Violins

A commenter writes,

Somewhat apropos of this post, it would be interesting to read a response from Arnold, or a likeminded person, to the following: Kevin Erdmann

Erdmann in turn links to this commentary from Treasury.

Behind these statistics are creditworthy families who have not been able to access the wealth-building opportunity of homeownership or enjoy full mobility. This lack of access is particularly acute for minority and low-income families whose homeownership rates are considerably below the national average.

My comments:

1. Whenever people start playing the affordable housing violin, we should anticipate bad policy is to follow.

2. Kevin and Treasury are pointing to credit scores as an indicator that mortgage lenders, including Freddie and Fannie, have tightened credit. I don’t really focus so much on credit scores as an indicator of risk. I worry mostly about loan type (government-sponsored lenders should stay away from cash-out refinances and non-owner-occupied loans). Then I worry about down payments.

3. If you give a mortgage to someone with a low credit score who makes a low down payment, you are setting them up to fail (not most of the time, but enough to make it a questionable proposition). And of course, when the defaults come, you will be accused of predatory lending and have to pay a big fine.

4. I think government should get out of the mortgage subsidy business. Mortgage subsidies are mostly crony capitalism for Wall Street and mortgage bankers. If you want to support home ownership, help people save for down payments.

Timothy Taylor on Home Ownership Trends

He writes,

Notice that homeownship rates tend to be much lower in large cities: indeed, if a homeownership rate below 50% seems implausible to you, you might reflect on the fact that this is already a reality in US cities. Notice also that homeownership rates in the Northeast and West regions are already below 60% (of course, this is in substantial part because there are more large cities in these regions). Thus, one’s belief about the future of homeownership is in some ways a statement about where people choose to live in the future.

In my view, the main drawback to renting (government distortions aside) is that you have to negotiate with the owner concerning maintenance and renovations. Perhaps somebody should work on contracts that address this.

As of now, one party (typically the landlord) must bear all of the costs, but maintenance and renovation is only done at the landlord’s discretion. One can imagine a different arrangement that allows the tenant to have discretion, but with incentive to protect the landlord’s interest.

For example, the cost of basic maintenance, such as fixing the HVAC system when there is a problem, could be split 80-20 between the landlord and the tenant. Because the tenant has skin in the game, the tenant gets to be in charge of getting the system fixed.

On the other hand, the cost of renovation, such as a kitchen remodeling, might be split closer to 50-50. Again, the tenant is in charge. The tenant pays a higher share than in the case of basic maintenance, because the renovation might prove less valuable to a subsequent tenant.

Another contractual possibility would be to address the state of the dwelling when the tenant leaves. In principle, the landlord could be compensated by the tenant for damage (that is what security deposits do, up to a point), and the tenant could be compensated by the landlord for increases in property value due to upgrades paid for by the tenant.

More Lifted from the Comments

Kevin Erdmann writes,

The way costs serve as a filter is by constricting supply. Those cities are well past the cost level that would trigger supply. So, a unit that would cost $300,000 is already worth $1 million. To build it, you basically have to negotiate your way through a series of fees and kickbacks so that local governments and interest groups claim the $700,000 difference. It’s like third world governance with a functional bureaucracy. You don’t necessarily bribe anyone, but the parks department gets $100,000 per unit because your building throws a shadow somewhere for 30 minutes, and that money funds a healthy pension.

“third world governance with a functional bureaucracy” describes a very effective kleptrocratic system.

Set Up for Failure

W. Scott Frame, Kristoper Gerardi, and Joseph Tracy write,

The extinction of the private subprime market and the rapid rise of the government insurance programs may strike many as a largely positive development. After all, it was the subprime segment of the mortgage market that triggered the global financial crisis and subsequent Great Recession as subprime loans defaulted at an astronomical rate during the housing bust. However, while government-insured mortgages are typically underwritten with more rigor and discipline than private subprime loans, they are not low-risk loans. The combination of high leverage and low credit scores documented above translates into extremely high default rates. The table above shows that five-year cumulative default rates (CDRs) by year of origination varied between 5 and 25 percent over our sample period. To put these numbers into perspective, the five-year CDRs associated with loans insured by Fannie Mae and Freddie Mac (the housing government-sponsored enterprises, or GSEs) are typically an order of magnitude lower. According to our calculations, the 2002 and 2009 vintages of GSE loans had five-year CDRs of approximately 2 percent, while Ginnie Mae’s same vintages had five-year CDRs of almost 10 percent and 13 percent, respectively.

