Housing policy: Too little too late

by Sam Johnson

8 November 2011

The recently announced “HARP 2.0” re-financing plan is a prime example of the timid and altogether clueless policy responses that have characterized the past two years.

“We can’t wait for an increasingly dysfunctional Congress to do its job. Where they won’t act, I will.”

President Barrack Obama, speaking in Nevada about the ailing U.S. residential housing market (October 2011)

While these words of encouragement show a growing awareness within the ranks of U.S. policymakers of the need for a more aggressive approach to kick-starting the housing recovery, do not expect a miracle. The reality is that the Obama administration has clearly failed in its implementation of the housing recovery plan, and that the latest policy response is a classic example of too-little-too-late. The latest development- an overhaul of mortgage re-financing standards- is another dose of the timid, piecemeal policy responses that have left the U.S. residential real estate in largely the same shape that it was in some two years ago.

This is not to say that U.S. policy-makers are not fully aware of the importance of the housing market as a driver of economic recovery. Declining housing prices indubitably lead to a vicious economic cycle. As home equity evaporates, more homeowners default, foreclosures rise, and distressed asset sales proliferate, putting further downward pressure on prices. Meanwhile, declining home equity also undermines consumer confidence, leading to an erosion of capital investment and consumption. Economist Jared Bernstein estimates that with every one-dollar decrease in the value of housing, consumers reduce their aggregate expenditure by about six cents. U.S. banks are also still highly exposed to the housing loan market via their holdings of mortgage-backed securities. President and CEO of the Federal Reserve Bank of Boston, Eric Rosengren, states that “housing price declines have a disproportionate impact on economic performance and on the recovery of growth and unemployment,” given its relatively small 2.2% contribution to U.S. GDP.

A recent Fed report acknowledged that the contribution of residential investment to the economic recovery has been lackluster. Whereas in the past three recessions residential investment contributed more than 20% to GDP growth in the first year of recovery, and 10% in the second, this sector has already experienced declines, meaning that it is in a GDP-extinguishing phase.

While the muted response of the industry is in large part attributable to factors outside of the Fed and government’s control - from the political stonewalling in Congress, to the opposition of lien holders to the subordination of loans as part of re-financing plans, to the mass movement towards rentals- there is no question that the current administration has failed to institute the required measures to establish a floor on housing prices and save what economist Martin Feldstein calls, “the greatest threat to the U.S. economy.”

The recently announced “HARP 2.0” re-financing plan is a prime example of the timid and altogether clueless policy responses that have characterized the past two years. The fact remains that officials possess a rapidly deteriorating set of tools with which to kick-start the sector’s recovery.

The central idea of the recent plan is to strengthen the monetary transmission effects associated with rock-bottom interest rates. With 30-year, fixed-rate mortgages available at 4%- a historic low- there is a significant opportunity for the 28 million U.S. borrowers believed to be paying above market rates to re-finance. By doing so they can reduce their financing liabilities, free up disposable income and boost consumption expenditure. Prior to this initiative, the problem was that existing homeowners with eroding or even negative home equity and a lack of collateral were ineligible to re-finance, and thus could not experience the benefit of these savings. Under the past “Home Affordable Refinance Program,” or HARP rules, those owners who are underwater by more than 25% are disqualified from the opportunity to re-finance. The new rules will eliminate that restriction, reduces the up-front fees associated with re-financing and remove loan-to-value limits.

There are several reasons why this is a woefully inadequate and largely overdue response to the crisis at hand. For starters, this idea has been circulating through the economic ranks for some time, initially proposed by two Columbia economists as a policy measure back in early 2010. Furthermore, the general consensus is that that this is not the comprehensive, bold solution that the housing market needed; especially as a means of re-injecting the key ingredient of consumer confidence back into the sector. This speaks to the detriment of a politically divided Congress, where Obama’s administration is resigned to enacting minor piece-meal policy initiatives that can bypass Congressional approval.

It is also the latest in a series of equally inadequate policy responses to the stagnating residential housing sector in the U.S. The Fed’s recent efforts to depress long term interest rates by swapping $400 billion worth of short term debt for longer term securities- dubbed “Operation Twist”- are part of a broader effort to stimulate interest sensitive components of the economy such as capital-intensive purchases like housing. In August they also maintained a pledge to keep interest rates at the zero-bound level until 2013. These are by no means radical solutions, and as mentioned above, keeping the interest rate low only provides stimulus if prospective homeowners can legitimately re-finance at such rates. Many are saying that this plan is simply not enough, and that the economic impact is likely to be considerably smaller than the forecasted reductions in default rates and financing costs.

It remains to be seen if “HARP 2.0” will spur a new wave of re-financings, or have a similarly small effect as the original program launched in 2009. Five million homeowners were expected to re-finance as part of the initiative- only 822, 000 did so.

The laundry list of more ambitious policy alternatives are likely too radical at this point, given the implied moral hazard associated with bailing out delinquent mortgagors and the likely opposition from private sector financial institutions. These include measures to cut principal debt (As Felix Salmon of Reuters notes, if a homeowner is underwater they will remain as such even after a round of re-financing, and such measures simply stave off what is likely an inevitable default), plans to convert foreclosed REO properties to rental units to allow banks to generate income, a mechanism to speed up the resolution of delinquent mortgages, and even a proposal to fund the demolition of vacated, unmarketable homes as a means to reduce the glut of foreclosed properties.

At this rate, normalization in the residential housing markets is years away, and it will continue to be a drain on the overall resurgence of the economy during that time. The economics group of Wells Fargo estimates that new housing starts are not expected to return to the pre-crisis 1.5 million unit pace on a sustained basis until the second half of the decade, and adds that they “see little prospect that any policy action will meaningfully impact the housing outlook over the next year,” and that HARP 2.0 will have little impact on the all-important price discovery process.

Considering that Wells Fargo has been one of the most active acquirers of high-risk commercial real estate loans from failed Irish banks and other financial institutions, this is clearly a well-educated claim.

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Housing policy: Too little too late

by Sam Johnson

8 November 2011