Loyal readers already know what I think of housing as an investment. The main issue, in my mind, is that it’s extremely risky as an investment: not only are most middle-class families putting more than their total net worth in a single asset class (and one with low average real returns compared to the stock market), but they are putting it into a single asset, which violates the most fundamental principle of investing.

That said, on a pure expectation basis (not considering risk), buying is probably better than renting. It’s not as simple as saying that “renting is throwing money away while paying a mortgage is building equity” because (a) homeowners usually pay more cash than renters on an ongoing basis (mortgage, homeowner’s insurance, maintenance, etc.) and (b) you have to consider the returns you could get by investing your capital (down payment and principal payments) in another asset class. But the tax deduction for mortgage interest probably tilts the scale toward buying.

So if you’re thinking about buying or renting, I recommend that you read “The Effectiveness of Homeownership in Building Household Wealth” by Jordan Rappaport, an economist at the Kansas City Fed (hat tip David Leonhardt). The most valuable part of the paper is that it clearly outlines the financial tradeoffs between owning and renting. Rappaport creates a model that estimates the cash flows from buying a house and selling it ten years later and renting for ten years, assuming that you invest all the money you save by renting. He then looks at historical ten-year periods beginning from the 1970s through the 1990s to see which strategy would have been preferable.

It turns out that, of those ten-year periods, owning was better in about half, renting was better in about a quarter, and in the other quarter it’s hard to tell. The ten-year periods that began around 2001 will probably favor owning, but when you get to 2003-2006 they will probably favor renting (because of the housing decline since 2006).

So, in short, owning does better than renting somewhat more often than renting does better than owning. Does that mean that buying a house is a good investment? It depends. First of all, Rappaport’s model assumes a ten-year holding period; as your expected holding period decreases, owning becomes less attractive because you have less time over which to amortize the transaction costs.

More importantly, Rappaport’s conclusions are based on averages – in particular, average house price appreciation. This goes back to my original point: housing is a lot riskier. Your house’s price appreciation could deviate wildly from the average in your neighborhood, let alone your Metropolitan Statistical Area, let alone the country, for any number of reasons. So the question is how much investment risk you want to take on. Sure, rental prices could go up faster than the national average. But over the ten years, an owner will be more sensitive to a fall in housing prices than a renter is to a rise in rental prices of the same annual percentage. (And that leaves aside the fact that a renter can adapt to unfriendly price changes — by moving — more easily than an owner can.) For a good discussion of the specific risks of owning, see Rappaport’s discussion on pages 45-46.

So if you are making the decision for real, the tradeoff is this: historically, on average, owning has beaten renting more often than the converse (if you have a ten-year holding period), but owning is riskier. You can’t tell now what is going to happen to house prices over the next ten years. But there is one thing you can sort of estimate: the current ratio of house prices to annual renting costs. David Leonhardt‘s rule of thumb is that if the ratio is below fifteen, owning will probably work out better than renting, and if the ratio is above twenty, renting will probably work out better than owning. (That is roughly borne out by Rappaport’s chart on page 51, but I think the chart implies that the “owning” threshold should be somewhat lower than fifteen.)

Now for the usual caveat: Everything above discusses buying a house as an investment. Most people get more consumption value from owning a house than from renting an equivalent house because most people get utility from living in a place that they own. They like the security, the ability to make modifications to the house (even though most of those modifications are probably money-losers), and so on. Also, in many markets you just don’t have a choice. I live in a small college town, and the rental market here is primarily geared toward students, so it’s hard to find a nice house for rent (especially one that will let you have a dog, which we did when we moved here). So there are plenty of good reasons to buy a house other than the idea that it’s a good investment. Those are valid reasons why you might buy a house even while thinking that it’s a bad investment. Except for scale, it’s no different from, say, eating at a nice restaurant now and then. Buying an expensive dinner is a lousy investment, but it gives me consumption value.

As Rappaport says,

“Homeownership, at least until recently, was often described as a great investment that also includes a place to live. More accurately, homeownership should have been described as a place to live that also includes an expected investment benefit.”

There is an expected benefit there, but remember that it’s not that big and it comes with greater financial risk.

Many commentators who want to blame Fannie and Freddie for the financial crisis base their arguments on analysis done by Edward Pinto. (Peter Wallison bases some of his dissent from the FCIC report on Pinto; even Raghuram Rajan cites Pinto on this point.) According to Pinto’s numbers, about half of all mortgages in the U.S. were “subprime” or “high risk,” and about two-thirds of those were owned by Fannie or Freddie. Last year I pointed out that Pinto’s definition of “subprime” was one he made up himself and that most of the “subprime” loans held by Fannie/Freddie were really prime loans to borrowers with low FICO scores. Unfortunately, I made that point in an update to a post on the somewhat obscure 13 Bankers blog that was mainly explaining what went wrong with a footnote in that book.

Fortunately, there’s a much more comprehensive treatment of the issue by David Min. One issue I was agnostic about was whether prime loans to people with low (<660) FICO scores should have been called “subprime,” following Pinto, or not, following the common definition. Min shows (p. 8) that prime loans to <660 borrowers had a delinquency rate of 10 percent, compared to 7 percent for conforming loans and 28 percent for subprime loans, implying that calling them the moral equivalent of subprime is a bit of a stretch. Min also shows that most of the Fannie/Freddie loans that Pinto classifies as subprime or high-risk didn’t meet the Fannie/Freddie affordable housing goals anyway — so to the extent that Fannie/Freddie were investing in riskier mortgages, it was because of the profit motive, not because of the affordable housing mandate imposed by the government.

