Rob Sama Grand Plan – The Housing Crisis

Rob Sama Grand PlanThe housing crisis is the proximate cause of our capital crisis, and while I believe that altering our tax policies will have a more immediate effect on bringing us out of that crisis, we do need to address the proximate causes of the housing crisis if we are to avoid re-inflating the housing bubble.

Back in November I wrote a longish essay detailing the causes of the housing crisis. You should go (re)read the essay to get yourself oriented. But we should briefly enumerate the causes here just to review anyway:

  • Local NIMBY attitudes towards building.
  • Mortgage interest income tax credit.
  • Community Reinvestment Act with its resultant relaxation of lending standards.
  • Implicit government guarantees of mortgage backed securities put out by Government Sponsored Entities (GSEs) Fannie Mae and Freddie Mac.
  • Non-recourse nature of home mortgages.
  • Mark-to-market accounting on performing loans that are not intended to be sold.
  • An apparent inability to unwind existing Collateralized Debt Obligations.
  • Absurdly low interest rates.

Not all of these elements need to be resolved in order to fix the housing mess, but a number of them do. And we certainly would be better off if we addressed all of the relevant issues. So let’s break this up into two sections: necessary fixes and optional fixes. And I’ll wrap up with some final comments and policy changes which would help accelerate our road to recovery.

Eliminate the Home Mortgage Interest Tax Deduction:

I already covered the general motivation for eliminating all income tax credits and deductions in the tax plank part of the Grand Plan. But I do want to debunk the general motivation for this particular deduction, as it is the driving factor behind so much of our government policy today regarding housing.

The impetus seems to be that it always a good thing for a person to own his own home, that owners have a greater stake in society than renters, and that it is therefore better to have a society made up of home owners over home renters.

The problem with this of course is that it isn’t necessarily true. Germany seems to have a good model set up where people are both renters and good citizens, and of course, there’s nothing to stop an owner from being neglectful about his properties or otherwise being anti-social.

And there are distinct problems with home ownership, which should be enumerated:

  1. Home ownership decreases a homeowner’s liquidity. Homes are difficult and time-consuming to sell, and therefore difficult to liquidate in a crunch. Consider that in normal times the inflation rate is 2.5% or so (which is rate at which your house should appreciate) and broker commissions are 5%. Therefore it will take you 2+ years of living in a house just to be able to cover the cash outlay on your real estate commission. That’s a long time to wait to get your money out of an investment, not to mention one that is likely to be larger than all your other investments combined.
  2. Homes are expensive to own, and therefore create a lopsided investment portfolio for the home owner. Home owners find it difficult to diversify their investments when owning a home tends to take up over 3x the owner’s annual earnings. This runs contrary to every theory of portfolio management, which tells investors to diversify, or to “not put all their eggs in one basket”.
  3. Home ownership limits an individual’s or family’s ability to move. This has two proximate effects: first they cannot quickly respond to changes in the labor market by moving to where labor is most needed; second they become sitting ducks for abuse and excessive taxation heaped upon them by their government. It takes an extraordinary amount of governmental abuse to motivate one to incur the 5% broker costs of selling one’s house and leave town.
  4. The poor and the young especially need to be mobile. Poor people and young people, often one in the same demographic, are the ones who most need to be mobile because they are the least likely to have savings. Moreover, they are the group who would most like to be mobile because nobody wants to settle down in a slum or a run-down neighborhood if they can avoid it. Some neighborhoods are meant to be renter’s neighborhoods, and there’s nothing wrong with that. Those occupants should save up and put money down to live in a nice neighborhood when they’re ready, rather than be encouraged to

The mortgage interest tax credit amounts to a tax on those who rent their homes, and renters are people who need to be mobile, are not yet settled with their lives, or are living in neighborhoods in which they do not wish to set roots. Look at it on a surcharge on those people rather than a credit for homeowners, because that’s what it is. Taxing renters for being renters is regressive and encourages people who on their own would not logically enter into a long-term commitment to do so when it would not otherwise make economic sense for them to so do on their own.

Moreover, giving people a credit on their income taxes for their home encourages them to purchase the largest home they can possibly afford, in order to maximize their credit. This leads to all sorts of market distortions, including the rise of so-called McMansions. But it also encourages taxpayers to have extremely lopsided portfolios, putting as much as they can into the home in order to get that guaranteed tax credit, rather than diversify into different investments. This is a risky strategy, and can leave people in a lurch should the real estate market take a turn for the worst, as it recently has.

So get rid of the deduction. It introduces bad market distortions, punishes the poor and renters. There’s nothing wrong with renters, so stop punishing them.

Break up Fannie Mae and Freddie Mac. Fully privatize them.

