Millennials, the Housing Crisis, and the Future

On August 29, 2011, in economic theory, housing, by Jon Lewis

Pinched: How the Great Recession Has Narrowed Our Futures & What We Can Do About It. Don Peck. Crown Publishers 2011, pp. 223, $22.00 While many books have been written on derivatives, the housing bubble, and regulatory policy in the wake of the financial crisis of 2008, few authors have yet sought to interpret how [...]

Pinched: How the Great Recession Has Narrowed Our Futures & What We Can Do About It. Don Peck. Crown Publishers 2011, pp. 223, $22.00

While many books have been written on derivatives, the housing bubble, and regulatory policy in the wake of the financial crisis of 2008, few authors have yet sought to interpret how the recession has impacted American culture. Pinched, a captivating and well-written analysis of how the financial crisis and the subsequent recession have already changed American society and may change the American future, is therefore a welcome addition to the growing corpus of literature on the financial crisis of 2008.

Don Peck, an editor at The Atlantic, makes the case that “[t]he crash has already shifted the course of the U.S. economy, and its continuing reverberations have changed the places we live, the work we do, our family ties, and even who we are. But the recession’s most significant and far-reaching ramifications still lie in the future.” He argues persuasively that the recession exposed “deeper economic trends” in American society, including in wealth distribution, class structure, and what he terms “the diverging fortunes of different regions, cities, and communities.” He emphasizes that the current recession is not comparable to the more recent previous downturns. “In its origins, its severity, its breadth, and its social consequences,” writes Peck, “the current period resembles only a few others in American history—the 1890s, the 1930s, and in more limited respects the 1970s.”

Peck devotes Chapter 4 of the work, “Generation R: The Changing Fortunes of America’s Youth,” to how the recession has already impacted the Millennial generation. His outlook, it should be noted, is fairly bleak. He contends that “[m]any of today’s young adults seem temperamentally unprepared for the circumstances in which they find themselves” and that “the fact that so many young adults weren’t firmly rooted in the workforce even before the crash is deeply worrying.” Although these statements might be rather alarmist, it remains the case that the recession has hit recent college graduates fairly hard; many have returned home to live with their parents. It has also impacted their political views; it should be noted that support for the Republican Party has apparently increased among white Millennials.

The Millennials will, of course, eventually grow up and will take their experiences during the past few years with them. Peck rightly notes that, “[t]he changes now taking place in Millennials’ political ideals and social attitudes will shape American politics and culture for decades.” This is the author’s most salient point, and one that can hardly be understated; indeed, as he notes, the longer the economy remains weak, the more likely it will be that the hopes and futures of many Millennials will become, in his words, “irretrievable.” An aspiring presidential candidate for 2012 would be well advised to frame his or her policy proposals in a manner that would appeal to this generation. A focus on jobs, rather than on gay marriage or vague promises of cultural renewal, would be particularly welcomed by college-educated twenty-somethings who are burdened by a weak economy, non-dischargeable student debt, and an increasingly perilous sovereign debt crisis that imperils their future prospects.

The author’s chapter on the housing crisis merits serious consideration. In Chapter 5, “Housebound: The Middle Class After the Bust,” Peck discusses how the housing bubble has negatively impacted the middle class. Not only has owning a home become a liability in many instances, also “everything they thought they were buying along with their house—good schools, a good neighborhood, the good life—is also now in question.” Of course, as Peck aptly notes, there is a distinct geographical component to the worst effects of the housing bust, with the Sunbelt cities of Orlando, Tampa, Phoenix, and Las Vegas affected the worst. In the concluding paragraph to the chapter, he states clearly what too many individuals and institutions in American society are reluctant to admit. “Houses are not magical assets; basic logic dictates that over the long haul, they simply cannot appreciate faster than the incomes of the people expected to buy them.” It is up to some politicians with courage to stress that, contrary to conventional wisdom, housing simply isn’t a good financial investment.

