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.