Another Example of the Law of Unintended Consequences
I listened to the well meaning Republican senator Mitch McConnell of Kentucky propose government mortgage lending to homeowners at below market interest rates. Like many Republicans he advocates “curing” the housing market as the way to revive the economy.
“Most people recognize that housing is at the root of the current economic downturn. So we should fix this problem before we do anything else.
“Republicans believe that one way to do that is to provide government-backed, 30-year fixed mortgages at approximately 4% to any credit-worthy borrower, reducing monthly mortgage payments and increasing demand for homes. According to this proposal, the average family would see its monthly mortgage payment drop by over $400 a month, which comes out to over $5,000 a year. Over the life of a 30-year loan, that’s a savings of over $150,000.”
The Republicans propose refinancing 80% of the mortgages in the country. By issuing 10 year notes, the Treasury can borrow money at 3% and lend at 4%. If these numbers are correct, then with 80% of home owners refinancing as they predict, the savings would amount to $160 billion per year. This, they claim would add up to a lot of stimulus to the economy. Sounds great.
This idea came originally from Chris Mayer and Glenn Hubbard of Columbia University. They claim it would stem a further 15% decline in housing prices, repair household balance sheets, and prevent further disaster to the collateralized mortgage market, including taxpayer borne losses from Fannie, Freddie, Ginnie, and the TARP bailouts of AIG and the like.
According to Mayer, “This isn’t a cost to the government. The government makes money on this,” he says, adding that this could be thought of as a “30-year tax break for 40 million households without running up the deficit.”
So, what’s the problem? In effect, they are proposing the nationalization of the US mortgage market.
There is a reason the housing market is bad
There is a reason housing prices are declining: they’re overvalued. The housing market is overbuilt. There are statistics showing that non-owner occupied homes (speculators) rose as high as 24% during the boom. This forced up home ownership statistics well beyond the norm in the US.
US Homeownership Rate
If real demand is less than home production, then demand for home ownership by speculators has no economic reality. Eventually someone has to live in them. Reality has set in: RealtyTrac reported that one-third of foreclosures are speculator owned. Calculated Risk estimates that about 3 million new units have come onto the market from conversions from ownership to rentals. As a result, rental vacancy rates have jumped.
Why should we save these people? If we do nothing these homes will find buyers, supply and demand will work itself out, and the proper amount of home owners will be determined by the market, not the politicians. If you artificially prop it up, and there’s no real demand, aren’t you just postponing the inevitable? Is our policy now that no one should suffer losses from bad investments? If we take the hit now, values will correct themselves and the economy will turn around.
What can we expect from this government run program?
What the Republicans are missing in their rosy analysis is that government run enterprise is (i) rarely efficient, (ii) potentially very risky in this case, and (iii) subject to political interference. See again, Fannie and Freddie.
It would be hard to come up with a government program that never cost taxpayers a dime. Fannie and Freddie would be a good example of this. These government-backed agencies were supposed to be self-funding and, with good lending standards, the government would never have to back up its implicit guaranty. We all know the end of that story.
This would be the biggest government program
Let’s examine the numbers.
There are about $10.610 trillion of outstanding household mortgages according to the Fed. In an interview with NPR, Chris Mayer of Columbia estimated that 80% of all mortgages in the US could be refinanced this way. This would mean that over a period of several years, the US Treasury would have to borrow another $7-8 trillion. This would make the Treasury the biggest investor of anything in the entire world. Consider that we have already borrowed $10.7 trillion to finance federal deficit, plus another $800 billion or so for the new bailout bill.
This would have serious impacts to financial markets. If this doesn’t drive up interest rates, what will? Consider also that the countries that usually lend to us are facing serious economic problems. Will they continue to lend at low rates? Would you as an investor buy US paper to finance another potential housing boom? This will negatively impact the entire financial market by driving up interest rates and it will squeeze out private borrowers from sources of capital.
Will inflation return? It will after the current deflation ends. That is, when accumulated debt is properly discounted and their underlying securitized assets valued at market prices, then the effect of the money pumping by the Fed will kick in. Right now banks are sitting on a tremendous amount of capital, much of which has been injected into the system by the Fed. Bank reserves went from $42 billion in December, 2007 to $852 billion in December, 2008. This massive injection of credit will ultimately raise interest rates.
There is substantial risk to this program
Will the Treasury be able to refinance its 10 year notes at rates below what it will have lent out to home owners? I don’t know the answer here, but I think it is a reasonable and significant risk to consider. If interest rates rise, then the 100 basis point spread between what the Treasury borrows and what it lends will be too small to protect their mortgage investments from being devalued. Currently the spread for private lenders is about 246 basis points. Is that a good investment for the taxpayer?
Politics will have a role
Will this loan program be free from political influence? If the history of Fannie and Freddie is any indicator, then the answer would be no. There would be pressure to make riskier loans which will threaten the viability of these loans. While there may be safeguards to limit refinancings to current borrowers, I would bet there will be political pressure to expand this program to include new home buyers. It would cause another boom in housing because of the cheap rates. Do we want another housing boom and inevitable bust?
This will kill the private mortgage market
And what about the private mortgage lending market? Will this discourage the formation of private capital for mortgages? How could anyone compete with the government? The capital for lending to home owners has been created for the most part by private investors. Much of it from bank deposits and much of it borrowed from the public in the form of mortgage backed securities (including Fannie and Freddie who guaranteed about one-half of the entire mortgage market).
If the Treasury refinances 80% of the mortgage market, private mortgage capital formation will practically disappear.
This will, in essence, nationalize the entire mortgage market.
Great. Another Republican advocating more federal gov’t intervention. Housing prices need to fall because they’re too expensive now. Savings have been wiped out by the financial crisis, so there is less money for downpayments now. People don’t have jobs. There are countless underwater mortgages now that can’t get refinancing. Even this proposed intervention would not help as long as this situation exists.
Can you explain how interest rates would rise if the Federal gov’t. has a lot more debt, but would also rise if the banks have a lot more capital? Shouldn’t more capital = lower rates?
Good question, Zach. What happens is that creating more credit (i.e., printing more money) eventually leads to higher interest rates. As money is devalued (inflation), which is what happens in when you print more money than people want, lenders understand that what they lend today will be paid back in devalued dollars in the future. They want more of a return on investment to offset this risk of renting money because dollars are going to buy less in the future. The longer the term of the loan, the higher the rate.
The government will have to compete for capital in the market with other borrowers to fund their programs. With all the debt they have, they will have to offer greater returns to lenders, who may or may not be the Chinese, Japanese, Canadians, and Americans.
We got into a serious inflation in the ’70s because the Fed under Arthur Burns kept creating more credit (money). I was developing a real estate project in 1979 and had construction interest rate bills of almost 22%. There were plenty of dollars, but they were being devalued all the time. Volker came in with Reagan and stopped it and rates came way down.
I remember 1979 well, too. A friend of mine bought a car. The interest on the auto loan was 18% and she thought she had gotten a good deal on that loan.
I guess what’s most scary is our national sense of “solution”. It doesn’t seem to differ much between left and right. Both are advocating huge fixes instead of dramatic backing off.
This is a very ambitious move from the Republicans obviously it will never come to play because the people at the top who govern mortgages are paid a lot of money and crazy bonus schemes (which may have some blame to take for the crisis we find ourselves in.) but the fact is these people are very good at their job and most would not work for a smaller wage. So it would leave more incompetent people in charge of a huge market.