Any entity two big to fail should be broken up by means of an antitrust lawsuit. That should be axiomatic. But Fannie Mae and Freddie Mac are problematic for reasons other than just being large.

Fannie Mae and Freddie Mac are what’s called Government Sponsored Entities (GSEs). That means these entities were formed by the government and can be taken back over by the government at any time. They are highly influenced by the Federal Government, and Fannie Mae in particular seems to have become a dumping ground for ex-Democrat politicians who are looking to manage social policy and collect an obnoxiously huge paycheck.

As a consequence of their tight relationship with the government, investors viewed Fannie and Freddie backed securities as coming with a guarantee from the Federal Government. This meant that Fannie and Freddie could engage in risky behavior, including outrageous accounting scandals that would have brought down any private company, and still have no trouble selling their securities to the open market. That fact alone created an inherent disfunction, but when congress started directing Fannie and Freddie to purchase the riskiest of mortgages and securitize them to be floated on the open market, that took the disfunction to a whole new level. Now the Federal Government, that’s you and me and the rest of the taxpaying public, was on the hook for the riskiest mortgages on the market. That’s systemic risk on a massive level.

The simple solution here is to divest the Federal Government from any involvement or say over Fannie and Freddie, and to break the two entities up into bite sized pieces, small enough to be owned by private equity firms. That way seasoned managers can weed out the political corruption inherent in these firms, adjust their risk profile to one that makes economic sense (as opposed to political sense to the likes of Barney Frank) and restore a healthy market in mortgage backed securities.

Repeal the Community Reinvestment Act.

Assuming there ever was a need for such a thing, those days are long gone. Financial institutions are more than willing to do business in poorer areas of town, and make mortgages where they make sense. What doesn’t make sense is telling banks to alter their individual risk profiles, or to relax their lending standards below what makes sense to them.

And yet, the current insanity continues. Witness:

East Bridgewater Savings Bank has stood out from the current swirl of chaos in the banking industry. While other banks have been failing, this bank, with $135 million in assets, has not a single delinquent loan or foreclosure on its books. It is not just breaking even, it is making profits.

The bank’s secret to success? The Boston Business Journal reports that it has only made loans to credit worthy borrowers. Shocking strategy, right?

So how have government regulators responded? They penalized the bank with a “need to improve” rating under the Community Reinvestment Act. Out of five possible scores, that is the second worst rating. “There are no apparent financial or legal impediments that would limit the bank’s ability to help meet the credit needs of its assessment area,” the FDIC claimed in evaluating the bank.

Utter foolishness. So our government is going to spend its time punishing healthy banks for making the right decisions and avoiding an irrational mania during the housing boom. If that isn’t considered wrong-headed policy than I don’t know what is.

Repeal the Community Reinvestment Act and leave the healthy banks to grow.

Eliminate Mark To Market Accounting.

This has largely already happened, so I’m not going to spend too much time on it. But basically, the rule made banks state their loan assets on their books at the value that that asset would gain if sold on the open market today. This works fine if the market is functioning properly, but it doesn’t work in a panic. In order to establish a market price, one needs a willing buyer and a willing seller. Mark to Market in essence voids that logic, and says in a world where there is no willing buyer, what’s the highest price one could get? In effect, it makes banks value their assets at firesale prices.

In any event, this has largely been taken care of. I have no issue with disclosing what such a firesale price would be, but surely marking down performing loans to their market value as opposed to the value of their discounted cash flows is needlessly conservative, and throws banks’ covenant and compliance ratios all out of whack for no good reason. While Mark to Market is not the cause of the crisis, it threw fuel on the fire, which was completely unnecessary. Best to leave the rule repealed.

Interest Rates

Currency issues will be dealt with in greater depth in another plank of the Grand Plan. But suffice it to say the Federal Reserve has done a lousy job managing our currency. They repeatedly fuel rapid growth (booms) by means of artificially lowering interest rates, and then when they believe things are getting out of control, they raise interest rates causing a crash (bust). To get us out of the crash, they lower interest rates again, and the boom bust cycle continues. Read a detailed account of this process here.

Today, the Fed has lowered interest rates again, this time to absurdly low levels. Look for this to fuel another boom, this time I predict in green energy. And then look for it to collapse again. Suffice it to say that I believe interest rates need to rise immediately, and that a long term structural change needs to be made in our currency system in order to get out of these boom/bust cycles once and for all.

