Last week both Democrats and Republicans in Congress floated housing proposals which say a lot about how politicians misunderstand our country's economic fundamentals.
Republicans in the Senate backed an amendment to the federal stimulus package that calls for a government-subsidized, four percent mortgage rate designed to spur home purchases and hence bolster falling prices, which Republican Senator Mitch McConnell described as "the underlying cause of the recent downturn." Although the proposal, lauded in some conservative circles, was defeated easily by the Democrats who control the Senate, the stimulus may well contain the Dem's version of housing incentive, namely boosting the current tax credit for those purchasing a new home to $15,000.
Although somewhat different, both proposals reflect an underlying assumption common among politicians that housing drives the American economy and therefore must be supported by government intervention, an idea that is at best a distraction, but at worst a prescription for policy nightmares. In good times, government looks for ways to sustain house buying even as prices rise, which often contributes to bubbles and foreclosure crises. And in difficult times the "support housing at all costs" mentality produces bailout ideas that are costly and ineffectivenot exactly the fundamentals of good government policy making.
Far from leading the way, the housing market often trails in an economic recovery. In a recent paper, economists Carmen Reinhart and Kenneth Rogoff looked at 18 major, recession-inducing financial crises around the world dating back to the Great Depression and found that typically housing is not the first but the last major indicator to recover in such sharp downturns. On average, housing prices declined 35.5 percent in these crises and took six years to bounce back. By contrast, gross domestic product snapped back in less than two years, followed by equity markets and unemployment.
The Great Depression, characterized not only by high unemployment and sharply contracting output, but by a massive housing foreclosure crisis, is a good example of how little impact massive government intervention has on housing during a downturn. The housing market back then was ripe for a fall. Production of new units had soared from about 250,000 a year in the early 1920s to 600,000 annually by the end of the decade. Banks had more than doubled their outstanding mortgage debt in the 1920s, and within 10 years the number of households that owned their homes had increased a whopping 30 percent.
Soon after the stock market's crash in October of 1929, the housing market began to collapse in a manner that recalls today's meltdown. As panicked depositors withdrew their money from banks, lenders stopped making mortgages, and homeowners, who in those days typically had short-term mortgages which needed to be refinanced several times before they could be paid off, suddenly couldn't find new loans and started defaulting rapidly. Lacking new financing, by 1933 some 1,000 homes a day nationwide were going into foreclosure.
State and federal government employed a variety of aid plans to bolster prices and stop the failures, including foreclosure moratoriums that largely proved to be ineffective because they did nothing to solve the system's fundamental problems. The most important bailout effort was the Home Owners Loan Corporation (HOLC), created in 1933 to buy troubled mortgages from banks and then allow homeowners to refinance these loans on more affordable terms with the government. HOLC was supposed to free banks to lend again because it purchased their bad mortgages. But although HOLC bought and refinanced about one million mortgages, total mortgage lending and production of new housing stayed absolutely flat for the rest of the decade because the country's underlying economic fundamentals were so poor that there was little demand for new home lending. What ultimately revived the housing market was not HOLC's bad mortgage buying program but the nation's broader economic recovery after World War II.
The government's housing interventions are generally even more troubling during good times because they help create bubbles and new foreclosure problems. After World War II, pent up housing demand sparked an explosion of new building and home buying. During that time the federal government's G.I. bill provided returning soldiers with the opportunity to buy homes with mortgages subsidized by the Veterans Administration, while the Federal Housing Administration also backed loans to spur lending. By 1949, 40 percent of all new mortgages were government-backed.
But as the housing boom continued into the 1950s and prices started rising beyond the reach of a new generation of would-be homeowners, the federal government came under pressure to loosen its credit standards. Washington began requiring smaller down payments, so that by the early 1960s government-subsidized loans for more than 90 percent of the value of a home were typical. At the same time, the government loosened income ratios, that is, the ratio of a borrower's income to housing payments, and began stretching out the terms of loans to longer periods.
The looser standards provoked rising delinquency rates and loan failures. The foreclosure rate on FHA loans spiked nearly five fold during the 1950s, while the failure rate on VA mortgages doubled. By the early 1960s, FHA loans were four times more likely to default than conventional loans and VA mortgages were more than twice as likely to default. In all, government-subsidized mortgages performed much worse during the recession of the early 1960s than did conventional mortgages, whose lenders had not reduced their underwriting standards.
This cycle has played itself out several times in the ensuing decades, to progressively more disastrous consequences. But we're obviously not cured of our fascination with housing stimulus yet, even though it's clear that the economic fundamentals don't augur well for a current housing revival led by tax credits or interest rate cuts.
The Democrats' plan to provide home buyers with a generaous tax credit is more likely to be used by people who would be purchasing homes anyway, producing a steep hit on the Treasury without much additional buying. And Harvard economist Ed Glaeser estimates that the Republican interest-rate plan would only result in enough new purchases to boost home prices by only about six percent, hardly enough to revive this a market. But more important, as Glaeser notes, lenders have only recently 'recovered their sanity' after the mortgage lending sprees of the last few years, and the last thing we want government to do is encourage them to go on a new lender bender.
Now if only our politicians would recover their sanity when it comes to the nation's housing market.
Original Source: http://www.realclearmarkets.com/articles/2009/02/housing_wont_lead_us_out_of_re.html