Min also analyzes Pinto’s claim that the Community Reinvestment Act led to 2.2 million risky mortgages and points out that, as with “subprime” loans, this number includes loans made by institutions that were not subject to the CRA in the first place. Of course, the CRA claim is ridiculous on its face (compared to the Fannie/Freddie claim, which I would say is not ridiculous on its face) for a number of reasons, including the facts that only banks are subject to the CRA (not nonbank mortgages originators) and most risky loans were made in middle-income areas where the CRA is essentially irrelevant.

Mainly, though, I’m just glad that someone has dug into this in more detail than I did.

By James Kwak

My previous post on Fannie/Freddie had two major parts. In the first part, I questioned whether the thirty-year fixed-rate mortgage would really go away (or become much more expensive) without Fannie/Freddie, as some people have argued. In the second part, I said, who cares?

The first part has gotten a fair amount of good criticism, for example from Arnold Kling and John Hempton (by email), and also in comments. My position, simplified, was that a thirty-year fixed-rate mortgage includes three kinds of risk: credit risk, interest rate risk, and prepayment risk. Credit risk can be diversified, interest rate risk can be hedged, and Fannie/Freddie didn’t do anything about prepayment risk anyway. This is the kind of theoretical argument people make all the time, and the obvious question is whether the world actually works that way.

I think there are two important criticisms. One, which Kling makes, is that while there are thirty-year fixed-rate bonds (like Treasuries) floating around out there, there just aren’t that many compared to the volume of U.S. thirty-year fixed-rate mortgages. So there might not be enough buyers, and without enough buyers the yields could go way up. One response is that the interest rate risk can be hedged, but that means you have to find a lot of people willing to take the other side of the interest rate swaps, and maybe that would be too hard. So the real question is how much demand there is for thirty-year fixed-rate assets.

The second criticism, which Kling and Hempton make, is that the big issue isn’t the thirty-year maturity; the big issue is prepayment risk. A thirty-year fixed-rate mortgage gives the borrower the right to refinance and pay off the loan at any time, which means that even if you want a thirty-year asset, you can’t count on it. When interest rates go down, you’re likely to get your principal back, and then you’ll have to reinvest it at lower rates. Now, the classical response is that this is just an embedded option (for the borrower), and you should be able to price the option into the mortgage. So the real question is how many people are willing to write those options, and maybe the markets just aren’t deep enough.

I’m not completely convinced by this, though, because Fannie/Freddie didn’t actually hold onto most of their mortgages. Instead, they created pools that issued mortgage-backed securities, and those things had both interest rate risk and prepayment risk (see pages 11-16 of this prospectus for a long list of prepayment risk factors). So people buying the MBS issued by Fannie/Freddie ($5 trillion of them), it seems to me, were happily taking on both interest rate risk and prepayment risk. This seems obvious to me, so I’m almost certainly missing something.

For this reason, I’m still not entirely convinced that the private sector couldn’t take this on. Sure, interest rates would have to be higher because the private sector wouldn’t have the Fannie/Freddie implicit government guarantee* (although, as one commenter pointed out, part of the private sector has something like it). And with higher interest rates, thirty-year fixed-rate mortgages might become less popular compared to adjustable-rate mortgages. But that’s not the end of the world.

Relatedly, John Hempton has another proposal for Fannie/Freddie: simply raise the fee they charge for guaranteeing credit risk. At some point the private sector will step in and take on the job, and in the meantime the government will lose less money and distort the economy less.

* Without the implicit guarantee, the credit risk would be properly priced into the MBS issued by Fannie/Freddie, because Fannie/Freddie already charge a fee for guaranteeing the MBS.

(Yes, I know that isn’t saying much.)

Most people think that Fannie Mae and Freddie Mac had something to do with the financial crisis. Some people think that they were the major reason the crisis happened, which (to them) proves that activist government policy was the cause of the crisis. Other people, including me, think they were a modest contributing factor because they did buy a lot of securities that were backed by subprime loans, but they were well behind the curve when it came to mortgage “innovation” and the creation of toxic assets. But that’s not the question here.

The question now is what to do about them. Although they had been private, profit-seeking companies for forty years, they were taken over by government regulators in September 2008 when they had become clearly insolvent, and are still being operated in conservatorship. Because Fannie and Freddie were very, very long housing, they have suffered massive losses since the financial crisis began. But because the private mortgage securitization market has collapsed, they are the bulk of the secondary mortgage market at the moment, which means the housing market could collapse without them.

On Planet Money a couple of weeks ago, Bethany McLean and Joe Nocera took the cutely counter-intuitive position that the most bizarre mortgage product is the thirty-year fixed mortgage — and that it wouldn’t exist without Fannie and Freddie. Basically, their argument goes like this: Borrowers like thirty-year fixed-rate mortgages, but lenders should hate them. Because of the fixed rate, they carry interest rate risk, meaning that if market interest rates rise the value of the mortgage asset will fall. (If you hold it to maturity, you will still get the cash you expected, but if you are a traditional lender you are funding the mortgage with short-term liabilities, and the interest rates you pay on those will go up — as happened to the entire S&L sector in the 1970s.) Furthermore, they carry credit risk, since lots of things can happen to borrowers over thirty years, and as a result they might not pay you back.* So, according to McLean and Nocera, no banker in her right mind would sell such a product — not, that is, without Fannie and Freddie there to buy the mortgage and take the risk off her hands.** Their punch line is that although Americans like to complain about government intervention in the mortgage market, Americans also want their thirty-year fixed-rate mortgages, and you can’t have one without the other.