Unwind The Mortgage Backed Securities

So the mortgage backed securities are toxic, and have been valued at near zero in many cases, precisely because nobody knows what is in any one bundle of securities. It would seem axiomatic then, to unwind these securities and find out exactly what is in each one. Doing this will have a number of positive effects:

  • Homes can be foreclosed upon more readily: This one is simple. If you can see that there are non-performing loans in your portfolio, and there are real, valuable properties backing those homes, then you have a real motivation to get those homes foreclosed upon and resold so as to get a cash return on the non-performing loan. Today, too many homes are languishing unsold or unattended to because the mortgage owner is unclear that he owns the property. Unwinding the MBS takes care of this problem.
  • Performing loans can be identified and valued properly: This is the flipside of the point above. performing loans are likely undervalued in today’s environment, and identifying them within the bundled security will allow them to be properly valued.
  • Fraudulent securities can be discovered and removed from the system: There is a fair amount of evidence that many holders of mortgage backed Securities were naked short sold them, i.e. they were sold securities that has no loans or mortgages backing them up. This is fraudulent, and those lonas need to be identified and removed from the system, and the parties who issued those loans need to be prosecuted. I’ll have much more to say on this topic in the financial regulation portion of the Grand Plan.

The commonality here is that the bundling of mortgages into Mortgage Backed Securities has hindered proper price discovery, and caused something of a panic in the marketplace. When prices cannot be discovered, people bail, and that is exactly what has happened here. The sooner prices can be discovered, the better off everybody will be.

Once prices are discovered, home owners should be given an opportunity to refinance their homes at the lower principle by buying back their mortgage on the open market. Particularly if the Fed is the current holder of the mortgage. Doing this will enable people to get themselves out from under water, and will recapitalize the banking system. it should be a win win for everybody involved.

Optional items.

There are a few items here that are optional. They’re methods that other countries employ in their home mortgage systems, that we may want to consider in our own:

  • The Australian System: In Australia, mortgages are not non-recourse, meaning that you can not incur a mortgage and just walk away from the mortgage and hand the house back to the bank. If the house value is less than the amount you owe on the mortgage, you are still on the hook for the remainder. The benefit of this system is that it encourages the borrower to consider the true home value of the home and the risks that they can pay off the mortgage before taking out the loan.

    The other thing they do in Australia is they do not offer 30 year mortgages. Rather, they offer only 5 year mortgages with balloon payments at the end. If you want to take 30 years to buy your home, you refinance 6 times. The benefit to doing that is that it encourages the home buyer to buy less home and stay within his means in order to avoid repeated refinancing costs, and it represents less risk for the bank, making them more able to hold onto the loan themselves, rather than floating it on the open market in a Mortgage Backed Security.

  • The Danish System: The Danish system securitizes mortgages and floats them as bonds as they do in the United States, but with a key difference. In the Danish system, the homeowner can always buy back their mortgage on the open market should it be trading at a discount, and present it back to the originating bank as a means of retiring principle. The benefit here is that instead of motivating the homeowner to walk away if the home value declines, the homeowner instead is motivated to buy back his mortgage at a discount, and retire or refinance it, thus avoiding the current problem of massive amounts of foreclosures. The Danish system has been in effect for over 200 years and has worked well, so it may be worth considering.

There are some problems which are strictly regional as well. Local NIMBY attitudes towards building can cause the cost of housing to reach astronomical heights. There’s not much that can be done on a federal level about that, other than perhaps suing local municipalities for unjust takings, perhaps.

And in some areas housing supply got WAY overbuilt. The problem with an oversupply is that is causes the price of housing to crash, which with non-recourse mortgages encourages people to abandon their mortgages, which in turn causes a cascade of failures. But there are also social problems with built but empty houses, namely they become occupied by drifters or they become crack dens. So Something needs to be done.

Holman Jenkins of the Wall Street Journal has suggested literally bulldozing these excess houses down. This would reduce the supply of houses, and increase the prices of existing houses, while eliminating the existence of empty houses that can become occupied by squatters. On the flip side, I’ve seen it suggested that we fast track immigration visas of anyone willing to buy and live in homes in these overbuilt areas, particularly inland California, Arizona, Nevada and Florida. This would make especial sense were we to fast-track highly educated immigrants this way, so that they use their education here and built businesses and the economy here rather than in the country of their origin. Given a choice, I would prefer the fast track to citizenship approach, but regardless, even bulldozing will be better than nothing.

* * *

Returning some sanity to the housing market will free up capital used in housing towards more productive ventures and enable proper price discovery so that bankers and investors are no longer afraid to invest. In total, my proposals will reduce the overall cost of housing, without encouraging those who should be renting from buying houses they cannot afford or otherwise should not be locked into, all while removing systemic risk from the system. The losers will be the construction industry and those who bought homes they could not afford, but they were bound to lose sooner or later anyway. But the biggest losers will be the GSEs and their politician masters. And again, they deserve to lose.

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