A Little Known Fact, And Good News, About This Crisis 31 comments
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Greedy businessmen and bankers price themselves out of the market. Greed is not enough to make you rich, you need a product that everyone thrives for.
The true culprit of this crisis was not greed, leverage or bad lending practices, but a little known fact. America has a tax code that allows Americans to deduct from taxable income, the interest on home mortgages, extendable to summer homes and sail boats. Up to 1 million dollars worth of mortgage.
The extent of this tax benefit is not always recognized. For example, at a 6% interest rate a US$ 1 million mortgage will allow you to deduct US$ 60.000.00 from your taxable income of, say, U.S. 200.000.00, reducing your taxable income to US$ 140.000.00.
Now multiply that by a 30 year mortgage, and you will have a taxable income deduction of US $ 1.800.000.00 on a US $1,000,000.00 mortgage. The number is not exactly correct, (interest diminishes with time) but that is how many homeowners calculate it. Depending on your tax bracket that can be a 50% saving.
Obviously it’s not a brilliant government economic policy, because it creates the following predictable consequences:
1. It stimulates indebtedness and over-indebtedness of practicably every American citizen. The higher the real estate debt, the higher your deductible allowances.
"There are no cows more sacred in the tax code than the deductions for mortgage interest and property taxes. Together, they add up to at least the $ 75 billion annual subsidy for housing and Homeowners. " The New York Times.
Houses paid in cash get no deduction. Rather than subsidizing the cost of home building, government is stimulating excessive loan taking.
2. It stimulates mortgages with minimal down payments, and maximum debt. Banks that demanded 30% down payments were outsmarted by competition.
3. The US tax code allows for a 100% deduction of the nominal interest rate, which means a 200% to 300% deduction of the real interest! So you pay 2% real interest, but get 6% tax deduction. The 4% inflation is actually income, it’s the amount your principal repayment is being eroded by inflation. No one is speculating with home appreciation, just waiting for inflation to do its job.
You need to live in countries with high inflation to understand all this, but believe me, the U.S. Tax code is allowing a much greater deduction by using nominal interest rates.
So no matter what your tax bracket that’s equivalent to zero real interest rate after tax!
Would you live in a house without paying interest? Who is being greedy here? Banks or taxpayers?
Only in America does someone secure a second mortgage after struggling for 20 years with mortgage payments. All over the world families want fully paid homes not fully leveraged homes. But the tax incentive here is too great to forego.
4. It stimulates over-production of home building and house price inflation. Especially when the FED established negative real interest rates, as they did in 1999, 2000,2001 and 2002. That was governments doing not banks.
Now for the good news. Because no one is mentioning all this as the real underlying driver of this disaster, this diabolical engine will remain in force, Obama is even considering more tax incentives.
In six months or less, Americans will be back buying up houses for the tax advantage.
Don’t forget that 1.5 million Americans will marry in 2009, and will be using their Mortgage Interest Deduction. Then there are those 200,000 who plan to buy Mortgage Interest Deductible summer homes and the 300,000 Americans that will be getting a divorce.
A total of 2 million homes, compared to 737,000 homes currently under construction. The inventory of truly salable empty houses is 300,000 to 400,000.
And more. The real interest rate today is now negative, homes are 12 to 25% cheaper, if not more.
Once Americans realize that the prices of housing have stopped falling, houses will be bought for their tax benefits once again if nothing else.
There is even a hidden cost in delaying home purchases, which is this nearly 50% tax incentive, depending on how you calculate the numbers and the inflation rate you expect.
The real culprit of this crisis was not the free market, banks, profit motive, or greed. It was an economic policy to encourage housing, distorting the free market, giving absurdly high incentives (nominal interest), in a ludicrous way via debt.
Disclosure: I do no not own any American bank stock. Only emerging market namely Brazilian shares, which includes one bank.
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This article has 31 comments:
Require 20% down, or 10% down with PMI and none of this would have happened.
Ah yes, the individual homeowner must be responsable, but a bank? God forbid. :)
Isn't it amazing people laugh at the margin of 10% for stocks in the 20's led to problems and was later changed but residential mortg today - has the same margins with greater participation and much greater debt amounts - 300k etc. This along with mark to market - a disaster.
Another joke is the carbon footprint business - watch the new codes will not ever encourage renting in a higher density city dwelling - has to be a subdivision 50 miles from work.
Still, I agree with his opening line - greed is not enough to make you rich. You must have a salable product or service (or receive an inheritance). The whole "greed" bromide is getting tired. What do we mean by "greed"? Profit? Isn't the objective of business the generation of profits? Then, isn't the more the better? If you blame profit (or the assumption that more profit is better than little), you really have a problem with the capitalist system - not any specific business or sector.
People who want to blame "greedy" bankers, etc. should first define what they mean by greed and then provide an example. I strongly suspect what they will discover in this process is that what was originally thought to be greed is actually simple hubristic profit-seeking; and they'll find a story (real estate always goes up) with little or no empirical backing, that too many people bought into and then leveraged into.
After we deal with the "greed" obsessed sound-byte spewing sect, I suspect that we'll need to deal with the conspiracy theorists.
