Why the GOP's Tax Gimmick for Homebuyers Won't Help One Bit

Posted by Joshua Holland, AlterNet at 11:49 PM on February 4, 2009.

Editor's note: This article originally appeared in PEEK, AlterNet's blog section.

Update: After this post was completed, the Senate tacked a $15,000 tax credit for new homebuyers onto the stimulus package.

According to the New York Times, "Republicans and Democrats are suddenly competing to bail out financially struggling homeowners." What fine news!

But let's look at their competing visions because the Devil, of course, is in the details* ...

There is a growing consensus among lawmakers in both parties that the deepening collapse of the housing market is at the heart of the country’s acute economic downturn.

But beneath the consensus over helping the housing market, there are huge differences over who should benefit under the competing plans. Democrats want to aim money directly at people in the greatest distress; Republicans want to aim money at almost all homebuyers, on the theory that a rising tide will eventually lift all boats.

Specifically ...

Senate Republicans are seeking new tax breaks and up to $300 billion in mortgage subsidies to attract homebuyers. Democrats want to spend at least $50 billion on federal programs aimed at reducing mortgage foreclosures.

First, the obvious: the Times piece is misleading: Democrats proposals are aimed at aiding homeowners, and Republicans want to give cash to <s>perspective</s> prospective homebuyers. Of course, that would help a small number of homeowners who are trying to sell in this market, but it's hardly the same thing as trying to help the 16 percent of homeowners who are now struggling under the weight of loans that are worth more than the value of their properties. And it won't help those whose adjustable rates have adjusted through the roof.

And the GOP's approach is based on the theory that a "rising tide will lift all boats." A simple question: how's that theory been workin' out for ya?

But let's forget about ideology for a second, and look at this from a commonsense perspective ...

An enormous housing bubble grew over the past 7-8 years. An asset "bubble", in simple terms, arises when prices get all out of whack from the basic relationship between supply and demand. Yale's Robert Shiller found that for a hundred years, going back all the way to 1895, average home prices tracked more or less with the rate of inflation (which makes sense, right?). But then, between 1996 and 2006, home prices increased rapidly, by 80 percent after adjusting for inflation.

And, as economist Dean Baker notes in his excellent new book, Plunder and Blunder: The Rise and Fall of the Bubble Economy (I'll have an interview with Baker  next week), if the rise in housing costs had been due to increased demand or decreased supply, then the rental market should have risen along with average sales prices (more or less). That didn't happen -- while home prices were almost doubling, rentals went up by just 4 percent. Baker estimates that at its peak, the bubble part of the real estate market was worth something like $8 trillion dollars, or $110,000 for every homeowner in America.

More common sense: that which is unsustainable shall not be sustained. The bubble burst, and now we're dealing with the aftermath of a massive loss in wealth. at least wealth that existed on paper (which is real, because it tells people what their net worth and what they can spend, and allows people to borrow cash against their equity).

Bien. So let's return to these competing interpretations of what it means to "bail out financially struggling homeowners."

We can try to reinflate the bubble. That means stimulating demand. You can do that by driving down interest rates. But the Fed has slashed its rates to next to nothing, and has signaled that it'll keep them there for the next few years, so that bullet's been fired.

Which leaves us with the GOP's broad approach: give out tax credits as an incentive to get people to buy homes.

Let's set aside the fact that those who are in a position to shop for a house right now are probably not the people who are suffering the most pain from the economic downturn. And let's set aside for a moment the fact that a tax credit passed now wouldn't have any impact on people's ability to buy a home in the short-term because they wouldn't see a dime until they filed their 2009 returns in 2010.

OK. Theoretically, if you could reinflate the bubble to some extent by increasing the number of people looking to buy, it'd help distressed homeowners, who would be able to refinance at lower rates or for longer terms, and it'd help lenders, who would have fewer "nonperforming" loans on their books. And it would help the financial industry unwind all those complex "toxic" mortgage-backed securities. In theory.