But this argument doesn’t make complete sense to me. If thirty-year fixed-rate assets are bad, that means no one would buy thirty-year U.S. Treasury bonds, yet people do (at 4.53 percent). A bank could originate a thirty-year fixed-rate mortgage and just buy an interest rate swap to hedge the interest rate risk. And if banks didn’t lend money to people because lots of things can happen to them that might interfere with their ability to repay, then they would never make business loans. Most businesses have much more volatile cash flows than someone with a good job. The first hedge against credit risk is the fact that you’re making lots of different mortgages to lots of different people, so you diversify away the specific risk in any given household. Now, it’s harder to hedge market risk — in this context, macroeconomic factors — especially if you do your lending in a local market. So the second hedge is that the mortgage is secured by the house, which means that as long as you have a reasonable loan-to-value ratio the bank is probably safe. And in any case, if you’re in traditional banking, macroeconomic risk is just part of your business.

The above also assumes that lenders are holding onto their loans. If they can sell their thirty-year fixed-rate mortgages on the secondary market, then the “problem” is completely off their hands. Yes, Fannie and Freddie are big players in the secondary market. But there’s no law of nature that says you can’t have a secondary market without them. What you need are standards, so that mortgages (or mortgage-backed securities) can be traded without investors having to look into every single mortgage. (For example, the development of standards for corn in (I think) the nineteenth century made it possible for different farmers to dump their corn into the same bin at one end of the railroad and for different buyers to take their corn out of the same bin at the other end — without every buyer having to verify her seller’s corn.) That’s one thing Fannie and Freddie provided with the conforming mortgage standards, but again, there’s no law that says that standards have to be set by companies with implicit government guarantees.

In fact, until recently we had a big secondary market for mortgages that didn’t rely on Fannie and Freddie — private mortgage securitization. Now, yes, I know as well as anyone that this turned out to be a big disaster. It turned into a disaster because the “standards” were set by credit rating agencies. But instead of setting strict criteria for underlying mortgages and then verifying that the actual mortgages met those criteria, the rating agencies used statistical models that attempted to predict how new, varied bundles of mortgages would perform, and they didn’t even do a very good job of verifying that the actual mortgages were consistent with the models. So in the end you had a secondary market that was vastly overpaying for crappy mortgages, and when everyone realized that, the market vanished.

So let’s think about what might happen if Fannie and Freddie didn’t exist. People would still want thirty-year fixed-rate mortgages, so some bank would try to originate them. That bank might just hedge the interest rate risk with interest rate swaps and hold onto the credit risk. Banks held onto the credit risk during the postwar boom. [Fixed, see below.] In 1960, for example, banks and thrifts held about $116 billion in home mortgages; government-sponsored enterprises held about $3 billion, with about zero in mortgage pools.***

Alternatively, that bank might try to package and resell mortgages on the secondary market. It doesn’t really matter if they are sold as packages of loans or as tranched mortgage-backed securities. The important thing is that there are verifiable and verified standards so that investors don’t have to inspect all the mortgages. That could be a private sector function, or alternatively there could be a government agency to define conforming mortgage standards and verify that the loans in a given pool comply with those standards. But the government agency doesn’t also have to be buying the mortgages. If investors can be sure that mortgages are what they say they are, then someone will buy them: pension funds, insurance companies,**** hedge funds, rich people, etc.

Now, the question is, how much will they pay? The Planet Money episode with McLean and Nocera cited Bill Gross of PIMCO saying he would demand an extra three percentage points in yield for a mortgage without a Fannie/Freddie credit guarantee. Although Bill Gross is no doubt one of the smartest investors in the world, there are a couple of reasons to doubt this.

There are at least two ways to estimate what mortgage rates would be without Fannie and Freddie. First, we can look at Fannie and Freddie themselves. Until 2008, they were profit-seeking companies, meaning that they were already paying as little for mortgages as they could. Their competitive advantage in the market was their implicit government guarantee — people thought that, in a crisis, the federal government would bail them out and protect them from default — which meant they could borrow money more cheaply than, say, banks. Without Fannie and Freddie, the new replacement buyers would have higher funding costs, so the increase in the yields they demand should be roughly the same as the difference between their fundings costs and those of Fannie/Freddie. Major banks these days have credit ratings around A, which means they pay about 80 basis points more for seven-year debt than do Treasuries. (I use seven years because that’s roughly the average time before a mortgage is paid off.) Even if Fannie and Freddie were paying the same yield as the Treasury Department, that means that mortgage rates would only be about 80 bp higher without them.

Second, we can look at the spread between conforming mortgages and jumbo mortgages (which are too big to be bought by Fannie and Freddie). A quick search yields this paper by Anthony Sanders, which cites several other studies (see Table 1) that show the spread to be between 16 and 40 basis points.

(Now, Bill Gross might still be right. In today’s market, if a mortgage isn’t guaranteed by Fannie or Freddie, there must be something wrong with it, so maybe you should demand 300 bp more to buy it. But that’s an adverse selection problem that wouldn’t exist without Fannie and Freddie.)

So according to the back of the envelope at least, a world without Fannie and Freddie would not send mortgage rates into the stratosphere. But more importantly: so what if it did?

The immediate response is usually that middle class families wouldn’t be able to buy houses. But this isn’t quite right. Higher mortgage rates mean buyers can’t spend as much on houses. But that means the demand curve would shift down and housing prices would come down; people would still need to move, they would still need to sell their houses, and the market would clear at a lower price level.

The market would also clear at a lower quantity, which means that over time the homeownership rate could go down. But this isn’t as big a problem as it sounds. It’s not like a consumer product market where lower quantity means less stuff. We’ll still have the houses we have; they’re not being destroyed. In fact, the current problem with the housing market is that we have too much housing stock for the number of households in the country (a point often made by Calculated Risk). Since housing at the margin can shift between homeownership and rental, whether a housing unit is used for one or the other doesn’t matter from the standpoint of total production. If we want to soak up the glut of housing, we need new household formation (e.g., people moving out of their parents’ houses). That is more likely to occur if the price of housing comes down. And only when the glut is soaked up will there be a reason for developers to build more.