Housing is a nonproductive asset, it doesn't spit out any widgets. For any lonely soul chopping at the roots of the tree of debt and sorrow there are a thousand wacking at the hydra-headed branchings and for each of those thousand there are ten thousand more applying fertilizer. The author correctly identifies the root for chopping, this middle class housing subsidy that results in such a grotesquely distorted housing market and the resulting serially catastrophic property debt implosions i.e. S&Ls.
A lone voice crying in the wilderness, he may as well use sign language. At least there is justice in the poesy of those ultimately responsible footing the bill, explicitly
where recognized, implicitly where hidden.
my entire tax deductions wil be relaized in my tax return check this spring every penny goign back into the house - hmm i guess that will stimulate the local ecconomy at least for the plumbers and carpenters doign the work
this guy is out to lunch
Now, if people didn't have to get a home equity line of credit to purchase consumer goods in order to get a deserved tax deduction, the problem would certainly be less acute.
Second, it is the job of the banks to allocate the money. A key rule when lending is the ability of the borrower to pay back, not the collateral given as a guarantee. If banks respect that rule, you don't have this problem.
Third, the second point doesn't matter if banks don't keep the loan in their books. Nobody cares, only collateral matters and it's hell when collateral values drop.
Fourth, if I take your example with a TI of $ 200k and a rate of 40% you'd pay $ 80K in taxes. Now if you drop your TI to $140K by borrowing and maybe you also drop you tax rate to 30% you'd pay only $ 42K in taxes. A tax saving of $ 38K against an interest payment of $ 60K which brings your cash flow down with $ 22K.
Now the question you should ask is; is my investment going to yield more than $ 22K a year?
In addition to that you failed to recognize that the primary problem was making loans to people who were lying about their incomes and had no money to put down. As the mortgage lenders played the role of the little monkeys with their hands over their eyes, their ears and their mouths we continued to sell homes to people who could not afford the payments.
By the way your numbers on available inventory are staggeringly wrong.
Truth is, our tax code is Frankenstein's monster. Not only does it favor some and penalize others, but it has taken many of our brightest and best minds and mired them in an "industry" that produces nothing other than tax dodges.
We need a flat tax with NO deductions whatsoever. None. Flat rate taken from every income source at time of distribution. NO 1040's, NO 1099's. No tax returns. No tax attorneys.... which means it'll never happen.
NO 1040's, No 1099's, NO RETURNS...or we stop paying completely!
1. Creative unscrupulous lending practices to sell and finance real estate. Why does it take hundreds of different types of mortgages to finance real estate? Like automobile sales the pitch is how much one can afford monthly not what the item is worth. Lower interest rates just inflated the sales price of a home. Therefore, hundreds of types of mortgages. Qualifying for a mortgage became a game of how not if one could qualify.
2. Where were all the government regulators during this time?
They seem to be the Monday morning quarterback's - with too little too late (Enron and WorldCom for example). Then to cover themselves want more regulation when they did not enforce current regulation.
3. Tax write off bull. Look at the actual cash flow it takes when one borrows. One dollar of income at a thirty 35% tax rate only saves the 35% in taxes when written off. The dollar is still spent. Add up all the interest paid and see what a motgage cost you on a cash flow basis.
4. The creation of all the derivatives, so called hedging and smoke and mirror terminology resulted in no one wanting to appear ignorant and saying "the king has no clothes". The hot potatoes can only be passed so many times until the taxpayers end up footing the bill. To reward those that earn money and pay their way the government answer is to tax more?
5. Property taxes have become rediculous. A whole new subject to be looked at by the American public. Once your home is paid for - you just rent it from the government via property taxes. Don't pay and you lose your home.
The fact is when it comes to real estate there is always some type of residual value ( 100%, 90% etc.). The straight lender is not going to lose 100% of the value. In times like this a realignment of values occur one way or another. Besides the hard asset remains in our country.
As far as pointing to the rich as culprits - why? In this country don't we strive to be successfull and financially independent? The rich invest there money and help create liquidity and jobs in the market places. Why should they be singled out versus those with their hands out unwilling to try to better themselves? Keep taxing them to death and money and jobs will continue moving overseas. Government needs to be held more accountable and tranparent for spending your tax dollars not the so called rich.
Wishing the best for our great nation and future generations.
Old Guy not a Rich Guy
First, that the author regards the mortgage income tax deduction as "a little known fact" seems odd -- every real estate agent hypes this benefit.
Second, as noted above, the math is wrong -- the total interest paid on a $1M loan would be about $1.15M, not $1.8M as referenced by the author.
Third, the author disregards the economic distortion of the much larger tax subsidy provided by the up to $500,000 exemption on gains from the sale of a qualifying residence (yes, I realize that $500,000 is nominally lower than $1.15M and the applicable rate would be LTCG, not ordinary income, but the tax benefit is available in the current year, not stretched out over 30 years, and has a much larger emotional component (i.e., "I just got $500,000 tax free!!!!")).
