We Have a Winner?

After seeing dozens of mortgage proposals emerge over the past several months, there are news stories that Larry Summers and the Obama economic team are converging on an unlikely candidate: the proposal by Glenn Hubbard and Christopher Mayer first launched on the op-ed page of the Wall Street Journal on October 2. Hubbard and Mayer published a summary of the plan in the WSJ last week; a longer version of the op-ed is available from their web site; and you can also download the full paper, with all the models.

I say “unlikely” not only because Hubbard was the chairman of President Bush’s Council of Economic Advisors, but because it doesn’t look like a Democratic plan; then again, it doesn’t look much like a Republican plan, either. Most plans I have seen have focused on minimizing foreclosures through some form of guaranteed loan modification for delinquent homeowners. Before getting to the policy specifics, though, I want to outline two of the premises, as elaborated in the full paper.

First, Hubbard and Mayer, like many others, have the goal of preventing an overcorrection on the downside (housing prices falling further than where they need to go to be reasonable). But unlike many others, they have calculated where prices need to go, and one of their central arguments is that we are already there, and therefore housing prices should be propped up right now. This was surprising to me, since I am familiar with Case-Shiller charts like this one from Calculated Risk (click on the first chart to expand), which seem to show prices still more than 50% above their 2000 levels (nominal prices, but in a low inflation environment). The authors divide cities into three markets – cyclical (San Francisco), steady (Chicago), and recent boomer (Miami), and conclude that (Figure 10): cyclical city prices are 10-20% above their average level of affordability over the last twenty years, but that is consistent with 2% expected annual real appreciation for these highly desirable cities; steady city prices are at their average level of affordability already; and recent boomers still have some way to fall. Looking at the imputed rent-to-income ratio (Figures 6-8), they find that housing prices are already where they should be in most markets.

Second, Hubbard and Mayer argue that housing prices are mainly a function of real mortgage rates. While they acknowledge that other factors took over at the peak of the boom, their model shows that most housing price appreciation through 2005 was due to fundamentals, primarily low mortgage rates. They show the price elasticity of user costs (the cost of owning a home, largely the mortgage) to be between 0.62 and 0.85, which means that a 10% reduction in user costs translates into a 6.2-8.5% increase in housing prices. Right now, they argue, mortgage rates are historically high relative to Treasury bond yields, and those high mortgage rates are pushing housing prices below their long-term levels. (Mortgage rates are only historically high because Treasury yields are world-historically low, but we’ll come back to that.)

Given those premises, the policy proposal is simple: force mortgage rates down to 4.5% (by reducing the cost of Fannie/Freddie debt relative to Treasuries), thereby propping up housing prices at a level that Hubbard and Mayer think is sustainable. 4.5% would be 1.9 percentage points above the yield on 10-year Treasuries, but the historical spread is only 1.6% (Figure 9). While many people’s first reaction will be that this is simply pumping up the next bubble, they have two responses. First, the price appreciation due to lower mortgage rates will only balance out the additional price depreciation (10-20%) that is currently expected. (I’m not sure I buy this, because forecasts for price depreciation are basically wild guesses moving in a herd; if the Hubbard/Mayer plan has the effect they intend, the current “pessimism” they expect to balance against their cheap mortgages will likely evaporate.) Second, they propose indexing mortgage rates to Treasury yields, so that as the economy recovers and Treasury yields go up, mortgage rates will go up as well. In effect, mortgage rates would become countercylical.

Now here’s the surprising part. In order for these mortgages to rejuvenate the housing market, they have to be available to everyone. This isn’t a program for reducing mortgage foreclosures; this is a program for boosting housing sales and refinancings across the board. This does have the nice property of eliminating all those worries about how to prevent solvent homeowners from turning insolvent in order to profit from a bailout. Homeowners with negative equity are almost an afterthought, but they do get two paragraphs on pp. 22-23: these homeowners would get new loans with 5% equity; losses would be split evenly between the government (a new Home Owners Loan Corporation) and the lenders. Lenders would have to accept the deal on all or none of their mortgages. (There isn’t any discussion of how to deal with securitization trusts, but a program like this is sure to include large amounts of legislation, so presumably this is one more bill to pass.)