Instead, one major effect of higher mortgage rates would be distributional: lower housing prices would hurt people who own houses (like me) and help people who don’t. In general, this means hurting the rich and helping the less rich, and that sounds like a good thing to me from a simplistic Rawlsian perspective. But that’s probably the main reason why our government has spent so much effort subsidizing mortgages and propping up the price of houses.

Then there’s the wealth effect, which is fictional on the one hand but unfortunately real on the other. If you have $100,000 in cash and a $300,000 house, and tomorrow the value of your house falls to $250,000 because all housing prices have fallen, you are exactly as rich as you were the day before for most practical purposes, assuming you still want to live in a house. You still have $100,000 and one house.(There are exceptions, like if you plan to move someplace where houses are cheaper, in which case you will end up slightly worse off.) But unfortunately, you feel $50,000 poorer, and that may crimp your consumption, hurting the economy. So if we’re going to move to a world where the government doesn’t suppress mortgage rates, we’ll have to do it gradually.

So here’s my not-very-thought-through proposal: Fannie and Freddie should continue doing what they are doing, as wards of the federal government. But every year, for each $1 in assets that get paid off, they should only invest $0.50 in new mortgages (the rest should reduce net debt). So gradually, over the next 15-20 years, their balance sheets should shrink to small fractions of what they are today, and then they should be shut down as borrowing and investing institutions. As I said above, I think it’s possible and perhaps preferable to keep them in the role of defining and verifying conforming loan standards so that investors have some confidence in securities backed by those mortgages.

Yes, this would be a big experiment. But we’ve had a big experiment in subsidizing homeownership, and I’d say it hasn’t worked out too well.

Now, to reassure regular readers of this blog, I’m not against subsidized mortgages because I’m against government subsidies in principle. I just think government subsidies should be saved for things that are worth subsidizing — like fruits and vegetables, for example. I should add that I’m no expert on Fannie and Freddie and I’m willing to be talked out of this position. But it seems to make sense to me.

* Actually, there’s a third kind of risk: prepayment risk. If interest rates go down, borrowers will refinance and pay off their mortgages. As a lender, you still get your principal back, but now you have to reinvest it at a lower interest rate. But Fannie and Freddie didn’t do anything about prepayment risk anyway — that was still the principal risk faced by investors in mortgage-backed securities.

** In fact, for the most part, Fannie and Freddie don’t buy and hold the mortgages outright. They create mortgage pools that issue mortgage-backed securities that have a Fannie or Freddie guarantee. At the end of 2009 the government-sponsored enterprises had $700 billion in home mortgages, while the pools had $5.3 trillion in mortgages, according to the Fed’s Flow of Fundszy report. Since the beginning of 2010, most of those pools are now consolidated on the Fannie/Freddie balance sheets, presumably because they are still on the hook for losses.

*** The originate-and-hold model did run into problems in the 1970s, but that was primarily because of volatile interest rates, not because of credit risk. Interest rate risk can now be hedged using interest rate swaps, which weren’t invented until 1980.

**** In 1960, life insurance companies held $42 billion in mortgages.

Update: Arnold Kling caught a mistake above. Originally I said “That bank might just hedge the interest rate risk with interest rate swaps and hold onto the credit risk. This is what banks did during the postwar boom.” I meant to say that banks used to hold onto the credit risk, not that they used interest rate swaps. I know that interest rate swaps didn’t exist back then (that’s a point made elsewhere in the post). My point was that banks used to hold onto both interest rate and credit risk, and that model broke down because of the interest rate side, not the credit side. And on the interest rate side, you can use swaps today. Now, maybe there aren’t enough people who want to take the other side of that swap, but there are plenty of pension funds and life insurance companies who need thirty-year assets.

Adam Levitin and Susan Wachter have written an excellent paper on the housing bubble with the somewhat immodest title, “Explaining the Housing Bubble” (which has been sitting in my inbox for a month). My main complaint with it is that it’s eighty-one pages long (single-spaced), which is most likely a function of law review traditions; had it been written for economics journals, it could have been one-third the length. I also have some quibbles with the seemingly obligatory paean to the importance of homeownership, which I think is an assumption that deserves to be contested. But overall it presents both a readable overview of the history and the issues, and a core argument I have a lot of sympathy for.

The argument is that the motive force behind the credit bubble was an oversupply of housing finance—in other words, the big, bad, banking industry. Levitin and Wachter’s key evidence is that the price of residential mortgage debt was falling in 2004-06 even as the volume of such debt was rising. As Brad DeLong’s parrot would say, that can only happen if the supply curve is shifting outward, not if the demand curve is shifting outward (which is what would happen if it were all the fault of greedy borrowers who wanted to flip houses).

This oversupply of housing finance happened because of banks’ desire to keep the securitization pipeline flowing after the 2001-03 refinancing wave tapered off. Private mortgage-backed securities were their preferred instrument because they are both complex and heterogeneous: complexity means they are impossible to price based on fundamentals, and heterogeneity means that comparing prices between private MBS is meaningless or misleading. And this was possible because there were no regulatory standards governing the private MBS market. The “market regulation” beloved of Alan Greenspan also didn’t work because, among other things, short pressures were soaked up by synthetic CDOs that were willing to sell CDS protection on MBS at artificially low prices.

A lot of the story will be familiar to financial crisis junkies, but you will probably learn something new (about the difference between the CMBS and RMBS securitizations, for example). And most importantly, with all the misinformation floating around about the causes of the crisis, Levitin and Wachter isolate the importance of our deeply flawed financial system.

