Former Reagan administration and current Harvard economist Martin Feldstein argues that any recession begins and ends with a housing recovery.
“HOMES are the primary form of wealth for most Americans. Since the housing bubble burst in 2006, the wealth of American homeowners has fallen by some $9 trillion, or nearly 40 percent. In the 12 months ending in June, house values fell by more than $1 trillion, or 8 percent. That sharp fall in wealth means less consumer spending, leading to less business production and fewer jobs.
But for political reasons, both the Obama administration and Republican leaders in Congress have resisted the only real solution: permanently reducing the mortgage debt hanging over America.”
So far, so good. Feldstein fails however when he suggests how to reduce mortgage debt: “To halt the fall in house prices, the government should reduce mortgage principal when it exceeds 110 percent of the home value.” He estimates that the “one-time cost” to taxpayers to be about $350 billion.
Feldstein’s prescription follows from a flawed diagnosis of the problem: “House prices are falling because millions of homeowners are defaulting on their mortgages, and the sale of their foreclosed properties is driving down the prices of all homes.”
Defaults are not the cause; defaults are an effect, the further effect of which is the fall in home prices. But the cause of defaults is that house prices rose to levels unsustainable by incomes. When the bubble’s burst also popped the illusion that housing prices only go up, the market began to confront the reality that real estate values are chiefly a function of a community’s incomes. Feldstein’s prescription does nothing to realign real estate prices with incomes. In fact, removing defaults and foreclosures as a means of forcing price discovery only prolongs the mismatch between what houses costs and what wage earners can afford to pay. While Feldstein is correct that “the only real solution” is to reduce mortgage debt, permanent” debt reduction will occur only through asset write-downs, not price prop-ups.
Feldstein’s target of 110% of a home’s current value does nothing to establish a permanent floor. That’s because in far too many cases the price basis upon which the 110% level is based is still an artificially contrived number.
A simple thought experiment demonstrates why this is so. If housing prices are still artificially high, then resetting mortgages to 110% of current prices does nothing to fix this imbalance. Sure, it might allow the current homeowner to stay in his home. But it does not enable a new buyer to pay the asking price. Ultimately, the value of an occupied home has little to do with what the current occupant can afford to pay, but is based instead on what a new buyer is willing to pay for it. The willingness of new buyers to enter the market at current levels is the only thing that determines whether or not homeowners have true portability to enable them to move to areas with “better job prospects,” or if there is any real equity that banks could collateralize in exchange for loans. But if there are other areas with better job prospects, that’s likely an indication that the current home is in a neighborhood with static or declining incomes, thus naturally precipitating declining home prices in response to the net outflow of population. If, on the other hand, housing prices were not artificially high, there would definitionally be willing buyers at that price. Feldstein’s implicit argument that houses are accurately priced, yet there are no willing buyers at that price, is an economic non sequitur.
The real problem, contra Feldstein’s diagnosis, is not that mortgages exceed home values; it is that home prices still exceed what income levels can support.
If the housing debacle has an epicenter, it is surely located in California. Few places saw the housing bubble inflate further and faster than the Golden State. And due to the preponderance of jumbo loans issued there, the value of California mortgages exceeds even their already large share of the market. On top of all of this madness for over five years now has been the anonymous blogger, “Dr. Housing Bubble.” The site is a wealth of information. Reading DHB, leaves one with the unmistakable conclusion that any solution that gets in the way of letting prices be determined solely by the laws of supply and demand is ultimately a losing game. Over 90% of mortgages issued in the last three years have been underwritten by the government. FHA-backed loan, requiring only a 3.5% downpayment–barely half of the usual realtor’s fee–have increased from only 10% of the market to a quarter of the current mortgage market. Mortgage rates, pushed down by unprecedented Federal Reserve actions, are well under half of their post-war historical average of over 8%. The suspension of mark-to-market rules have allowed for the accumulation of nearly six million homes, long behind in their payments, to sit in shadow inventory without their mortgage values being written down, ready to flood the market with yet more supply in the face of already low demand. Every conceivable trick has been thrown at the problem of arresting the fall in home prices. Unfortunately, most of these attempted solutions have come at the expense of taxpayers (and to the benefit of the bankers who made bad bets). And house prices continue to fall in spite of the tricks.
Feldstein’s old boss was fond of saying that complex problems usually have simple solutions; the complexity is that the simple solution isn’t always easy. The simple solution to the housing problem is to do exactly what Feldstein says must not be done: “we should just let house prices continue to fall until they stop by themselves.” The difficulty is that millions of homeowners will default, entire communities will see further household price declines, many banks will go bankrupt, and new home construction will come to a standstill. That’s a horrible thing to accept. Unfortunately, all of those things are going to happen eventually anyway if we continue to try to prop up house prices above what new homebuyers can afford to pay. The only question that remains: do you want those things to happen now, or do you want them to happen later–after we have frittered away another $350 billion of taxpayer money we don’t have?
Reagan was also fond of another saying, “The trouble with our liberal friends is not that they are ignorant, but that they know so much that isn’t so.” I don’t think that anyone has ever considered Feldstein to be a “liberal,” but at least in this case, what Martin Feldstein knows just isn’t so.