Although Peck qualifies his policy recommendations in Chapter 9, “A Way Forward,” with the caveat that he isn’t a policy analyst by trade, many of his observations and proposals are very much worthwhile. They are also notably refreshingly free from ideological blinders. Indeed, Peck will make no friends on the talking points-oriented Left or Right with the apt observation that “[t]ax cuts and government spending won’t fix the various structural problems that afflict the economy. Simply juicing demand won’t magically turn factory workers into nurses any faster, not will it turn laid-off high-school graduates into more-skilled college grads.” The problems facing the American economy, Peck implies, are complex.

Peck rightly notes that the size of the debt is a serious cause for concern, but notes that these concerns need to be put in their proper context and contends that “[i]n the short run, austerity, not deficit spending, would be irresponsible.” Peck is on target when he mentions that, “[w]e should embark on tax reform to broaden the tax base and close distortionary loopholes.” He also rightly notes the urgency of tackling Medicare, labeling it “the real source of our long-term budgetary problems.” He cites two possible approaches to Medicare reform: either to provide more authority to the Independent Payment Advisory Board established by the Affordable Care Act or convert Medicare into a voucher system. Although he appears somewhat agnostic as to what would be preferable, it should be noted that the latter approach would give consumers far more choice and freedom and would give power to individuals rather than to unelected bureaucrats.

Peck is most persuasive in his discussion of how to fix the housing finance system. While he rightly suggests that, in the short run, the government should get the housing market running smoothly, he noted that, in the long run, “we should reconsider whether the promotion and massive subsidization of homeownership—through mortgage-interest tax deductions and other measures—is doing the nation more harm than good.” Indeed, there is good reason to believe that the mortgage-interest tax deduction has had a distortionary impact on the housing market, causing housing prices to be artificially higher. Most significantly, the mortgage-interest deduction has not increased homeownership rates.

In conclusion, Pinched is a provocative read, rich in anecdotes and with numerous citations to recent economics scholarship. Peck admirably does not shy away from contentious issues. Although the book is not a particularly optimistic assessment of the current state of the American economy and society, it can serve as wake up call for policymakers willing to put aside tired memes and to think seriously about how deep a mess we’re all really in.

Jon Lewis (c) 2011

Housing and the American Dream

On August 21, 2011, in housing, by Jon Lewis

Regaining the Dream: How To Renew the Promise of Homeownership for America’s Working Families. Roberto G. Quercia, Allison Freeman, and Janneke Ratcliff. Brookings Institution Press, pp. 160, $19.95 Since the Great Depression, and especially since the end of the Second World War, purchasing and owning one’s home has been perceived to be part and parcel [...]

Regaining the Dream: How To Renew the Promise of Homeownership for America’s Working Families. Roberto G. Quercia, Allison Freeman, and Janneke Ratcliff. Brookings Institution Press, pp. 160, $19.95

Since the Great Depression, and especially since the end of the Second World War, purchasing and owning one’s home has been perceived to be part and parcel of the ‘American Dream.’ For decades, the federal government has instituted numerous policies, most notably via spending through the tax code, to promote homeownership rather than renting. Recent scholarship, however, has suggested that tax subsidies for housing have not been economically efficient, nor have they reduced income inequality.

Unfortunately, this has not resonated with the Obama administration. Indeed, despite the fact that federal government support for the housing sector and risky behavior by Fannie Mae played a significant part in precipitating the financial crisis of 2008, President Obama has recently signaled that he would like to see proposals for a plan that would maintain a substantial role for the federal government in the mortgage market. Indeed, it is even possible that Fannie Mae and Freddie Mac, both now in government conservatorship, could be preserved, albeit under different names and in somewhat different forms. It should likewise be noted that any attempt to downscale the federal government’s role would have to be done gradually; the federal government currently backs 95 percent of new mortgage loans.

In Regaining the Dream, Roberto G. Quercia, Allison Freeman, and Janneke Ratcliffe, all affiliated with the Center for Community Capital at the University of North Carolina-Chapel Hill, suggest that “[t]he current crisis provides an invaluable opportunity to regain the dream by expanding access to sustainable and affordable mortgages for American families.” They premise their argument on the notions that homeownership, through the build up of equity, “helps build prosperity” and that it “signals thrift and an intention to provide for one’s own needs.” In their formulation, homeownership has an important collectivist element. “Buying a home signifies a willingness to commit to something larger than oneself—a specific neighborhood or community.” Long-term, civic-minded renters in New York City would naturally contest this assertion.