Since most of you probably read Calculated Risk, you’ve probably seen the Sun Sentinel story of the man in Florida who paid cash for a house–and still lost it in a foreclosure. Not only that, but he bought the house in a short sale in December 2009, the foreclosure sale happened in July 2010, and only then did he learn about the foreclosure proceeding.

Even after that,

“Grodensky said he spent months trying to figure out what happened, but said his questions to Bank of America and to the law firm Florida Default Law Group that handled the foreclosure have not been answered. Florida Default Law Group could not be reached for comment, despite several attempts by phone and e-mail. . . .

“It wasn’t until last week, when Grodensky brought his problem to the attention of the Sun Sentinel, that it began to be resolved.”

Bank of America now says it will correct the error “at its own expense.” How gracious of them.

If the legal system simply allows Bank of America to correct errors, at cost and with ordinary damages, after they happen, this type of abuse will only get worse. There’s obviously no incentive for banks not to make mistakes, and as a result they will behave as aggressively as possible at every opportunity possible. Yes, this was probably incompetence, not malice, on the part of the bank. But if you don’t force companies to pay for the consequences of their incompetence, they will remain willfully incompetent, and the end result will be the same.

“Housing Fades as a Means to Build Wealth, Analysts Say.” That’s the title of a New York Times article by David Streitfeld. Here’s most of the lead:

“Many real estate experts now believe that home ownership will never again yield rewards like those enjoyed in the second half of the 20th century, when houses not only provided shelter but also a plump nest egg.

“The wealth generated by housing in those decades, particularly on the coasts, did more than assure the owners a comfortable retirement. It powered the economy, paying for the education of children and grandchildren, keeping the cruise ships and golf courses full and the restaurants humming.

“More than likely, that era is gone for good.”

I’ve been telling my friends for a decade that housing is a bad investment. These are real housing prices over the past century, based on data collected by Robert Shiller:

Housing is generally a worse investment than either stocks or simple U.S. Treasury bonds. Then why do so many people think it’s such a great investment?

1. Leverage. Housing is the one area where ordinary people can get 5x, 20x, 30x, or even (during the boom) infinite leverage on their capital at a decent interest rate. With that kind of leverage, even a modest real return on the underlying asset turns into huge returns on your capital. Of course, we all know the dangers of leverage.
2. Price illusion. People remember the nominal price they paid for their houses. When they sell them thirty years later, they look at the difference between the nominal purchase and sale prices and think they made a ton of money. This is especially true of the generation that bought houses in the 1960s and early 1970s before inflation hit; they saw their home prices go up by a factor of ten and thought it was due to high real returns.
3. Bubbles and optimism bias. Every now and then we have a huge bubble like the one at the right-hand end of the chart above. For a while, people think that’s the new normal. For a while after that, they continue to think it’s the new normal, because they are biased toward optimistic expectations about the world. (Note that during the first half of the decade that I was advising friends that housing was a bad investment, housing was actually a great investment, assuming you could get out in time.)

OK, so now we all now the real story. Or do we? “In an annual survey conducted by the economists Robert J. Shiller and Karl E. Case, hundreds of new owners in four communities — Alameda County near San Francisco, Boston, Orange County south of Los Angeles, and Milwaukee — once again said they believed prices would rise about 10 percent a year for the next decade.” There’s that optimism bias.

But I don’t think it’s correct to say that an era is over–an era when housing appreciation was the key to the economy. The chart above shows simply that that era never existed; housing was flat for a long time, and then there was a bubble. Instead, we had the illusion of an era of housing appreciation, produced mainly by leverage and price illusion. For every homeowner who made a killing because she got a fixed-rate mortgage in 1970, there was a new family that couldn’t afford a house in 1980 because interest rates were too high, or a savings and loan that failed because it was weighed down by those fixed-rate mortgages. That whole phenomenon was just a transfer of wealth within society.

One last caveat, however. When “analysts say” one thing, they are usually wrong. Remember back in 1999-2000, when most analysts were saying that stocks were the best investment for everyone, all the time? Generally the best time to buy an asset class is when conventional wisdom has shifted against it. So while I still think housing is overpriced–and we should slowly remove the props on that price, like the mortgage interest tax deduction–maybe in the long term it’s not such a bad idea after all.

Update: An earlier version of this post had some incorrect calculations of the return on a hypothetical housing investment. Sorry–I’m out of practice at this blogging thing.

Mike Konczal did some more great work earlier this week in two posts on the not-so-exciting topic of second liens. I don’t have much in the way of new insight or analysis to provide, so let me just summarize.

A second lien is a second mortgage on a house. The second lien is junior to the first mortgage, meaning that if the borrower defaults and the first lender forecloses, the proceeds from the sale go to pay off the first mortgage; the second lien only gets paid back if the sale proceeds exceed the amount due on the first mortgage. You can see where this is heading.

Konczal’s first point was that in the stress tests almost a year ago, the big four banks held $477 billion of second liens and estimated that these assets were worth 81-87 cents on the dollar, so they would take $68 billion in losses (under the “more adverse” scenario). Konczal estimated that they were instead worth 40-60 cents on the dollar, implying $191-286 billion in losses.

After Ryan Avent questioned whether second liens were really in such bad shape, Konczal came up with this great chart from Amherst Securities:

Here’s how to read it:

“The second to last column is the current loan-to-value, LTV, of the first lien. If it is greater than 100, it is underwater on the first mortgage by itself – the loan is greater than the value of the house. . . . The last column is the current CLTV, or combined-loan-to-value, which is the loan to value on all the debt of the property. . . . These are averages – the data sources aren’t more specific.”

