Three Things That Won't Help End the Foreclosure Crisis
Falling home prices, rising foreclosures rates, and a slowing economy have created a perfect storm for homeowners who bought in bubble-inflated markets, or used subprime, adjustable-rate mortgages to purchase their homes.
Members of Congress have responded to the crisis facing their constituents by proposing various measures, some strong, like amending the bankruptcy law to cover primary residences, and some misguided. The following are three major proposals that would actually do more harm than good. As Congress seeks to pass legislation to stem the foreclosure crisis, legislation containing elements of these proposals should not be on the table.
1. Subsidies for Home Buyers
Homeownership can be a useful way for families to accumulate wealth and to provide good secure housing. However, if families are buying homes with bubble-inflated prices, then they are not likely to accumulate any wealth in their home, since the price is likely to fall back to its trend level before they sell their home. (The median period of homeownership for moderate-income families is just four years.) Furthermore, they are likely to pay far more in housing costs each year, than they would to rent a comparable unit.
In the case of moderate-income families facing serious budget constraints, the additional housing costs associated with owning an over-priced home are likely to come at the expense of other necessary items, such as health care and child care. It is difficult to see how the government will have helped a family by encouraging them to buy into such a situation.
Additional tax credits for home buyers in a bubble-inflated market can put more people at risk by encouraging them to buy an over-priced home that will fall in value. In addition, tax credits for the purchase of homes that are in the foreclosure process, but have not yet been returned to the lender, provide a perverse incentive to lenders to foreclose on current homeowners, since they increase the resale value of the house following a foreclosure.
2. Artificial Price Floors
This has nothing to do with linoleum, and everything to do with how prices get set for homes that are refinanced and backed by FHA loans as proposed in legislation being considered by Congress.
If home prices continue to decline, and the government issues guarantees of mortgages at prices that are near current levels, then the government is likely to face a substantial cost associated with a high default rate. The most important factor determining both the default rate and the cost of each default is the movement in house prices.
If prices continue to fall, then many homeowners will again find themselves owing more than the value of their home. This situation leads to defaults for two reasons. First, if a homeowner owes more than the value of her home, then she does not have the option to borrow against equity in order to make her mortgage payments. This eliminates an important source of security if job loss or unusual expenses leaves the homeowner temporarily unable to pay his or her bills.
The other reason why this situation increases default rates is that homeowners who owe more than the value of their home can effectively save themselves money by simply surrendering their house to the bank. If a homeowner owes $200,000 on a home that is currently worth $180,000, the homeowner can effectively save $20,000 by just giving the house back to the bank. While this move will hurt the homeowner's credit rating, if they don't have any special attachment to the house, a homeowner may choose this option.
In addition to increasing the number of defaults and foreclosures, falling house prices will also increase the loss on each foreclosure. If the house is still valued at close to the amount of the mortgage, then the losses on the foreclosure will just be the administrative and transactions costs associated with carrying through the foreclosure and reselling the house. However, if the house sells for less than the value of the mortgage, then this can be a substantial source of additional losses for the government.
The government can limit the risk that it will set the guarantee price on new mortgages too high by using an appraisal of rental price as the basis of the guarantee, rather than an appraisal of the sale price. Since rents never rose out of line with fundamentals, an appraisal based on some multiple of annual rent (e.g., 15 times annual rent) should ensure that the government's guarantee price is set at a level that is close to the price that the home will command after the bubble has deflated.
3. Incentives to Build More Homes
Not letting prices fall back to their equilibrium (see above), or giving generous tax credits to homebuilders will encourage them to build more homes. The more homes that get built, the greater the over supply. This will imply a longer adjustment process and a larger price decline. There is no public interest in taking any steps that can delay the process of price adjustment in the housing market. This process is very painful, but delaying it will only make it more painful.
More research and information on what Congress should do can be found here.