10/24/2008

Housing Baliouts Simplified

By Martin Gremm

Hardly a day goes by without somebody proposing a way to fix the housing market and, by extension, the economic problems currently plaguing us. All of these plans are quite complex, but the basic housing conundrum is actually quite simple: If you buy a house, you will have to pay for it.

Before the housing bubble, most Americans would have hesitated to spend much more than two and a half times their annual earnings on a house. Then, starting after the Tech Bust of 2000, multiple Fed rate cuts lowered mortgage rates to about half of what they normally are. This encouraged people to buy more expensive houses because they could afford the monthly mortgage payments.

At first blush, this seems like a good thing. People get to enjoy bigger houses for a manageable mortgage payment. However, once mortgage rates return to normal levels, the next buyer will need to make significantly more money to afford the house unless its price declines. Even without adjustable rate mortgages and subprime borrowers, many homeowners eventually would have found themselves unable to sell their houses for what they paid for them.

We suggest that the median price of a single family home divided by the median family income (Price to Income Ratio) is a better measure of long-term housing affordability than measures that take interest rates into account. Interest rates tend to fluctuate around a long-term average. This approach ignores short term fluctuations in affordability due to the level of interest rates. By eliminating interest rates from the measure of housing affordability, we can simplify the discussion and focus on the two components that matter in the long run: house prices and family income.

From 1968 to 2000 the Price to Income Ratio has held steady between values of 2.3 to 3. During this period, the median short-term borrowing rate (the Fed Effective Rate) was 6.51%.

From 2001 to present the Price to Income Ratio increased sharply to 3.95 before falling back to about 3.3 at the end of 2007. This value is still at least 15% above historical norms, indicating that the housing market has not returned to equilibrium so far. From 2001 to September 2008, the median short-term borrowing rate was 2.5%.

The main advantage of using the Price to Income Ratio for determining housing affordability is its simplicity. It has only two moving parts: the price of a house, and the median family income. In order to bring the Price to Income Ratio back down to normal levels, one or the other will have to change.

If we want to keep housing prices high, incomes have to go up. This could be accomplished through a rise in real incomes driven by productivity gains and strong exports, but in the current environment this seems unlikely. The only other way to raise family incomes is via inflation. It will result in higher earnings in dollar terms (nominal income), but quite possibly in less buying power (real income) for families.

If incomes do not rise, housing prices must decline, which will result in more homeowners owing more on their mortgages than their house is worth. This is not a problem for homeowners who have fixed rate mortgages they can afford and who are not planning to sell their houses. However it is a problem for anyone who needs to refinance, perhaps because they have an adjustable rate mortgage, or sell their house, perhaps because they are changing jobs.

For these people, the proceeds form the sale of their house will not be sufficient to pay off their mortgage in full. They would have to make up the shortfall to sell their house. Many homeowners in this situation decide to default on their mortgage, which causes more write-downs as mortgage portfolios become increasingly impaired, and more failures or bailouts of financial institutions.

No matter what regulators decide to do, the unwinding of a bubble really doesn’t leave any room for a graceful exit. None of the enacted or proposed bailout plans can do anything to alter the reality that housing is far too expensive for the amount of money a typical family makes. Somebody will have to absorb the inevitable losses as the Price to Income Ratio returns to normal levels. Regulators and politicians can decide who will absorb these losses, but they cannot legislate them away.

Some proposals, like offering a special tax credit to home buyers, aim to prop up housing prices by encouraging more buyers to enter the market. Such policies add to the national debt which in the long-run causes inflation, for example by devaluing the dollar. Inflation may not take place immediately, but over time it is all but certain. As long as housing doesn’t participate in inflation, this process will eventually bring the Price to Income ratio back in line with historical norms as nominal incomes rise.

Since inflation affects everyone, this plan redistributes the consequences of the housing bust from the people who invested in overvalued real estate either directly or through mortgage related securities to the population as a whole.

Some proposals and enacted policies aim at shoring up banks. It is not clear that these policies address the underlying problem at all. They mostly amount to bailing out large banks and other real estate investors at the taxpayers’ expense. Such bailouts may help keep the financial system operational, but they do not directly affect housing prices. However, they again add to the federal deficit, which in the long run fuels inflation. These policies leave homeowners to absorb the decline in the value of their properties and deal with inflation down the road, while immunizing certain real estate investors from the consequences of their investment decisions.

About $4 billion of the $700 billion bailout that was signed into law in September can be used by cities and states to buy up foreclosed properties in an effort to shore up property values. This is probably the cleanest example of a policy that aims to prop up housing prices by creating direct federally funded demand. In the long-term this will either fail, in which case housing prices will continue to decline, or it will create wage inflation to make houses at elevated prices more affordable.

Policymakers have some degree of choice between letting real estate prices decline or long-term inflation accelerate, but there is no painless way out of the bubble. Price declines cause pain now; inflation causes pain in the future.

Bubbles generally only form when leverage is cheap and easily available. The Federal Reserve does not control the risk tolerance of private lenders, but they do control short-term interest rates. It would be highly desirable if they placed a greater emphasis on the long-term consequences of their policies to avoid housing and other bubbles in the future.