So, for example, looking at the third line, the borrowers currently owe $32.1 billion on first liens and $6.0 billion on second liens. The LTV of the first mortgage is 105%, so the current value of the property is $30.6 billion. In other words, the first mortgages are underwater, so the second liens are more or less worthless. (In practice, the second liens do have some small value, based on three things: (1) the hope that some borrowers will continue to make payments on second liens, even though would do better (financially) to walk away; (2) option value, since housing prices could rise enough to make the second liens worth something; and (3) the possibility that the government will start paying off second lienholders to stop blocking short sales.)

So, looking down the chart, the problem seems obvious: the second liens are not worth very much, so the big banks are sitting on major unrealized losses. What’s more, these second lienholders are blocking the principal writedowns that would make sense if there were only one lender involved (a single lender would often rather lower the principal and keep the borrower in the house making payments than foreclose), because those writedowns would wipe them out; but they don’t want to foreclose, either, because that would also wipe them out. So instead we get “extend and pretend,” and possibly servicers pressuring borrowers to pay off their second liens before their first liens.

Now, John Cassidy doubles down on his defense of the stress tests in a blog post that responds to Konczal. Cassidy says:

1. Banks have to write down loans that are delinquent for six months, and we haven’t been seeing this in bulk.
2. “Most second mortgages aren’t piggybacked on first mortgages that are underwater. . . . according to one official I spoke to, roughly thirty per cent of second mortgages are in this dire predicament.”
3. “About one in five second mortgages aren’t really second loans at all. Typically, they are home equity loans taken out by people who have fully paid off their first mortgages. . . . The monthly payments on such loans are usually relatively small—a few hundred dollars—and the likelihood of default is relatively small.”

Not surprisingly, I’m not very convinced. As for 1, a lot of this is probably people who are underwater but are still making payments–but might decide to stop. Some of it is probably people who got trial modifications on their first mortgages, so they can still make payments on their second liens. (The servicers who are in charge of those modifications are often the same bank that hold second mortgages.)

As for 2, this seems to directly contract Konczal’s data, which I would trust over “one official I spoke to.” Now, Konczal’s data are originally from LoanPerformance; I believe they get their data from securitizations, but I don’t know if that means that the second liens in their sample were securitized, or just that the first liens were securitized. (My guess is the latter.) It is likely that loans that went into securitizations were more toxic than those that didn’t. So if the banks in question are holding onto whole second liens where the primary mortgage was not securitized, then that could lean in Cassidy’s favor. (If on the other hand they are holding onto ABS based on second liens, then that would lean against.)

As for 3, what we care about is not the number of second liens that are underwater, but the dollar amount. If a HELOC is small and hence easy to pay off, by the same token it is relatively insignificant to the question at hand. More importantly, as Konczal says in a comment to his second post, citing Amherst Securities: “many borrowers are not paying their 2nd, but most of those are unpaid 2nds are home equity lines of credit. The unpaid interest is simply added to the balance, and the loan technically remains current.” So the default rate on HELOCs is artificially low.

The failure of the Obama administration so far to come up with a working solution to the problem of mass defaults and foreclosures may be due to practical barriers, such as lack of capacity among mortgage servicers or legal uncertainties regarding securitization trusts. Alternatively, however, it may simply be that the administration doesn’t care that much. Perhaps the primary goal of homeowner assistance all along was to detoxify the toxic assets on large banks’ balance sheets; now that those banks are off of life support, maybe the mortgages themselves don’t matter that much.

Congressman Brad Miller’s proposal in The New Republic should put that question to the test.*

Miller says we should stop expecting the mortgage lenders, securitizers, and servicers who created this mess to be the ones to clean it up. Instead, the government should create a new Home Owners’ Loan Corporation, modeled on the one created by FDR in June 1933 (three months after taking office), to buy up mortgages and modify them. The HOLC could pick and choose the mortgages it buys and modifies, so it could focus on mortgages that could be successfully modified to keep the homeowner paying something and give the HOLC a small profit. I spent half the article wondering how the HOLC cold avoid overpaying for the mortgages (since the banks would try to hold it up for a high price), and then Miller suggested the solution: eminent domain. (The idea would be to take market data about mortgage prices and force banks or trusts to accept that in exchange for the mortgages, instead of letting them demand the inflated prices they may be keeping those mortgages at on their books.)

Both administrations, and the Federal Reserve, took absolutely extraordinary measures to rescue the financial system, simply shoving the private sector out of the way and, for example, buying over one trillion dollars of agency bonds and mortgage-backed securities in order to prop up prices in the market. By contrast, the homeowner assistance measures have been tentative, based on “nudging” private sector actors to do the right thing through small cash incentives. Those measures have largely failed; the cash incentives seem to be motivating mortgage servicers to “extend and pretend,” stringing homeowners along to keep them paying something without ever making the principal reductions that are necessary for a real solution.

Will the administration take bold measures — either those suggested by Miller, or something else commensurate with the steps taken to save large banks — to keep homeowners in their houses and stop the wave of foreclosures? Or is it content to pretend that its half-measures are working?

* Note that as far as I can tell Miller actually writes his own articles (and blog comments, even), as opposed to many public figures.

Update: Paul Kiel at ProPublica has yet another story on the challenges facing homeowners trying to get their mortgages modified through the government’s program. Among other things, modification trial periods were supposed to last only three months, yet 475,000 homeowners have been in trial periods for longer. That’s a lot of people. This is the problem that Miller is trying to fix. The administration may not agree with his solution, but I think something similarly bold is necessary.

Alyssa Katz has a great article in The American Prospect about extend and pretend when it comes to multi-unit residential buildings, focusing on New York City. Expensive condo towers are now “see-through” buildings (so named because you see through the glass walls right through the empty floors–a phenomenon I first saw in 2001, after the Internet bust, along Highway 101 on the San Francisco Peninsula). Another problem is apartment complexes that were bought by private equity firms and flipped to developers during the boom with plans to evict the low-rent tenants and replace them with high-rent tenants; the high-rent tenants never arrived, the developers can’t make their loan payments, and no one is maintaining the buildings for the remaining tenants. (And no one is saying that property developers have a moral obligation to pay their debts rather than turn their properties over the bank.)