The goals of the program are to stop the slide in housing prices, stimulate the economy by unfreezing home sales and through the wealth effect of increased housing prices, and stabilize the value of mortgage-backed securities, thereby aiding the financial sector. (Presumably we’re past the point where a flood of prepayments will reduce MBS prices any further.)

One question is whether the loans will be sustainable. Hubbard and Mayer say that 1.9% is more than enough because the ordinary spread is 1.6%. But these are not ordinary times, and even if the plan does help turn around the economy, we are probably looking at 1-2 more years of rising unemployment and resulting defaults. Furthermore, conforming mortgages rates are already down to 5.2% (thanks in part to the Fed talking rates down), so Fannie and Freddie could face the problem of getting stuck with riskier mortgages while the private sector keeps the better ones. But in any case there are signs that some version of this plan will be brought to the floor.

23 thoughts on “We Have a Winner?

  1. Even if home prices stop falling, I do not see them appreciating like 2002-2006 period. Also, hard reality is consumer driven economy (driven mainly by credit and appreciating home prices) is not sustainable.

    Question is, will consumers spend again or they will save? If they don’t spend, we have more unemployment down the road and probably more defaults.

  2. This plan is a “game changer.” I would immediately go long the S&P, if it were enacted. Just think, almost every piece of toxic paper will get called. If it isn’t called, it means the mortgagee is probably beyond help and can now be written off and the property foreclosed. Banks are happy, mortgagees are happy, housing market stabilizes, banks lend again, corporate bonds recover and confidence returns.

    This is as good an option as any fiscal stimulus package. Japan tried them without much success, so lets try something different and creative.

    However, the talk of a fiscal stimulus package has all the politicians salivating. They are now “programmed” to get their hands on the pork package of $600M-$800M so they can “help” their constituents. Also many States and Municipalities are now abandoning curent infrastructure projects so they can be funded by the stimulus package. All this leads me to believe the political pressure will be placed on Obama to do a stimulus package rather than this program. That’s why I’m still hedged against the S&P and will probably remains so for a very long time.

  3. It’s not an mortgage interest rate issue, it’s a mortgage availablity issue. It doesn’t matter if rates are 0% but you are upside down and your credit is less than perfect. If they say anyone with a 600 is in, then we have a game changer.

  4. Jeffreyb:

    You may be mis-interpreting the proposal in the baselinescenario website. ANYONE with a current mortgage is going to be refinanced if they so choose. No new appraisals, no equity buydown, no credit score analysis, no moral hazard, no “my neighbor who was delinquent got a better deal than I did.” Come to the Fed’s refi window, manned by your current mortgage servicer, hand in your current mortgage and then walk out with a 30 year fixed at 4.5% based on your current morgage balance. End of story. All toxic paper gets taken out of the market. Those who don’t do this refi- and are in trouble- are sent to the garbage bin and marked down accordingly

  5. two points:
    1. demand for new single family homes is decreasing sharply (demographics are ugly for housing: baby-boomers -median age now 60- are looking to down-size ASAP)
    2. The inventory of unsold single family housing is still wickedly elevated at 11 months.

    implication: supply, supply sypply… no demand.

  6. I found the Wall Street Journal summary article disturbing. After calculating the reduction in home mortgage payments caused by refinancings and the supposed subsequent increase in housing values the authors then hope that re-financed homeowners will feel the “housing wealth effect” and banks, now freed from many of the mortgage-backed securities by these re-financings,:

    “. . . would flood the market with additional liquidity that the private sector could deploy to other uses such as auto loans, credit cards, commercial mortgages and general business lending.”

    So consumers with terrible balance sheets are going to lower their mortgage payments and then increase their credit card debt or buy a new car. I really hope that the average consumer is smarter than that.

  7. What Bill W said…and mo: that pile of inventory which we wish we could take back to the store for a refund, represents GDP brought forward, not merely sales brought forward. Similarly, current mortgage payers on over-priced (above trend wrt wages) houses represents consumption brought forward…not to mention crowding out of all non-housing related economic activity…which might have made for a more balanced and sustainable, less ponzi-prone economy feeding on decadent pockets of corrupt and corrupting officials.
    This cannot and must not happen: letting house prices fall…the Invisible Hand has had it’s day in the sun and now it’s time for The Boot.

