Category Archives: Housing and housing finance

The 30-year Fixed-rate Mortgage

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From my essay on mortgage interest-rate risk:

Interest-rate risk migrates toward those financial institutions that enjoy the highest level of perceived government protection with the least effective form of regulation. The perceived government protection enables them to serve as reliable counterparties to households and firms seeking risk protection. The relatively less stringent regulation leads the risk-bearing institutions to reap gains when interest rates are relatively stable, without having to hold sufficient capital to survive a major shock.

…Suppose that regulators actually succeed in locating all of the bearers of interest-rate risk and holding them to strict capital standards. I believe that the consequence of this will be that the interest rate on 30-year fixed-rate mortgages will rise significantly relative to mortgage instruments where rates are fixed for a shorter period.

Underwriting Waivers

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Garett Jones read an obscure audit report from the Federal Housing Finance Agency, the regulator of Freddie Mac and Fannie Mae. The report says,

During the housing boom, Fannie Mae issued a substantial number of variances – reaching over 11,000 in 2005. Many of these variances increased credit risk and effectively relaxed underwriting standards. For example, from 2005 to 2008, Fannie Mae granted variances that included many higher-risk features, such as loans made with unverified income or assets, or little or no down payment…loans Fannie Mae purchased during this period were characterized, on average, by higher LTV ratios and lower borrower credit scores than those the Enterprise acquired from 2009 to September 2011.

As I read it, each variance could result in many loans. That is, a variance (at Freddie Mac we called them waivers) is an agreement with a lender to accept a certain number or fraction of loans (sometimes waivers allow for an unlimited number of loans, but that is rare) with characteristics that violate a provision in the standard guidelines. It could be something trivial (like using a bank statement record of automated pay deposits instead of an actual pay stub as documentation for income) or something major, like allowing 110 percent LTV (loan-to-value) on a cash-out refinance (this probably did not happen). So I am not sure that the number of variances is always going to be a reliable indicator of credit quality. But in this case, it probably does tell us something.

The 1920s as a Housing Bubble?

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Stephen Gjerstad and Vernon L. Smith (GS) take that view.

Most notably, housing expanded rapidly by nearly 60% from 1922 to 1925, leveling out in 1926 and then began its long descent, not bottoming out until 1933. In 1929 new housing expenditure had returned to its 1922 level before any of the remaining expenditure categories had declined more than small temporary amounts…the 60% increase in the rate of new home construction expenditures from 1922-1925 was matched by a 200% increase (from $1B to $3B) in the net flow rate of mortgage credit.

This sound similar to the more recent episode. That is, much of the decline in housing construction was already behind us when the bottom dropped out of the rest of the economy. GS point out that the credit boom in the late 1920s did not raise house prices as it did more recently, because (they argue) in the 1920s the housing supply was more elastic.

Edward Leamer, in Macroeconomic Patterns and Stories, shows that spending on housing and consumer durables generates much of the variation in GDP growth relative to trend. However, in the typical recession, as GS also note, the decline in housing construction coincides more closely with and accounts for a larger share of the decline in GDP. Continue reading →

Re-defaults

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The blogger at Sober Look writes,

This is telling us that mortgage modification programs have not been very successful, as the probability of re-default rises. By modifying mortgages, banks in many cases are simply kicking the can down the road – and now some are writing down these mortgages (which may be what is driving the higher charge-off numbers). We are therefore seeing an increase in delinquencies, but mostly among modified mortgages and concentrated in sub-prime portfolios.

It actually helps to have some experience in the mortgage business. Unlike Joseph Stiglitz, Martin Feldstein, Glenn Hubbard, and others who have written op-eds and influenced policy makers, I actually know something about the track record of giving delinquent borrowers a “break” by modifying their mortgages. What lenders have found is that, even in good times, loan modifications just set borrowers up to fail again. Maybe in the confines of your faculty office you can design a program that should work in theory. But in the real world, we observe failure in practice.

Home Ownership and Wealth

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According to Edward Wolff,

median wealth plummeted over the years 2007 to 2010, and by 2010 was at its lowest level since 1969.

I see this as a result of the policy of encouraging the middle class to take a highly levered position in housing. I had just been looking at an earlier paper by Wolff, which looked at the wealth data through 2007. In that paper, if you looked at the middle 60 percent of the wealth distribution, the gross value of their homes accounted for 65 percent of their wealth (because of mortgage debt, their net equity in homes was less than 40 percent of their wealth).

In my opinion, households would be better off if their savings were in diversified asset portfolios, including shares in funds that invest in stocks and real estate. Instead of making a mortgage payment, you should use that money for a combination of paying rent and saving in a diversified portfolio.

I think that the main reason that debt-financed home purchases are the standard savings channel for most households is that it is a mechanism for pre-commitment. Most households will not have the discipline to put money into savings every month. Moreover, of those that have the discipline, many will shy away from higher-yielding assets because of loss aversion. Taking on a mortgage is a way of pre-committing to sinking money into a risky investment (housing is indeed risky in real terms, even though nominal house prices typically rise), rather than spending the money or putting it into low-yielding safe assets.

If public policy wants to take a paternalistic approach to incent savings, we should be looking to create pre-commitment mechanisms that encourage people to set aside money that they invest in diversified mutual funds, rather than highly levered investments in their homes. Of course, such a policy would have to run the formidable gauntlet of the housing lobby.

Note that I would be rather uncomfortable with the idea that the government should take on this paternalistic role at a time when it is engaged in such heavy deficit spending. Politicians would be saying to households, in effect, “Save more so that we can do the spending.”

Other Recent Essays of Mine

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Reforming the Housing Transaction offers suggested improvements in the real estate process.

Who Needs Home Ownership? suggests that the social benefits of home onwership are overstated.

How to Think About QE3 gives an “on the one hand, on the other” analysis.

Subjective Value and Government Intervention looks at how the Austrian economics focus on subjective value tends to bias one against government intervention. Conversely, justification for government intervention often seems to require an expert to calculate value objectively, and this is problematic.

Libertarians and Group Norms points out that libertarians may not have a simple way to respond to the fact that people display group loyalty.

Housing Usually has a Positive Nominal Return

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Thomas Alexander Stephens and Jean-Robert Tyran write,

When viewed in nominal rather than real terms, the capital gains from US housing look more appealing. From 1946 to 2012, nominal house prices showed a 12-fold increase. On an annual basis, housing investments have mostly resulted in gaining money (in 58 out of 66 years), while at the same time producing real losses more often than not (in 36 v 30 years)

Thanks to Mark Thoma for the pointer.