One of the underlying problems is that developers (or the banks that inherited their properties) have an incentive to hang on and hope for a return to prosperity that will deliver the promised condo buyers or high-rent tenants–in other words, betting on another boom. The alternative is selling the properties to someone who will convert or restore them to the type of housing that there is actually demand for–affordable rental units–but that means that someone has to take a loss, because an affordable building is simply worth less than one stuffed with investment bankers. Unfortunately, as Katz says, “With so many lenders at the brink of insolvency, the Treasury Department and the Federal Deposit Insurance Corporation (FDIC) appear to be in no rush to cause them further pain.” The lack of urgency was unwittingly confirmed by a Treasury spokesperson, who said, “The commercial real-estate market is something we’re watching closely, but it’s premature to discuss solutions.”

By James Kwak

Yesterday at a Cato Institute conference, Edward Pinto, chief credit officer at Fannie from 1987 to 1989 and currently a real estate financial services industry consultant (according to recent Congressional testimony), rolled out the new line. The new argument is a curious mirror image of the old argument (which Pinto himself may not have made): now the subprime explosion did not cause the housing bubble, but was caused by the housing bubble and … wait for it … the CRA caused the housing bubble, along with the affordable housing goals of Fannie and Freddie.

Before going further, it’s time for my favorite lesson on correlation and causality.

The idea that the housing bubble caused the explosion in subprime lending is not crazy. The worst excesses in mortgage lending happened in 2003-06, after housing prices had already reached historical highs. The idea is that with prices so high, lenders had to offer exotic mortgages (and stop checking for documentation) in order to make the houses affordable for new borrowers. (Of course, there should have been stronger safeguards against those exotic mortgages — consumer protection enforcement, better credit rating agencies, etc. — but that’s another topic.)

But the weirder part of the argument is that the CRA caused the housing bubble. A policy could push housing prices up by increasing the availability of credit in a way that increases borrowers’ buying power. However, that can only contribute to a bubble if (a) it increases the number of loans that cannot be paid off, making price rises unsustainable and (b) there is some continually-increasing aspect to the policy, without which prices should simply reset at a higher level.

Pinto gets into an argument with the Federal Reserve study (cited above) on the performance of CRA-covered loans, claiming that those loans are doing worse than the Fed claims; I can’t judge that without seeing something in more detail. But even so, there are a few missing elements to the causal chain. One is that the CRA should only have an effect in low-income communities, and unless the people buying houses in the Nevada desert were all people who had been priced out of low-income communities by the CRA, it’s hard to blame the real housing price craziness on the CRA. Another is that the CRA itself has provisions that say that lenders do not have to make loans that are unprofitable. A third is that if the CRA was forcing banks to make unprofitable loans, then you would expect the nonbank lenders to stay out of those market segments; in fact, we saw just the opposite.

Back in 2000, Cato had a different line on the CRA. Jeffrey Gunther wrote an article in a Cato journal arguing that the CRA should stand for “Community Redundancy Act” because competitive forces in the market made it unnecessary — lenders seeking profits would not discriminate against particular communities. Gunther cited subprime lending as an example of the type of profit-seeking innovation that made the CRA unnecessary. He noted exactly what CRA defenders argue today:

“If CRA were the driving force behind the recent increases in home-purchase lending in low-income neighborhoods, we would see evidence of a treatment effect. Lenders subject to the ‘CRA treatment’ [regulated banks] would have refocused their activity toward CRA objectives to a greater extent than lenders in the untreated control group [nonbank lenders]. However, there is little evidence of such a treatment effect. To the contrary, it was lenders in the control group that refocused their efforts in line with the mid-1990s boom in lending in low-income neighborhoods. In fact, lending in low-income neighborhoods grew faster than other types of lending at institutions not covered by CRA, whereas low-income lending grew at the same rate as other types of lending activity for CRA-covered lenders.”

Gunther’s optimism about subprime lending seems naive in hindsight, although it was shared by many prominent economists and policymakers from Alan Greenspan on down.

For the CRA to be the problem, the causal factor would have to be availability of credit in low-income communities. But from what I’ve read, it seems like today’s problem is no longer redlining — plenty of lenders were willing to lend to the poor. It’s predatory lending — they found that for various reasons it was easier to steer poor people into unnecessarily high-cost loans. Now, I’m no fan of policies to encourage homeownership in general. I think we have too many of them. But the CRA is primarily a policy to discourage discrimination, and that is something we unfortunately still need.

By James Kwak

• Income eligibility for first-time home buyers stays at $75,000 for individuals, and $150,000 for couples.
• For move-up buyers, income eligibility is $125,000 for individuals and $250,000 for couples.
• There is a minimum 5 year residency requirement – in their current home – for move-up home buyers.
• The tax credit is the lesser of $7,290 or 10% of the purchase price.
• The credit runs from Dec. 1, 2009 to April 30, 2010, with an additional 60 day period to close escrow. (So end of April to sign contract, end of June to close escrow)
• Expect bill to be signed by Friday, packaged with the unemployment benefit extension.

So my wife and I fit under the $250,000 couples limit. We’ve lived in our house for eight years. So now the government is willing to give me $7,000 to buy a new house? That would be a sale that wouldn’t have happened otherwise — but what good would it do the economy?