The authors advocate for community reinvestment programs that allow for low-income individuals to purchase homes. In their book, the authors trace the impact of the Community Advantage Program (CAP), an initiative designed to assist low- and moderate-income individuals to purchase their own homes. CAP was established by Self-Help Ventures Fund, the home and business lending division of a North Carolina-based community development financial institution and was a program that, in the authors’ words, brought “the secondary housing market into community reinvestment lending.”

In order to maintain an adequate capital base, Self-Help obtained a fifty- million dollar grant from the Ford Foundation. “In essence, the Ford Foundation grant strengthened Self-Help’s capital base so that it could purchase affordable home loans from lenders and then work with Fannie Mae to securitize the loans, using the Ford grant as recourse against losses.” Quercia, Freeman, and Ratcliffe contrast what they perceive to be the successes of the CAP program with the failures of the subprime mortgage industry. CAP’s ability to provide sustainable homeownership for persons who otherwise would not have qualified for a mortgage “was achieved by providing borrowers with carefully underwritten, fixed-rate loans that they could afford to repay over time.” They make the claim that CAP’s success was due to “the careful matching of affordable product with borrower.” Indeed, they argue that, “it was not risky borrowers but rather mortgages with unsustainable characteristics that led to massive defaults at the onset of the crisis.”

The authors argue that CAP can provide a model for rebuilding the American housing system and that it is a model for linking the primary and secondary markets. They put forth the case that “a national credit enhancement fund could play a role like that of the Ford grant within CAP.” In cover the cost for this special insurance fund, Quercia, Freeman, and Ratcliffe contend somewhat vaguely that, because “the market is a continuum,” and because “all industry benefits from systemic stability, then all industry should contribute to achieving the same.”

Unfortunately, the authors are scant on the details of how such a mechanism would work and why private parties should be forced to subsidize an insurance fund to provide housing assistance to individuals who cannot obtain a traditional mortgage. It is somewhat disconcerting that the authors would promote CAP to be a workable national model when they admit that “[u]nder CAP, lenders offered loan-to-value ratios of 95 to 103 percent and flexible ways of considering a borrower’s credit and income” (emphasis added). If the recent housing bubble has taught us anything, it is that the short-term advantages of “flexible” methods of assessing credit are outweighed by the long-term disadvantages.

In a certain sense, the most important facet of this recent work is its title: Regaining the Dream (also, it should be noted, the title of Chapter 8). The authors clearly subscribe to the prevailing notion that promoting homeownership for lower-income individuals is desirable goal of public policy. To that extent, they advocate a larger role for government regulation as a necessary precondition for housing finance system that would allow for community reinvestment lending. “The financial market’s failure to self-regulate,” they write, “provides a strong justification for more, and more effective, government regulation.” A bolder approach to rethinking housing finance, and one that would have utilized the title, Rethinking the Dream, would have been a study that substantially broke from conventional thought and rethought the very premises underlying American dream of homeownership. Indeed, there are indicators that suggest that housing is neither a lucrative investment, nor it is a necessary precondition for good citizenship.

In conclusion, Regaining the Dream offers a model for rebuilding the housing finance system that would necessitate greater government regulation. While the goal of promoting homeownership for lower- and middle-income individuals is a noble one, it is not without cost to responsible taxpayers who can afford traditional mortgages. That fact alone should be enough to promote a national policy debate about the hidden costs of policies designed to foster homeownership.

Jon Lewis (c) 2011

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Fannie, Freddie, and the U.S. Covered Bond Act of 2011

On July 13, 2011, in Dodd-Frank, Fannie Mae and Freddie Mac, housing, moral hazard, by Jon Lewis

The American Mortgage System: Crisis and Reform.  Edited by Susan M. Wachter and Marvin M. Smith.  University of Pennsylvania Press 2011, pp.392, $49.95 There is a direct correlation between the housing bubble and the freezing up of the credit markets in 2008.   Indeed, many commentators have held the largely unregulated derivatives market – much of [...]