  8. Calmo:

    Come on. If George “The Bailout” Bush says “this time its different.” And Joe Biden says “this economy is about to implode.” And Barack Obama says “just fill in the blank_____” You can bet YOUR house that no one is going to “get The Boot” because in our society the Invisible Hand has been deemed the Black Hand. I’m getting my mortgage papers ready right now for my 4.5%refi cause this time I’m gonna get mine just like everyone else and, if I don’t get mine, I’m gonna call my government reps and tell them I’m gonna vote them out in 2010.

  9. It seems the most dangerous aspect of this proposal is the potential for reigniting the housing bubble, as James alluded to.

    Wouldn’t it make more sense to allow the Fed to determine how high the mortgage interest rate should be above the 10 year Treasury yield, rather than setting it to a fixed 1.9% above Treasury yields? In other words the indexing spread between Treasuries and mortgage rates should be a variable which is adjusted based on how overheated the housing market appears to be.

  10. Some tough views:

    This is just unfair to many people who saved and put big down payment in their houses (20% or more) compared to those who went for minimal or zero down (let’s say in the same neighborhood).
    Also, so bets on housing went wrong and we have a bailout, but what about bets on stock market and 401ks, where is bailout for that?
    Anyway bailout means few crooks will again behave irresponsibly and profit from it. We are nothing but encouraging bad behavior.
    Why not just let things get corrected by its own means.
    For future, if some institution becomes too big to fail then it should be split before hand. No one company should be allowed to become too big to fail.

  11. Brad DeLong thinks this proposal can make money for the government but I’m not so sure:


  12. There is an important component of their user cost model that is wrong: The choice is between buy, thereby investing the down payment in housing market i, and renting, where an amount equal to the down payment is invested elsewhere. Given that they include only house price appreciation as part of their user cost, they are effectively assuming that renters will invest the funds needed for the down payment in an asset returning 0%. Even if they consume, rather than save, they should get a dividend yield. In other words, the opportunity cost of investing in housing is not included in their model. As this opportunity cost will likely be imperfectly correlated with house price appreciation, user costs will be understated, and estimates will be biased.

    Furthermore, regional housing markets are positively correlated, not perfectly correlated. While some markets may have returned to historic equilibrium values and are in danger of over shooting, others are still well above. Most notably, the home town of the authors, New York City (Of course, due to subsidized housing as part of their compensation package at Columbia, I doubt either has direct experience with buying here). User costs in my neighborhood imply prices at about 20 times rents, well above the historic of 12 times. Subsidizing mortgage rates simply keeps the bubble alive.

    Finally, does this apply to loan amounts above the current agency amount (625K for NY and other high-priced areas, 417K for most others)?

    In my opinion, as someone doing research in this field, the model they are using abstracts from too much to support such broad and relatively certain conclusions.

  13. My biggest concern is what does this do to banks on the other side of this crisis? If we’re anticipating several years of at least moderately high inflation and we’re going to at this time encouraging banks & people to refinance mortgages at extremely low rates, how are the banks suppose to be making money once inflation picks up? If the banks are weak now, this wouldn’t seem to be the best approach.

    Wasn’t this the same situation which started banks down the road that caused the S&L crisis (low rate mortgages fro 60’s & early 70’s going underwater as inflation accelerated)?

    I don’t have any better ideas, but it seems there is a lot of unspoken risk built around assumptions that may really be beyond our control, like how well the FED will be able to control inflation later on.

  14. To thaddeus:

    Niggling point on “the pork package of $600M-$800M” – shouldnt that be $600B-$800B?

  15. To Econ Dan:

    At least someone read my post! Thank you sir $600B-$800B stimulus package. Now we hear talk of the stimulus being more like $1T! Who knows? But more importantly, who really cares? Just be ready to adjust your portfolios. Pehaps short government bonds (symbol:TBT) and the dollar (symbol:UDB)and go long gold (symbol:GLD)and for a quick pop in the 1st quarter of 2009 go long the S&P 500 (symbol:SPY). But always remember Japan and their fiscal stimulus results. Maybe nothing can actually work to reverse what is already in motion.