But nothing in that equation would change the fact that home prices were out of line with the fundamentals of the economy. It also wouldn't change the crucially important underlying issue: that American families are maxed out in terms of debt, have no savings, and all but the top ten percent haven't seen their real wages increase in 35 years. For these reasons (and I'm simplifying here), this approach: A) won't work, and B) even if it were to work, it would only kick the problem down the road a bit. After all, that which is unsustainable shall not be sustained.

So let's return to the other broad approach, which can be summed up pretty simply as this: allow the market to return to its historic levels and help homeowners deal with the fall-out. That can be done either by modifying the terms of existing mortgages -- converting shaky loans that started with gimmicky teaser rates which have since turned into high foreclosure rates into longer, fixed rate mortgages -- or writing down the value of those shaky loans so they're inline with the new reality of a market that's fallen back to earth. Or both (for a slightly wonky discussion of the finer points of the issue, read this).

Let me return to Dean Baker, urging "a quick price decline of 20 to 30 percent in the most over-valued markets." From a report put out by his shop, the Center for Economic and Policy Research:

After this drop, homebuyers need be less fearful of further price declines, both boosting demand and reducing vacancy rates. At the same time, the consequent flow of loans into non-bubble markets would help prevent a downward price spiral in these areas and avert the risk of overshooting on the negative side.

"A rapid return to trend levels is significant for homeowners in that it gives them a sense of how their home equity figures into their real wealth and how they have to adjust their consumption and saving decisions," said Baker. 

Again, common sense: trying to reinflate an artificially inflated bubble is a fool's errand. Or a Republican's errand -- same thing when it comes to economic policy.

But here's where it gets sticky. If we accept the market returning to somewhere near its historic levels, then someone's going to have to take some lumps. And distressed homeowners, unfortunately, don't have the political clout Big Finance does -- recipients of TARP funds alone spent $114 million lobbying last year. The result of that imbalance? The government's enacted a half-dozen programs to "bail out financially struggling homeowners," and none of them have been effective in actually keeping people in their homes. Why? Because the lobbyists got their hands on them, and some require homeowners to pay an up-front fee for modifying their loans equal to a couple of percent of the inflated purchase price, others require borrowers to pay around 40 percent of their income to service the loans -- regardless of how far their homes' values have shrunk -- and all have been voluntary, even for institutions receiving tax-payer money. And the financial institutions aren't going to write down their bad loans voluntarily, or at least not to a degree that would save a lot of homeowners.

That doesn't seem likely to change anytime soon. So while the Democrats' general approach to helping homeowners is right, the policies they've pushed don't go far enough, and the foreclosure crisis continues to snowball.

A final word: we've heard that the problem with "cramming down" the principle on outstanding loans is that it poses a "moral hazard." If you let borrowers off the hook for taking out loans they ended up unable to repay, you encourage more bad behavior in the future.

Fair enough. But I think there are two things to keep in mind when pondering the moral hazard issue. First, while offering tax credits to encourage people to buy houses doesn't have the same degree of direct moral hazard as, say, taking the crappy loans off of the banks'' books, it has its own indirect moral hazard: it sends the message to investors that they can follow the herd, lemming like, into the next speculative asset bubble, whatever that may be, and the government will figure out some way to trim their losses when it pops. (Also, as I've written before (here, and here), it was the financial industry -- and the politicos in its pocket -- that fueled the growth of the bubble to a far greater degree than individual homeowners.)

Second, this is not like the crash of the dot-com bubble; people never lived in their hyper-valued tech stocks. Foreclosures have a ripple effect on communities. They cause blight and homelessness, bring down the values of surrounding properties further, and devastate communities' tax base when the need for various services is at its peak. 

So, it seems to me that the real hazard -- for society -- is not doing enough to keep people from losing their homes.

*This hackneyed cliché is dedicated to the lovely and talented Sophie.

Tagged as: housing bubble

Joshua Holland is an editor and senior writer at AlterNet.