As I tried to explain previously, an $8,000 credit for first-time homebuyers will raise prices by less than $8,000 (leaving aside the effect of leverage for simplicity), because demand at any price point only goes up for first-time homebuyers, not all homebuyers. That means that the buyer gets a fair chunk of the subsidy. But vastly expanding eligibility like this (about 67% of households own houses, and probably about half of them have been in the same house for five years) increases the amount by which prices will go up, which lowers the buyer’s share of the subsidy and increases the seller’s share.

By James Kwak

There are many arguments against the tax credit. One argument we make is that the tax credit is a benefit for sellers of houses more than for buyers of houses. This is simplest to see if you imagine  a permanent credit available for all buyers: “Imagine the credit were expanded to all home buyers and made permanent. This would simply boost housing prices at the low end of the market by close to $8,000, since all buyers would be willing to pay $8,000 more. (Prices would rise by a little less than $8,000 because at higher prices, more people would be willing to sell.)”

It turns out Nemo had made a similar argument already.

Small point: Nemo (in a follow-up post) says that the tax credit should boost prices by exactly $8,000 (leaving aside leverage for now), because in the short term the supply curve is vertical. I’m not convinced. The reason we said “close to $8,000″ is that the supply curve is typically upward-sloping, not vertical, as shown on the graph in that follow-up post. The supply of houses can shift quickly, because people can decide to sell their houses (say, retirees planning to move to apartments in the city can move that decision forward). Also, if the credit is not available to everyone, it won’t shift the demand curve by exactly $8,000 at every point, because the demand curve for houses is the sum of every individual’s demand for houses, so only some people’s demand will change. This is why expanding the tax credit to everyone is such a bad idea. When you restrict it to first-time homebuyers, they get at least some of the benefit.

Bigger point: Nemo points out that the $8,000 increases the homebuyer’s ability to make a down payment; since mortgages provide leverage, this means the potential impact on prices is much higher. If you are buying a house with 3.5% down, then arguably an extra $8,000 in cash (which some states will advance you) can boost your buying power by $200,000. Now, this is a complicated issue, since unless you can get a no-doc loan, you still need to qualify for the monthly payments. (Nemo discusses this here.) But I think it’s fair to say that at least some buyers are constrained by the down payment more than by the monthly payments, especially with interest rates so low (I saw this in my summer legal services job). So the potential impact on a household’s buying power could be a lot more than $8,000, as Nemo says.

The net effect is that the buyer pays an inflated price for a house, which will get deflated when the tax credit prop gets taken away. I believe in some places you can effectively use the tax credit as your down payment; this means you will have close to zero equity when the credit goes away, unless housing prices rise.

By James Kwak

Unemployment is always a lagging indicator, and given the record low number of average hours worked, it will turn around especially slowly this time. Until then, people will continue to lose their jobs and wages will remain flat, and any small rebound in housing prices is unlikely to help more than a few people refinance their way out of unaffordable mortgages. So unless the other part of the equation – monthly payments – changes, the number of foreclosures should just continue to rise.

Calculated Risk provides this great chart from Matt Padilla (see the CR post for definitions of the categories):

The foreclosure problem has gotten a little more press recently as the Treasury Department attempts to follow through on its “name and shame” campaign to pressure mortgage servicers to modify more loans.

There seem to be two main explanations for why more loans are not being modifyied. The New York Times recently reported that for the servicers at the center of the process, it is simply more profitable to make fees off of delinquent loans than to foreclose on them and give up that stream of fees. On this theory, the cash incentives being provided by the government are simply not big enough to change their financial incentives.

The servicers prefer to argue that their hands are tied by the investors who own the mortgage-backed securities that have swallowed up the mortgages. On this theory, the Pooling and Servicing Agreements that govern these securitization trusts restrict the ability of servicers to modify mortgages. However, an article by Karen Weise in ProPublica yesterday casts serious doubt on this claim. Weise follows a household that is trying to get a modification of their mortgage, serviced by Wells Fargo, under the Making Home Affordable plan. Wells Fargo claims that it cannot modify the mortgage under those terms because “the investors need their money,” and instead proposed a different modification, which would increase the loan principal by $80,000. However:

researchers at UC Berkeley’s law school looked at the contracts covering three-quarters of the subprime loans that were securitized in 2006. The researchers found that only 8 percent prohibited modifications outright. About a third of the loans were in contracts that said nothing about modification, and the rest set some limits but generally gave the servicers a lot to leeway to modify, particularly for homeowners that had defaulted or would likely default soon.

And that is the case with the loan in question, for which the servicer need only make a “reasonable and prudent determination” that the modification is in the investors’ interests. What’s more, in this case, “Deutsche Bank [trustee for the securitization trust] spokesman John Gallagher said servicers are ‘solely responsible’ for deciding all modifications.”

According to Weise’s article, the administration anticipated servicers’ fear of being sued by investors, but a key phrase in the proposed legislation was removed by Congress as a result of lobbying efforts. Servicers would probably have preferred the phrase be left in, but the end result is it gives them a convenient excuse for failing to modify mortgages – which, as the Times pointed out, is often in their own financial interests.

It will be interesting to see if the administration chooses to take serious action to reduce foreclosures, or whether it sticks to a “name and shame” strategy that is likely to be ineffective.

By James Kwak

Let’s make this a little more concrete. Let’s say you bought a house with zero money down for $300,000 in early 2006. A few years later, the house is now worth $200,000, so your negative equity is 50% of the market value. Yet only 17% of people in your situation would walk away from the house. The other 83% would continue to pay the mortgage,  essentially throwing money away. Apparently people value the transaction costs of moving and the damage to their credit ratings at $100,000 (I think my numbers are approximately on the right scale – if anything they are probably low) – even after the fact that you can live in a house for free for several months before being evicted.

Or people are not as rational as economists would assume.

By James Kwak