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.

Comments

[Tradememe:]

One possible solution to reduce the human suffering of evictions is to turn all those who can't pay their mortgages into renters. I believe some banks are already starting doing this.

Feb 03 02:56 AM

[Roger Knights:]

Or let the gov't. pick up Rex & Co's. strategy of giving homeowners a lump sum payment in exchange for a percentage of the profit (above current market value) on the future sale of the house. That lump sum could then be used by the homeowner as a down payment on a renegotiated mortgage with lower monthly payments.

Feb 03 04:22 AM

[Steven Hansen:]

this whole subject is not well thought out. the objective is to get the housing market to bottom asap. once that happens, the economy can stabilize. creating an artificial bottom will only prolong economic recovery.

turning homes into rental units ends up weakening the rental market which will in turn weaken the housing market more.

it is impossible for a politician not to meddle - and not knowing what to do is no obstacle. we are just serving up a turd sandwich for the next generation.

Feb 03 04:25 AM

[know nothing:]

As home prices went up,up and away, so did property taxes. With homes being devalued, when will the Gov't lower our property taxes? Never!

Feb 03 08:18 AM

[Mark Anthony:]

Very nice article.

To fix America's housing problem and prevent future housing bubbles and bursts, we MUST abolish the absurd "mark to market" rule, and adopt a more reasonable "mark to cost" rule.

You must read this to understand why "mark to market" is absurd:
stockology.blogspot.co...

I think housing price is now approach fair price again.

Feb 03 10:27 AM

[Duude:]

One thing that must be addressed is the vindictive damage done to homes. Most of these delinquent and soon-to-be apartment dwellers are hopeful of becoming homeowners again. We need to engage in a more active enforcement of property damage laws by tieing an unacceptable level of damage to their credit rating along with their foreclosure. We know the foreclosure will be history in 7 or 8 years, but property damage must ride their credit report for as long as it takes to reimburse the forecloser for expenses in repairing the property. It has to be obvious damage and not normal wear and tear or inattention to upkeep. If this type of policy would become law and is made clear to the homeowning public, foreclosurers wouldn't be subject to this type of extortion and/or vindictiveness.

Feb 03 11:34 AM

[Jon Smirl:]

Given the massive inflation coming from all of this "stimulus" the probability that any of these 30 year loans will be underwater at the end of their term is close to zero.

A lot of people are being stupid. I know of two couples that have purposely triggered foreclosures. Both are now living in apartments and paying more per month than they were on their houses. Both think they "beat the system" since they got out of houses that were $200K underwater and lived in the houses for about a year without making payments. Are these couples better off?

Why would I ever sign a new contract with the people? First sign that things are going against them they will just break the contract again.

Feb 03 12:27 PM

[sd4439:]

A major stimulus would be an across the board government regulated reduction of all current mortgages for every homeowner. It would be important to have this streamlined with no exceptions. Banks are taking government handouts and hoarding the money. In order to stimulate spending, Americans need to be better off then they were yesterday. A mortgage rate reduction would put money in American's pockets each month and be a long term investment not a temporary band aid . Although some Americans can refinance, the restrictions are so stringent right now many do not qualify. Even if you do, it is extremely costly to do so. This would allow more of homeowner's mortgage payment to go to reducing their principle, therefore, allowing equity to be built up faster helping to offset the drastic home value reductions.

In addition to assisting average homeowners. the foreclosure problem should be approached by the government in the following way:
All banks that have or will take government handouts should be required to rework loans in the following way: A one time forgiveness of all past due interest and elimination of any added fees and penalties. Currently banks are just adding past due amounts with interest, late fees and penalties to the principle, adding huge unexplained fees (corporate expense?), and not reducing interest rates. This is creating even larger monthly payments for distressed homeowners whose home values have plummeted. The desperate homeowners aggree to anything because they are terrified they will lose their homes. The banks provide no worksheet explaining the additional costs eventhough the homeowner is in no postition to question the additional fees. The "reworked" loans end up delinquent several months later because the homeowners are worse off then they were before the modification. The argument not to help "irresponsible" homeowners can no longer hold up. Banks are being bailed out left and right and not giving back. Rework the loans based on principle balance plus any real estate taxes and homeowners insurance due. Reduce the interest rate to the national rate. Eliminate the "counseling services" because the don't work. Lenders are not successfully rewriting mortgage loans to prevent foreclosure. This crisis is dragging down the American economy and much of it is because of the banks refusal to step up and do their part. Investors will lose the past due interest amount which is better than losing their entire investment if the homeowner forecloses. They can write that off on their taxes. Americans have seen their investment portfolios plummet in value. That is the current economy. The only way things can turn around is if the mortgage crisis is address in a national streamlined way immediately. Banks and investors will be more fiscally sound in the long run because their investments in homeowners will be more stable.