The American Mortgage System: Crisis and Reform.  Edited by Susan M. Wachter and Marvin M. Smith.  University of Pennsylvania Press 2011, pp.392, $49.95

There is a direct correlation between the housing bubble and the freezing up of the credit markets in 2008.   Indeed, many commentators have held the largely unregulated derivatives market – much of it based on securitized mortgages – responsible for nearly bringing down the entire financial system.  The Dodd-Frank Act has attempted to reform the derivatives market by imposing a clearing requirement on swaps.   That said, the ongoing challenge is how to reform the housing market itself so working Americans can afford to purchase homes.   A separate question, of course, is whether the federal government’s emphasis on homeownership for all (or as many as possible) during a time of exceedingly low interest rates was itself partially to blame for the financial crisis.

With housing apparently now back on President Obama’s agenda, the release of The American Mortgage System: Crisis and Reform could not have come at a more opportune time.  Edited by Susan M. Wachter, from the Wharton School and PennDesign, and Marvin M. Smith, from the Federal Reserve Bank of Philadelphia, this volume contains a collection of fifteen essays on the housing crisis, its community impact, and ways to reevaluate and to reform housing and mortgage finance.

In their Introduction, Smith and Wachter premise their argument on the notion that, in order for the United States to have a sustainable mortgage system, it is necessary to remake that system, and that redesign is indeed possible.  They call for a separation of “innovations that increased – and sustained – homeownership from those that merely increased profits and risk.”

Although they acknowledge that the current system is broken, Smith and Wachter emphatically do not want to replace long-term fixed rate mortgage with an entirely new system.  Indeed, the authors argue that “[w]ith interest rates preparing to rise and sovereign debt at nosebleed levels, consumers need the long-term, fixed-rate mortgage now more than ever.”  They note that the focus of the collection is “[h]ow to create such a system and safeguard it from recurrences of the recent catastrophe.”   Smith and Wachtel are thus more interested in reforming, rather than fundamentally restructuring, housing finance.

For readers interested in an accessible and brief introduction to Fannie Mae and Freddie Mac, Chapter 1 is worth particular consideration.  In “The Secondary Market for Housing Finance in the United States,” New York University faculty members Ingrid Gould Ellen, John Napier Tye, and Mark A. Willis, enumerate what they consider to be the strengths and weaknesses of the GSE (government-sponsored enterprise) model prior to the federal government’s putting Fannie Mae and Freddie Mac into conservatorship.

The authors are on the mark in citing the following as weaknesses: the implicit federal guarantee which made Fannie and Freddie susceptible to moral hazard; a favored regulatory status which created “a net bias toward investing in housing in the economy overall”; lack of proper oversight; duopoly power; a race to the bottom with lower underwriting standards; and their too-big-to-fail large size, which concentrated systemic risk.

It is notable that the authors point out how Fannie and Freddie’s structure created a net bias toward investment into the housing sector.   Although this is not necessarily an original point, it is nevertheless an important one.   The very existence of the GSEs (and indeed, the mortgage interest tax deduction) provides incentives for individuals to invest in housing, rather than in savings or in the money market.

Ellen, Tye, and Willis conclude with the observation that, while the GSEs should indeed be improved, “it would be a mistake to assume that simply reforming the GSEs, without making significant reforms to the private-label market would prevent another crisis.”  While technically correct, this misses the larger point; namely, that the GSEs, at least prior to their being placed into conservatorship, were very unique entities in which an implicit guarantee allowed gains to accrue to shareholders, with losses socialized and, hence, passed on to taxpayers.

In Chapter 13, “Improving U.S. Housing Finance Through Reform of Fannie Mae and Freddie Mac: A Framework for Evaluating Alternatives,” co-authors Ingrid Gould Ellen and Mark A. Willis list nine characteristics that, in their view, can be utilized to distinguish among the different approaches for reforming the secondary mortgage market: credit enhancement; regulation; securitization of non-favored products; market concentration; provision of credit to underserved markets; financing multi-family rental properties; allowing direct investments; methods of ownership; and transition issues.

