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Cleaning Up the Housing Mess Is Key to Growth
I’ve been at the Milken Institute’s annual global conference this week, and plan to file several blogs on certain subjects that were raised in panel discussion or in the hallways. This first entry deals with the continued depression in the U.S. housing market. Several factors, including falling prices, a large unsold inventory of foreclosed homes (with more on the way), and roughly 25% of homes “underwater” — meaning mortgage balances exceed the value of the home — continue to act like a wet blanket on consumers and thus the broader U.S. economy. There is broad agreement, or it so it seems to me, that U.S. growth will not noticeably exceed its potential of 2% to 2.5% annually — and thus significantly reduce unemployment — until and unless something is done about the housing mess. The Milken panel — which included former HUD Secretary Henry Cisneros, mortgage securities pioneer Lew Ranieri, Senator Bob Corker, and former Bush Treasury official Phil Swagel — agreed on several things. First, although Congress is unlikely to take any major housing-related action this year, regulators (especially the new Consumer Financial Protection Bureau) are continuing to write rules relating to mortgage products. Several of the conference participants worried this may discourage future mortgage lending. Second, securitization needs to be continued in some form. Third, when Fannie and Freddie are eventually reformed there is likely to be some role for the government in housing finance, although private investors will be required to take the first loss. Finally, the mortgage-interest deduction needs to be trimmed, through some combination of income limits, making it inapplicable to second homes, or capping it and other deductions as a percentage of adjusted gross income (as suggested in the Simpson-Bowles deficit reduction package). However, the panel agreed that nothing is likely to happen on the mortgage-interest deduction issue unless it is part of a comprehensive tax-reform and budget package. The remaining big question that the panel was not asked to discuss but which I continue to wrestle with is: What, if anything, should be done to shrink/eliminate the housing wet blanket on the economy? On this, there appear to be two broad schools of thought (which, again, were not discussed on the panel). One approach is to let the housing market find its bottom, quickly, without further government support programs (of which there have been roughly 15 since the crisis began, which the Milken panel said had worked modestly well, but have been limited in scope). The notion behind this option is that government intervention creates uncertainty about the bottom, reducing the willingness of buyers to buy or builders to build. The sooner the bottom is reached, the sooner the recovery — in housing prices and construction — can begin. This is the lesson of taught by the Resolution Trust Corporation in the 1990s, which sold vast amounts of distressed commercial real-estate properties quickly, allowing the market to clear and then rebound. I have an uneasy feeling about this approach for several related reasons. First, the current housing crisis is much worse than the commercial real-estate bust in the 1990s, and is therefore much harder to deal with. Second, since housing is the most important asset for most consumers, and consumer spending accounts for roughly two thirds of GDP, any policy that is likely to send housing prices down even further, and more quickly, runs a great danger of shattering consumer confidence just when it has picked up, threatening a continuation of the weak recovery. If the economy falls back into recession, or even if growth slows significantly, then that will aggravate the decline in house prices and strengthen the vicious downward cycle that is keeping the economy from rebounding. The alternative option is for the government somehow to facilitate the writedown by lenders of the principal amounts of underwater mortgages in return for the banks and/or the government (if it is providing funds to lenders) taking an equity stake in the borrower’s house. In effect, this is what bankruptcy courts do for the debt of distressed companies — convert some or all of a class or debt to equity. It is amazing to me that this model has not been widely used for homeowner debt, at least on a voluntary basis (that is, homeowners who are underwater could opt in to having their principal reduced if they agreed to give up some equity, but not be forced into doing this). I understand some of the limitations that have prevented this outcome, most important the fact that most mortgages now are securitized and thus ownership of mortgage debt is split into many owners rather than held by a single lender, a bank, or a thrift institution. In addition, if the government were to provide funds to encourage writedowns of the first mortgage, how would second mortgagors be treated? I confess to being not sufficiently expert to answer these questions. I hope there are readers out there who have ideas of how to overcome them. My gut instinct tells me that equitizing much mortgage debt is a far better approach to getting out of the housing mess than waiting for more foreclosed homes to be dumped on the market, driving prices down and making the “bottom” in housing prices an even more remote event.
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