How to Fix America’s Housing

Ed Glaeser’s massive, 3,000-word TNR review of the new book by Robert Ellickson is a thought-provoking must-read for anybody interested in the dynamics of the housing boom and bust, and the policies which should be followed now. I’m not going to try to summarize it, but I do want to annotate a few passages.

As mortgages began to default, the owners of mortgage-backed securities became de facto homeowners, acutely sensitive to the price of housing.

This is very true, and quite obvious when you think about it, but it’s a fact which I don’t think has sunk in for many people in the policymaking world. Essentially the MBS market has priced in a massive debt-to-equity conversion, even as plans to buy up bad loans tend to value them not as home equity but rather as fixed-income instruments.

The current foreclosure crisis is an extreme example of an Ellicksonian fight over household space. Delinquent homeowners want to inhabit and to control their homes. Lenders want to get them out and to limit the damage done to the property. During the foreclosure process, home occupants have no reason to invest in their homes. Indeed, spite sometimes pushes them to abuse the property. Ellickson’s logic suggests that such periods ensure an abuse of the housing stock, which is one reason why homes often lose close to half of their value when they go through foreclosure.

One current policy response to the housing debacle is to create lengthy foreclosure moratoria. Ellickson’s analysis suggests that this is just about the worst of all possible policy responses. By drawing out the foreclosure process, these moratoria increase the time during which homes are no-man’s-land. During such periods, homes and neighborhoods depreciate. A better policy would move the home quickly, either back into the hands of the owner with a new, more realistic mortgage, or into the hands of a new owner that can afford the house.

I’m not sure I buy this: it seems to be predicated on the notion that foreclosure proceedings start pretty much automatically as soon as a borrower becomes delinquent, and that once those proceedings have started, the main interest of the lender is to get the borrowers out of the house as quickly as possible.

In reality, however, banks are — or should be — generally reluctant to initiate foreclosure proceedings. And it’s certain that if there’s a foreclosure moratorium in place, then no bank is going to try to foreclose. Since homeowners who aren’t subject to foreclosure don’t mistreat their homes in the way that evicted homeowners do, I don’t see how a moratorium would create entire neighborhoods of neglected housing.

Certainly if there’s a chance of putting the house back into the hands of the owner with a new, more realistic mortgage, then the bank should always explore that option before initiating foreclosure proceedings, rather than afterwards, as Glaeser implies happens. On the other hand, he’s quite right about this:

Mortgages are being handled by servicers, not by conventional banks, many of whom have little expertise at wisely handling delinquent loans. The servicers are scared of being sued by the security owners that they represent. For this reason, they follow rules of thumb that lead to evictions that could have been avoided…

Like Humpty Dumpty, the mortgages are in too many pieces to be put back together again.

Remember this fact — that existing loan servicers are simply not up to the task of maximizing mortgage values. It’ll be important when we get to bankruptcy in a minute.

The best that can be done, I think, is to create an as-if situation that gets servicers to act like local banks… If the government sets a series of rules that give servicers safe harbor from lawsuits, then the whole process can be made more efficient. For example, the rules might specify a simple test that determines whether the current occupant can plausibly support the home. If thirty percent or less of the current owner’s income can pay for reasonable mortgage payments, marked down to the level implied by current housing prices and interest rates, then the owner can afford the house. If the owner can afford the house under those terms, then the loan should be renegotiated, since that is pretty much all that the house could generate in the best of circumstances. If the owner cannot afford the house, even at today’s lower prices and interest rates, then the owner should be quickly moved out.

This is a extremely hazardous. If these simple tests are set in stone, then anybody currently paying more on their house than they would if they bought it at "current housing prices and interest rates" would have an enormous incentive to default. Unless there’s some way of penalizing opportunistic defaults, it’s going to be extremely hard to make this work, even if homeowners with renegotiated loans do lose some of the equity upside in their house. Most of us, at this point, would much rather have a lower mortgage payment and half the upside above say $200,000 than a higher mortgage payment and all the upside above $250,000.

To reduce the human suffering of speedy evictions, the government could give people who lose their homes a lump sum payment, perhaps $5,000, a relatively modest sum that would help at least to offset the costs of moving and finding a rental unit. For current foreclosures this sum would be paid for by taxpayers; it would be small beans relative to most proposed housing programs. In the future, this payment could be funded with an appropriate tax, tied to the riskiness of new mortgages. If the payment was contingent on the house being left in good order, this would reduce the incentives to abuse the housing stock.

