Propping up the American Dream: Housing Reform Proposals Are on the Rise

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Consider these numbers: The median home sales price is at its highest for the season since the housing bubble burst, up 8% since this time last year; the supply of existing homes is half of what it was just three years ago, and home builders are breaking ground again, with 17% more new homes sold last year than in 2012.

Alongside these encouraging signs, a mix of lobbyists, think tanks and Congressional committees have been urging the adoption of key housing policy changes.

Last month, for example, the Senate Banking Committee introduced a bill to replace Fannie Mae and Freddie Mac with the Federal Mortgage Insurance Corp. At the end of March, Rep. Maxine Waters, Democrat from California, introduced a bill that would replace the public/private hybrids with a co-op of private lenders.

And while this Congressional session has not yet produced a bill to get rid of the mortgage interest deduction, think tanks from both sides of the aisle have been calling for some major reforms. Last month, the conservative R Street Institute released a study arguing that the deduction only benefits the rich. This was followed by an editorial from the Urban Institute calling for an end to the deduction, noting that it does not promote homeownership.

Whether or how these changes will occur is still in question, but most everyone agrees that they would have a notable impact on the housing market. “It could be a catastrophe,” says Wharton real estate professor Fernando Ferreira. “The market is extremely fragile, and an increase in interest rates or a reduction of available credit would decrease the [number] of loans. And if homeowners enjoy less of a tax break, it means less demand for housing.”

The New Normal

While home sales numbers are up since the darkest days of the housing market crash five years ago, and some analysts have even used the term “resurgence” to describe the current state of the industry, other experts warn that the sector is still fragile. Wharton real estate professor Susan Wachter points out that while housing prices are generally up, many other indicators of the health of the market are down. “The new normal is not the old normal,” Wachter says.

“The market is improving, but it is improving unevenly.” Todd Sinai

For instance, in March 2014, 354,000 existing homes were sold, down nearly 8.5% from the previous year and the lowest level since July 2012, according to the National Association of Realtors. And while the number of new home sales has steadily climbed year over year, the supply of new homes on the market rose last year to a 5.1 months supply, compared to 4.5 months in 2013, the National Association of Home Builders reported. Additionally, four million homes returned to positive equity in 2013, real estate aggregator CoreLogic said, but there were still 6.5 million homes — 13.3% of all residential properties with mortgages — underwater.

Though the housing market is improving in some areas, it varies widely based on geography. For example, nearly 30% of houses in Florida are still underwater, compared with just 5% of houses in Texas, CoreLogic reported. “The market is improving, but it is improving unevenly,” notes Wharton real estate professor Todd Sinai. “With every degree of improvement, it varies from quarter to quarter, from city to city and even from neighborhood to neighborhood.”

The key metric to watch when gauging housing market strength, says Jack Guttentag, Wharton professor emeritus of finance, is the number of homes in foreclosure. As of January 2014, that number stood at 794,000 homes, according to CoreLogic, with thousands more being added each month. “I would not expect a really strong market to emerge until the backlog of foreclosed homes, millions of which are now being rented pending sale, is absorbed by buyers,” Guttentag states.

An Era without Fannie and Freddie

While the housing market has been slowly improving, Fannie Mae and Freddie Mac have been languishing in federal conservatorship ever since the market crashed. And whether it is due to political motivation, a true desire to help struggling homeowners or just plain embarrassment, most everyone agrees that this private/public structure must go.

“The changes have been Draconian, and any underwriter’s discretion is being squeezed out of the system. A lot of good loans are not being made.”  –Jack Guttentag

Under the bi-partisan Senate Banking Committee proposal, the Federal Mortgage Insurance Corp. would regulate all participants in the mortgage-backed security creation process and would also insure securities, kicking in once private guarantors had assumed 10% of the loss. On the other hand, the Waters bill would create a co-op of lenders that would be the sole issuer of mortgage-backed securities, and the government guarantee would kick in only after the private lenders assumed 5% of the loss.

The main result if either of these two bills goes into effect would be an increase in private involvement in the housing market and decreased government subsidies, thus causing interest rates to go up. However, with a cautious wind-down, Sinai says he expects the rate to go up by only 30 basis points. “An interest rate change does effect a wiliness to pay, but not by much,” he adds.