Pointer from Mark Thoma.

The Federal Housing Administration, FHA, sets up many borrowers to fail. One could argue that these borrowers put up so little of their own money that this is a worthwhile risk from their point of view. It is the taxpayers that are being set up to fail.

Reverse Mortgages

An NYT story says,

it may surprise you to learn that some community bankers are quietly offering the loans, too, bringing a kind of Main Street respectability to a product that has long lacked it.

Pointer from Tyler Cowen.

Here is how I think of a reverse mortgage.

Step 1. Sell your house to the bank.

Step 2. The bank rents your house back to you.

Step 3. The bank forgives the rent, but instead charges you interest that accumulates until you die or move out.

Step 4. When you die or move out, the bank adds up the accumulated unpaid rent and interest. If you want to pay it up, you can get your house back. Otherwise, if the debt is higher than the value of the house, then it makes more sense to let the bank keep the house.

In principle, whether this works out financially depends on how long you live in the house relative to expectations at the time you take out the reverse mortgage. You want to live so long that the value of living rent-free in step 3 is so high that at step 4 you or your heirs gladly hand the bank the house rather than pay all that rent and interest. But if you move out or die relatively soon, the bank will have priced the mortgage in such a way that if you or your heirs pay off the debt the bank will come out ahead–and it will come out ahead even more if you give up the house.

Thus, as in any sort of life insurance or annuity situation, you are making a bet against the financial institution. My guess is that this is unwise.

1. In general, the individual loses bets against financial institutions. I tell my daughters, “remember that insurance companies always price to make a profit.” My point is not that you should never buy insurance of any kind. But you should always at least consider self-insuring (rather than paying for extended warranties, for example) or alternative ways of insuring.

2. I think that old people are inclined to over-estimate how long they will live in their houses. They do not like to think about how they might lose the ability to climb steps, to tolerate bad weather, or to live independently.

3. I do not think that many old people need to live rent-free in the short run. In the short run, you can just take out a regular mortgage and use some of the proceeds from the mortgage to meet the payments. Ten years from now, after you have used up most of the proceeds on making the payments and financing consumption, you can think in terms of selling the house. By that time you will probably want to. See (2).

Upward-Sloping Demand Curves

Why are big cities becoming expensive places to live? One answer is that they have good jobs and restrictions on housing construction. That may be right.

But one possibility I want to throw out there is that people want affluent neighbors. If I want an affluent neighbor, and an affluent neighbor is going to live in a neighborhood with high prices, then in some sense I want to live in a neighborhood with high prices. In the extreme, this makes my demand for neighborhoods upward-sloping. Higher prices make me want to live there.

I first considered this possibility many years ago when thinking about school vouchers. I thought that if what people really want for their children is to have them go to school with affluent children, then vouchers would not work as well. Instead of allowing non-affluent parents to send their children to good private schools, the result would just be that good private schools would raise prices so that only affluent children can attend.

I also think that some colleges that are not in the top tier may face upward-sloping demand. George Washington University, which is hardly an academic icon, may benefit from charging very high tuition. Affluent parents come and see a student population that is predominantly affluent, and this gives them comfort that sending their children to GW is a high-status thing to do.

Back to cities. Suppose that an important “urban amenity” is having a lot of affluent people around. Young singles may wish to meet potential marriage partners who are affluent. People who have acquired affluent tastes (sushi, yoga, wine) may want to be around people with similar tastes.

If that is the case, then there is not much that a mid-sized midwestern city can do to lure affluent people. The cost of living there is not high enough to create a barrier to non-affluent people living there. And that means that affluent people will not want to live there.