The authors devote significant attention to the question of credit enhancement, which they consider “[a]rguably the most critical feature of any proposal.”  Free market advocates who would like to see the federal government exit the mortgage guarantee business entirely (something that is unlikely in the near term) would likely disagree with the authors on various points.

That said, their proposal for limiting federal guarantees to mortgage backed securities only – as opposed to corporate obligations and debt – should be given serious consideration.  They argue that “to limit moral hazard and taxpayer risk, the government should only guarantee MBS holders’ timely payment of interest and principal in the case of default rather than guaranteeing the corporate obligations of the issuer or even the underlying mortgage debt.”  Ellen and Willis should be commended for their acknowledgment of the correlation between the GSEs’ moral hazard problem and taxpayer risk.

In light of the House Financial Services Committee’s recent vote in approval of H.R. 940, the United States Covered Bond Act of 2011, perhaps the most salient aspect of Ellen and Willis’ essay is to be found in their discussion of covered bonds in their Appendix B.   They argue that covered bonds differ from mortgage-backed securities (MBS) in two ways: the covered bonds, unlike MBSs remain on a bank’s balance sheet and that bonds are usually regulated so as to be over-collateralized, with the mortgage pool exceeding the value of outstanding bonds.   Although the authors doubt the likelihood that covered bonds will replace the GSE MBS system of housing finance, they do suggest that “[I]n a more radical restructuring, the GSEs could be abolished, and the entire system could switch to covered bonds, or the GSEs could be reformed into covered bond issuers.”  This, in their view, “would seriously disrupt the housing finance system.”

Covered bonds do offer significant promise.  The Senate should take up similar legislation.  It should be noted, however, that George Soros’ proposal to eventually wind down the GSEs and to replace the current housing finance system with a Danish-style covered bond system based on the principle of balance would not be the best option for a dynamic American housing finance system.  What would be far more preferable would be to allow market forces to operate as freely as possible and to allow consumers and investors to have choices.  Indeed, as Ellen and Willis astutely note, covered bonds “could directly compete with the GSEs in the prime mortgage market.”  This may be the best option.

The goal should not be to replace the current American housing finance system with a model that has worked, until now at least, exceedingly well in a relatively geographically small and homogenous Nordic country and to expect that that model could be replicated in the United States.   Furthermore, Soros’ proposal that the GSEs should now begin to introduce securities based upon the Danish principle of balance should be rejected.  If this is to be done at all, it should be done by the private sector under a proper regulatory framework established by Congress, not by the GSEs.

In conclusion, bold thinking is needed to reform the American housing market.  Reforming the GSEs is a good idea.  Replacing them entirely and minimizing the federal government’s involvement in promoting the housing sector at the expense of other sectors of the economy, while still preserving opportunities for responsible homeownership, would be even better.  For those policymakers interested in a recent collection of essays on housing finance, The American Mortgage System: Crisis and Reform is worth ample consideration.

Jon Lewis (c) 2011

Guaranteed to Fail: Fannie Mae, Freddie Mac, and the Debacle of Mortgage Finance

On May 22, 2011, in Fannie Mae and Freddie Mac, housing, by Jon Lewis

Guaranteed To Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance. Viral V. Acharya, Matthew Richardson, Stijn Van Niewerburgh, and Lawrence J. White. Princeton University Press 2011, 222 pp. $24.95. Guaranteed To Fail is timely collaborative effort by professors at New York University’s Stern School of Business. In this academic monograph, the authors [...]

Guaranteed To Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance. Viral V. Acharya, Matthew Richardson, Stijn Van Niewerburgh, and Lawrence J. White. Princeton University Press 2011, 222 pp. $24.95.