Yet Guttentag is concerned about the lending process tightening up even more under these two proposals, noting that all the new regulations have already made the loan process extremely stringent. “The changes have been Draconian, and any underwriter’s discretion is being squeezed out of the system. A lot of good loans are not being made,” he notes.

As an alternative, Guttentag suggests that lawmakers look at a structure which has been adopted and done well in Denmark. Under this model, mortgage banks would do all the work in the mortgage-backed security process — originating, aggregating and guaranteeing all their loans. Guttentag says this model would evolve into a “robust” secondary market, encourage the development of new mortgage banks and eventually get the government out of the picture altogether. “With this approach, lenders take their own risk and use their own discretion,” he adds.

Still, with no support from interest groups or Congress, the Danish model is far from becoming a reality in the United States. And few people expect that the two proposals being floated in Congress will gain much momentum.

A Benefit for the Wealthy?

In the meantime, interest groups and economists have stepped up their call to get rid of — or at least cap — the mortgage interest deduction. The argument for its end is that the deduction only benefits wealthier homeowners. Unlike most of the tax code, the mortgage interest deduction is regressive, in that the more income someone has, the larger the tax break. And to get the benefit, a taxpayer would have to itemize his or her deductions, something done mostly by those with higher incomes because others find that the standard deduction is greater than their itemized tally.

“The question really is, should we provide more incentives for homeownership or more incentives for renters? The answer is not clear.” –Fernando Ferreira

“The mortgage interest deduction is a really ineffectual policy if the goal is to get people who would otherwise not buy houses to buy a house,” says Sinai. “What it does quite well is to get those people who are already planning to buy houses to spend more money on them.”

Consequently, if the government were to end or cap this deduction, the effect — a smaller tax refund for those homeowners who do take advantage of it and a reluctance to pay as much for housing as a result — would be felt primarily by higher income households. Sinai says while an exact number is hard to predict, he thinks that when housing prices are on the rise – like they are now — prices would simply grow at a slower rate in wealthier coastal cities where there is little room to build.

Elsewhere, he notes, there would be little effect because new housing starts would equalize things. But if the deduction were to be cut while housing prices are falling – as happened a few years ago — Sinai says a drop in home prices would be felt everywhere, as much as 10% in some urban areas. Therefore, he suggests now might be as good a time as any to amend the mortgage interest deduction.

For the 6.5 million people still underwater with their mortgages, however, slower growth or even a slight drop in home prices may just be enough to send them over the edge, says Wachter. “We still have a foreclosure problem, and a downward shift in housing prices would make homeowners even more vulnerable.”

On the other hand, Ferreira points to the 40% of Americans who rent and are being unfairly treated because of the mortgage interest deduction. Getting rid of the deduction would simply equalize the housing market, he says, adding that homeownership is not necessarily something the government should encourage, especially in the tax code. “The question really is, should we provide more incentives for homeownership or more incentives for renters?” he says. “The answer is not clear.”

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Join The Discussion

3 Comments So Far

Steven Andersen

The question of incentives ignores the substantial percentage of investor-owned homes, particularly in high-cost areas such as the San Francisco Bay Area and the greater Los Angeles Area. Eliminating the mortgage interest deduction on non owner-occupied homes would reduce incentives for investors and maintain incentives for renters to buy homes.

David Loring

Perhaps the government should not continue to encourage economically unqualified people to own homes thru zero or low percentage equity payments(they then have no “investment” in the pr0perty) or the banks to renegotiate loans (interest rate and principle reductions) with borrowers who have not paid their loans in several years (and seem to be proud of it).

VENKATESH VILAPAKAM

In countries like India home ownership requires the owner to put about 20% of the loan amount upfront thus tying the buyer with the property. Hence the defaults have been significantly low considering that in India we do not have sophisticated credit score rating agencies as yet. It is this indiscriminate disbursal of credit with zero down payment that resulted in the bubble and housing market collapse. When the buyer could not pay he just defaulted and left the property with the banks holding the sack!!! Housing reforms must be accompanied with credit reforms too. Also the tax incentives tend to distort the purpose of home ownership and move into the realm of property as an investment vehicle which must be discouraged.