Feb 03 12:50 PM

[Jon Smirl:]

The government could reduce everyone's effective interest rate tomorrow without incurring billions in refinancing fees simply by temporarily allowing the tax deduction of 150-200% of interest paid. If you pay $20K in interest, you would deduct $40K from income instead of the current $20K.

It is the perfect formula for immediate and effective stimulus. Absolutely zero waste from friction.

Of course it doesn't let the politicians pick and choose who wins and who loses. And we know that's more important than helping the general public.

Feb 03 01:12 PM

[cadoggy:]

Smirl... The people you speak of who walked away are certainly better off and yes they did beat the system. They lived rent free for a year and they instantly corrected their household balance sheets by wiping off a toxic asset.

I'm not sure why they're paying more for an apartment now but that's not usually true in the cases I'm aware of.

If people understood that they can walk away from a mortgage without having the debt pursue them for life I think we'd see a tsunami of walk-aways.

Feb 03 01:32 PM

[Jubilee Year:]

sd4439, you are right on the money. A massive debt cancellation for everyone is the only positive solution. It should be part of the upcoming (and inevitable) nationalization of the banking system. It should also include a lottery to gift bank-owned homes to current renters.

Feb 03 01:35 PM

[joof:]

You want to elminate mortgage interest deducitbiltiy for owners. How about for investment property owners? If not teh altter , wouldn't that tilt the tax economics subsidies in favor of renting?

Feb 03 04:33 PM

[mrmillergd:]

Here's a suggestion -

LET THE MARKET WORK ITSELF OUT.

That's the only way to walk back down the path of faux growth we have had over the last five years.

Anything else is artificial and only forestalls the inevitable.

Feb 03 05:27 PM

[thatguy57z:]

you know the banks got a bailout, and you have people who have lived in there homes for years and have either lost there jobs or taking a cut in pay because banker that are running them in to the ground and caused the meltdown and got there bailout from the taxes payers and will not work with the home owners to help them at these hard times that everyone is going trough, and the government has no plans to help the taxes payers or any home owner. If they where so concerned about home owners the something would have been done sooner, there is nothing but talk, and more people will be losing there homes and add to the homeless to the streets. It sure is a dame shame that one give a flying f--k, you all should be a shamed of yourself and myself. I use to think it would not happen to me,but it has and I'm losing my home because of construction 50% lose in income. GMAC got there fails bailout tried getting them to work something out and they would do nothing after ten years of paying for may home. I'm a single male 51yrs old and have four grand kids 3yrs to 12yrs old that was trying to keep a roof over there heads, well it doesnt look like that's going to happen because April 23 my house go's up foreclosure sale. I hope it doesn't happen to you all, god be with you all.

Feb 03 10:14 PM

[Tradememe:]

"the objective is to get the housing market to bottom asap."

No, the objective is to stop the vicious circle which results in the fall in housing price.

"turning homes into rental units ends up weakening the rental market which will in turn weaken the housing market more. "

No true. You have same number of people and same number of housing units. The law of supply and demand still works in a recession. Perhaps you prefer to throw people on the streets.

Feb 04 08:40 AM

[Jeffrey A. ...:]

The article was about how to fix America's housing [crisis]. 'Tradememe' says stop the vicious cirlce while 'The hand' says get the housing market [prices] to the bottom fast. It seems to me that if we do the latter the former will occur also.

So far every effort by public and private officials alike is oriented towards "solving" the housing cum financial crisis but only if they can minimize the losses to the banks and investors. When banks are on the hook for multiple trillions (especially if we include CDS's) there is no way to minimize their losses without bankrupting the country.

Ed Glaeser's review of the book by Robert Ellickson adds little to the debate. Basically Ellickson [apparrently] again tries to diminish the losses to banks and homeowners by crafting a whole new set of rules. If this market circumstance teaches nothing it should teach that "rules" create a system that the 'financial geniuses' can circumvent to their profit.

I'm more in tune with 'The hand' and 'MrMillergd' in that the housing prices need to be allowed to bottom, banks need to fail, investors need to take serious losses and then government can provide some assistance to individuals. Shoveling money into banks only props up their balance sheets, it does nothing to solve the housing crisis.

Feb 04 12:50 PM