Guaranteed To Fail is timely collaborative effort by professors at New York University’s Stern School of Business. In this academic monograph, the authors argue that, despite the fact that they contributed significantly to the financial crisis of 2007-09, “Fannie and Freddie barely register as news.” This new book is a bold, and overall successful, attempt to demonstrate the centrality of Fannie and Freddie to the recent financial crisis in which banks failed, credit markets dried up, and the federal government stepped in to bail out supposedly too-big-to-fail institutions. In Guaranteed To Fail, the authors provide ample evidence that the flawed business model of Fannie and Freddie (“they were run as the largest hedge fund on the planet”) contributed significantly to the largest economic downturn in the United States since the Great Depression.

The authors begin with a concise and understandable overview of Fannie Mae and Freddie Mac’s history and mission. They emphasize that the two GSEs (government-sponsored enterprises) had two main functions, residential mortgage securitization and residential mortgage investment. Fannie Mae’s conversion into a private company in 1968 and the Housing and Community Development Act of 1992, which gave the GSEs a mandate to expand homeownership for lower-income persons, had significant impacts on the mortgage finance market. In the authors’ view, the mission goals of the Community Development Act “essentially gave the GSEs a mandate to purchase lower-quality mortgages. These riskier mortgages received the same implicit government guarantees nevertheless.”

Indeed, the main argument of Guaranteed To Fail is that Fannie and Freddie were fundamentally flawed because they were too-big-to-fail, were incentivized to take on increasingly risky investments with implicit government guarantees, and had a business structure that privatized gains and socialized losses. Because of this, Fannie and Freddie damaged the free market system for mortgage finance. The authors emphasize that, after the deregulation of the mortgage finance market beginning in the 1980s, Fannie and Freddie benefitted from their perceived government guarantees. “But there as nothing free about these markets . . . Fannie and Freddie had a special status, which meant that the financial markets believed that there were implicit government guarantees on any debt that they issued and on the mortgage guarantees that they provided.” Politicians, the authors note, did little to mend this state of affairs. “There was no one left to restrain Fannie and Freddie, of course, other than the federal government; but in the myopic goals of boosting home ownership at all costs, each successive presidential administration turned a blind eye.” The authors, like others before them, have serious reservations about the federal government’s role in subsidizing home ownership through tax policy and low interest rates, a theme they develop in their last chapter.

If Fannie and Freddie have proved to be such a debacle, what is the most workable solution to this overarching problem? Here, the authors are blunt in their overall assessment: “nothing short of bringing the shutter down on Fannie and Freddie in the long run will suffice.” That said, after several chapters of diagnosing the problem with clarity, including a notable chapter in which they argue against the wisdom of keeping GSE securities on the Federal Reserve’s balance sheet, the authors articulate a potential solution to the ongoing problem of Fannie and Freddie. Opposed to permanent nationalization, the authors contend that they are “agnostic with respect to the complete privatization option, at least in the near term.” Instead, they offer what they term “a pragmatic middle ground” in the form of a “public-private partnership for the guarantee business” in which “the private insurance market would help to establish a market price for mortgage default risk” and wherein the government would provide capital for the remaining mortgage insurance. They propose a 25%-75% model, in which the private insurers have a 25% stake and the federal government is “a silent partner in this effort, simply providing capital for the remaining 75% of the mortgage insurance and collecting fees on the 75%, albeit using a price determined from the mortgage insurance company’s 25% stake.” They call for the establishment of a new government agency, the Government Mortgage Risk Corporation (GMRIC) that would, in their view, “be a boring government-run utility with the sole purpose of passively co-insuring the credit risk on conforming (core) mortgages.” It should be noted that the authors do not envision the private-public partnership to be viable for the nonconforming loan market.

Guaranteed to Fail is a must read for persons working on or interested in GSE reform. Although the authors could have devoted more attention to the complex and nuanced politics of housing issues in Washington, they succeeded admirably in demonstrating that politicians need to be bold and constructive in their approach to winding down the GSEs. One could easily envision a follow up monograph in which the authors devote their full attention to the wisdom of government subsidies to homeownership. In conclusion, the authors have written a useful, albeit not completely original, primer on why Fannie and Freddie failed and why the government must withdraw from the business of distorting the market for mortgage finance through implicit guarantees. Only then will the federal government’s involvement in mortgage default insurance not be guaranteed to fail.
Jon Lewis (c) 2011

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