Fourth, although it is often suggested that the tax tail always wags the economic dog, but -- as many of the comments above suggest -- tax implications are but one (often small) factor in determining whether a particular deal makes sense (the prevalence of the rent versus buy calculators available on the internet suggest that people are actually doing the math) -- factors such as equivalent rent and expectations of future asset appreciation or depreciation or rent increases or decreases are far more important.
Fifth, the economic value of the mortgage deduction tax benefit decreases every year as the annual interest paid decreases and inflation increases the spread between the fixed tax benefit and inflation adjusted taxable income (e.g., in 2038, the final year of the hypothetical 30 year mortgage, the borrower would pay only $2000 in interest but presumably (hopefully) would have income far greater than $200,000 -- the deduction would only be worth $800 that year assuming a 40% marginal bracket).
There are many good reasons to buy a house, but anyone who does so based solely on the mortgage interest deduction (to the exclusion of other, more important, factors) is in my view misguided.
Also, in reference to a comment above, mortgage interest isn't a preference item for purposes of the AMT.
What if there were no Fannie May to buy, package, and resell mortgages with the implied guarantee of Federal bailout, which has become a reality?
What you're really talking about is a tax code that was designed by Keynesians and Fabian Socialists in the 1930's that was designed to prevent you from acquiring wealth and to discourage you from saving.
Would there be a capital crisis if interest earned from any source and dividends were not taxed at all?
Burton A. Johnson, MD, JD. President, Burton A. Johnson Portfolio Management, Inc.
> People who want to blame "greedy" bankers, etc. should first define
> what they mean by greed and then provide an example.
That's easy. Greed is the selfish pursuit of personal aggrandizement above and beyond need, and characteristically at the expense of others.
From Wikipedia:
"Some desire to increase one's wealth is nearly universal and acceptable in any culture, but this simple want is not considered greed. Greed is the extreme form of this desire, especially where one desires things simply for the sake of owning them... [and] entails acquiring material possessions at the expense of another person's welfare "
Example: The packaging and securitizing of mortgages of questionable quality, and selling them to the next bigger fool (yes, the buyers were just as guilty of greed as the sellers). Then compounding the damage of that avaricious (and immoral) undertaking by taking out insurance for many times the value (via credit default swaps) on the fictitious security.
Home buyers who lied to get a house they couldn't afford were greedy. Mortgage brokers who encouraged this and complicitly presented false information to the mortgage underwriters were greedy. Mortgage underwriters, who, with a lack of due diligence, and with a wink at protocol, put "making the sale" above proper underwriting criteria were greedy.
The evidence of all of this greed and its ramifications? Countrywide, Indymac, Bear Stearns, AIG, et. al. and a financial sytem in crisis. That is why greed is different from a simple profit motive. Greed causes people to bend the rules, ignore the social contract, and sometimes break the law in the pursuit of inordinate profits.
Greed is the pursuit of profits without regard to moral or legal conventions.
"Once Americans realize that the prices of housing have stopped falling, houses will be bought for their tax benefits once again if nothing else." - prove to me you can make money simply by owning a house. as a real estate investor, i can tell you that you only make money on appreciation.
you really must hone your articles before submission.
In Canada, mortgage interest on a principal residence is considered personal expense and hence not tax deductible. This spurs homeowners to pay off the mortgage as soon as possible. This is why there was no such mortgage bubble bursting and bank failures in Canada. Perhaps it is time to remove the tax break on interest expense for personal expenditure and keep it only for interest outlays to earn business income.
On Dec 03 01:19 AM The hand wrote:
> Stephen, this is not a classroom. this is the second article you
> wrote which has taken a lot of liberties with the truth. i did not
> comment last time after fred bank's comment. but this one really
> was not good.
>
> "Once Americans realize that the prices of housing have stopped falling,
> houses will be bought for their tax benefits once again if nothing
> else." - prove to me you can make money simply by owning a house.
> as a real estate investor, i can tell you that you only make money
> on appreciation.
>
> you really must hone your articles before submission.
>
I'm with those who see this as a small contributore relative to CRA, loose Fed money, Fannie/Freddie non-oversight, etc. But it's a factor.
BTW, the right way to look at the interest deduction is as a haircut on the interest rate itself, then you end up with a 6% interest rate with a 33% tax rate deduction is really 4% - if you can borrow at 4% you'll take that. So most smart middle-class homeowners would pay of credit cards and car loans but keep the mortgage.
Now may be the wrong time to change this rule, but mortgage interest deduction is bad public policy overall in encouraging over-consumption and over-indebtedness. We need simpler, flatter, fair tax system with lower rates on production and more emphasis on taxing consumption, ie, tax imports from China.
In your article "Plano emergencial..." you indicated that in this article one would find "signs that the American recession is reversing its course". There are nothing like that here. Or do you mean that your "predictions" on marriage and divorce rates are indicative that people will start buying houses soon?
And there you mentioned that the mortage aplication were up las month. But did you consider the question "why did the mortgage applications go up in November?" Is it because these Americans are investing, or desperate?
Nice effort. In my own case, newly married and ready to start a family with my lovely wife, this would drive down home values another 5-10% (or more), push us out and force us to consider whether we can afford to live anywhere near a city where we can both contribute to GDP.
Great idea. Can we send Glaeser to live with you there, Mr. Dumas?