    To Name:

    Calculated Risk is a great blog but their tone now appears to be somewhat fixed on: “Its bad, getting badder and “Oh, by the way, there is no solution but some well-modulated collapse.'” I don’t necessarily disagree with their analysis or their solution. Everyone is brighter than me. My point about this program, as opposed to the fiscal stimulus, is derived from an investor’s perspective. I immediately go long the S&P if it gets enacted. That’s all. I do so, not because I believe it will work, but because many other citizens will see direct benefits almost immediately. Its all about restoring confidence. I stay mostly hedged against the S&P if Barack opts for the fiscal stimulus until I see it take hold. I feel he may very well enact a big one because of political demands by the Congress. They all just love their New Year’s pork!

  16. The Hubbard-Mayer proposal is an effort at price controls and is based on the mistaken perception that the price correction in housing is over and we are about to overshoot its normal value. They justify this by doing calculations of housing affordability. But the real measure of the price of a house is (gasp!) the price of a house. Robert Shiller has an index of real U.S. historic housing prices in an excel file available here:


    Note that the index was set to 100 for the year 1890. It had a low of 65.6 in 1921 and a high of 202.8 in 2006. It currently stands at 145.2. The average over the period from 1946 to 1997 was about 111 The average over the period from 1890 to 1997 was about 100. The average from 1921 to 1942 was about 75. All of this implies we have much more deflating in the housing bubble to go and at the current rate of decrease (about 3.3% a quarter) it will take 2 years to get to the postwar average, 3 years to get to the century average and 6 years to get to the all time low. The rate of decrease will likely decrease so where ever we are going housing prices will probably fall for years. Robert Shiller was quoted in 2007 as predicting a bursting housing bubble would probably take about ten years to correct itself.

    There is also the example of Japan. Their proxy for housing prices (the urban land price index) peaked in 1990. Since then prices have fallen about 60% as of 2007 and will likely continue to fall in 2008. I can’t find the link right now to the data (web site down?) It is complied by the Japan Real Estate Institute (JREI).

    And lest you’re not convinced real estate does not appreciate in real terms ocer time consider this. Piet Eicholtz did a study of dutch real estate values in Amsterdam from 1628 through 1973. A glance at his graph of real estate prices over 350 years of data shows large variations but that the overall trend is horizontal. There is even one period from the mid 1700’s to the early 1800’s where housing prices fell for about 80 years. The link for the paper is here:


    In short I feel the Hubbard-Mayer proposal is a huge mistake.

  17. “they propose indexing mortgage rates to Treasury yields”

    You folks seem to have missed that.

  18. Thanks for all the comments. On reflection I think that the premise that housing prices have fallen “enough” is pretty questionable. In particular, the idea that certain attractive markets should appreciate 2% per year in real terms seems dubious. (Of course, housing prices have continued to fall since the paper was written, and would continue to fall until any plan was actually enacted, so maybe, by then … ?)

    Mark Sadowski’s point that real estate does not appreciate in real terms is a good one, although I think it is a bit overstated. It makes sense that Amsterdam real estate hasn’t appreciated since 1628, because Amsterdam in 1628 was the center of Europe. By contrast, I don’t think anyone would argue that real estate in Orange County has appreciated a lot in just the last 50 years. So some real estate does appreciate. But perhaps not as much as the Hubbard-Mayer proposal needs it to.

  19. Thanks for keeping my point in perspective Mr. Kwak. I only meant to ground things nationally. As a matter of fact I have been keeping track of regional real estate prices for selfish reasons. Where I live (Hockessin, Delaware) we have had only modest depreciation from peak (2-9% depending on the index).I suspect when the dust settles we will have radically different relative real estate price ratios. New York for example will still be 20% above real rates in 1997 and Detroit will be 50% below what they were. My town on the other hand will be about 45% above those values. Bully for me (and my town)!

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