Glaeser here is trying to get the government to do something the private sector already does perfectly well. If you’re being foreclosed upon, the bank will quite happily and quite regularly offer you a few thousand dollars to move out quickly, cleanly and quietly. I’m not sure why we need a new tax to get the government to take over that role.

Simple rules, rather than judicial discretion, have the best chance of improving the foreclosure process. Some have suggested that bankruptcy courts should be able to re-write, or cram down, mortgage terms for primary homes. Ellickson’s warnings about legal fees and transaction costs should scare us away from that idea. If individual judges adjust every mortgage on an ad hoc basis, the system will become more costly, less predictable, and less fair.

The problem is that when you get into the nitty-gritty, Glaeser’s ideas are not nearly as simple as they seem at first glance. Meanwhile, bankruptcy judges are already looking at debtors’ ability to pay in full, rather than using easily-gamed rules of thumb. They’re in a very good position to take over the role which servicers have proved themselves incapable of performing. Mortgages should be adjusted on an ad hoc basis: indeed, that’s a much better way of ensuring that the system is fair than trying to throw all mortgages into the same legislative bucket and dealing with them all en masse.

Since the New Deal, the government has promoted housing and homeownership by means of subsidizing borrowing. The Home Mortgage Interest Deduction makes it cheaper for wealthy itemizers to borrow to buy more expensive homes. Fannie Mae and Freddie Mac provide mortgage insurance at subsidized rates. The Community Reinvestment Act pushed banks to lend to lower income homebuyers. Subsidizing borrowing is so attractive to politicians because its looks like a free lunch. Borrowing at Treasury rates and then lending at slightly higher rates seems to allow the government to do well by doing good. Of course, this free lunch is an illusion. The government can only offer below-market rates by taking on the risks of defaults. Taxpayers are currently paying for the costs created by Fannie and Freddie.

I’ve long been an opponent of tax-deductible mortgage interest, which is a much greater villain in this story than the Community Reinvestment Act. What’s more, the illusion of the free lunch is not mainly a function of mortgage default rates; instead, it’s much more obvious, in the form of foregone tax revenue, and the increased taxes and borrowing elsewhere which are needed to make up for it.

Why is unaffordable housing now a national desideratum? The most recent housing boom made some of America’s most economically dynamic and beautiful places unaffordable to ordinary Americans. Higher housing prices made it difficult for young and middle-income families to get by in America’s costly coastal regions. There is much to like about housing’s return to reality, not least its increased affordability, and much to dislike about artificially trying to make homes expensive.

This is absolutely true. Unaffordably expensive cities lose their dynamism, and more affordable cities are generally more vibrant. We might need to prop up house prices to try to deal with the present financial crisis, but expensive homes are not a desirous end in and of themselves.

Roughly 87 percent of all single-family detached homes are owner-occupied. Roughly 87 percent of all homes in buildings with five or more units are rented…

The connection between homeownership and structure type implies that when the federal government gets into the business of supporting homeownership, it also gets into the business of supporting single-family detached homes–and this means supporting lower-density living… You do not need to be an enemy of the suburbs to wonder why the government is implicitly urging Americans to drive longer distances and flee denser living.

Again, this is spot-on; Ryan Avent has more.

Ellickson notes that many lenders require that home-buyers pay for one-fifth of their home with their own cash. That cushion is thought to be enough to ward off the dangers of default, but that is not the case when we are at the top of a housing bubble. On average, for every dollar that prices rise over five years, relative to local and national trends, they go down by thirty-two cents over the next five years. In markets that have more than doubled over a five-year interval, lenders should expect declines that will wipe out any 20 percent margin.

I can’t make the math work here. Consider a house which was worth $100,000 in 2001 and $200,000 in 2006. According to this rule of thumb, it should decline by $32,000 over the next five years — which is less than a $40,000 20% downpayment if it was bought at the the top of the market. But still, it’s a moot point: very few homes were bought at the top of the market with a 20% downpayment.

Rather than credit subsidies to increase borrowing, it would make more sense to re-think land-use controls. There are certainly legitimate reasons to regulate building, but it seems to me that many jurisdictions have gone too far, putting their own parochial interests first. Perhaps housing policy would do better to create real affordability by eliminating the barriers to building, rather than just inducing lower-income Americans to leverage themselves and bet more on housing.

This is absolutely right. Intelligent land-use and zoning regulations can do much more for the cause of affordable housing with sustainable growth than any number of desperate plans to buy up toxic mortgage-based assets. I hope that the Obama economic team listens to Shaun Donovan as much as it does to Sheila Bair.