Friday, August 29, 2008

Housing and Mortgages -- Dealing with the Crisis

In a series of recent posts (on August 18, August 21, and August 27), I have discussed housing policy in the United States in the context of the current mortgage crisis, a crisis that began with the excesses in the subprime sector but that has now spread into the rest of the housing market and the financial sector as a whole. The two most recent of those posts were mostly devoted to: (1) disproving the myth that home ownership is the key to financial success for average Americans, and (2) showing that home ownership is not the only way to create safe and stable neighborhoods. Owning one's own home has become something that every politician extols, employers encourage, the tax code subsidizes, people write songs about, and just about everyone believes should be the goal of a good society. It is genuinely surprising, then, that the benefits of home ownership are so overstated and the costs so ignored.

One possible conclusion to this line of posts would be to say, "Well, now that the party is over, the best thing to do is let the chips fall where they may. To the extent that specific policies have encouraged home ownership, the best thing to do is to repeal those policies immediately. In any event, too many people are in homes that they shouldn't own; and the last thing we should do is help them stay in those homes." As I have suggested in those earlier posts, however, I do not take that view. The current post-bubble disaster in housing calls for an aggressive policy response, in an effort to minimize the number of people who will lose their homes.

This seemingly paradoxical position -- advocating policies in favor of current home owners, even though I believe that they never should have bought houses in the first place -- is based on the simple idea that policy should be based on an assessment of where we are, not where we wish we were. If we could go back in time, I (like almost everyone else) would have done things differently -- in this and in so many other areas of national policy. (Iraq, anyone?) We cannot, however, simply pretend that there is no crisis just because we know how we might have avoided it in the first place. While it is possible that the right response among the entire range of policy responses is to "let 'em rot," in this case I agree that doing nothing would turn a terrible situation into an all-out disaster.

The Home Owners in or Near Default -- The place to start is with the people who stand to lose their homes. Many of them were approved for mortgage loans that made sense (even from the lender's perspective) only if housing values continued to climb at unsustainable rates. As I argued last Monday, however, these new home owners were hardly the well-informed bargainers that classical contract theory assumes. The mortgage approval process is set up to make people believe that they can afford homes if they are approved for a mortgage. Moreover, I do not believe that people are immune to the hype that surrounds home ownership in this country (and others). To a large degree, millions of people bought homes because we collectively told them that that was the patriotic (and financially wise) thing to do. Telling them now to deal with it on their own evokes a line from the now-classic comedy "Animal House": "You f_cked up. You trusted us!!"

This does not mean, of course, that mortgage loans should simply be erased. It does suggest, though, that there is good reason to try to allow as many people as we reasonably can to stay in their homes. The consequences of default and eviction include thousands of dollars of expenses at a time when people can least afford it, destroyed credit ratings, and often destroyed marriages and personally destructive behaviors. This is not something to take lightly, even if we wish that these people had not been so eager to buy their piece of the American Dream.

Other Home Owners -- Whether or not one feels the same level of sympathy as I do about the defaulting home owners themselves, the simple fact is that the rest of us are at risk if policymakers do not smooth out this crisis. People who have done everything right -- buying a house that they could clearly afford, signing mortgage papers after diligently reading every word on every page, making payments on time and in full -- stand to lose because of what is going on around them. Most obviously, those who currently need to sell their homes because they need to move to a new job or for any other reason could easily lose everything. Given that even safe mortgages are made on 80% of the house's value, a drop of 10% in housing prices wipes out half of an owner's equity in a home. When defaulting home owners flood the market, the downward spiral takes other home owners with them. Stopping that spiral can mean the difference between an innocent home owner's being wiped out entirely or "merely" losing a huge chunk of her net worth.

Just as seriously, the external costs of widespread housing dislocation go beyond financial losses. Communities around the country find themselves looking at neighborhoods in which half the homes are suddenly empty. This causes increases in crime, as criminals find it easy to move into empty homes. (When I owned a home in Ann Arbor a few years ago as an absentee landlord, my renters moved out. I asked my insurance company to change my policy to cover the empty dwelling while I tried to sell it. I discovered that there was no insurance company that would insure -- at any price -- an empty home for more than a couple of months. The risk, even in an otherwise fully populated neighborhood, was deemed "uninsurable.") People whose only sin is living in a neighborhood where half of their neighbors defaulted find that they cannot win either way. If they try to sell, they cannot sell their homes without themselves defaulting on their mortgages. If they stay, their neighborhoods are unsafe for their families to live in.

The Economy and the Rest of Us -- Even those of us who do not live in neighborhoods that will be affected by declining home values have much to lose from the current crisis. When banks and other financial institutions fail -- even when their failures are, as is so often the case in the current instance, due to poor internal management of risks -- it affects the rest of the economy and puts the entire financial system at risk. Loans for sound investments become harder to get, equity in formerly good institutions disappears, and it becomes essential not to let things get further out of hand. In Japan, for example, a once-roaring economy was choked by a real estate collapse in the early 1990's. That country is only now recovering from almost two decades of recurrent recessions and depressed economic activity. Thankfully, U.S. policymakers have understood that we have too much at risk to let that happen here.

The exact contours of the appropriate policy response to the current mortgage crisis are well beyond what one can describe in a blog post. My point here is simply to say that even someone like me who thinks that the long-term best policy is to encourage people to be more realistic about the choice between home ownership and renting can still see the importance of an aggressive policy to keep as many people as possible in their homes right now. Ultimately, this is in everyone's best interest.

-- Posted by Neil H. Buchanan