Jul272010

Eliminating Government Housing Subsidies Will Improve the Economy

Government subsidies are spending someone else’s hard earned pay. All of us who work are paying for McMansions everywhere through the home-mortgage interest deduction that subsidizes the McMansion owner’s loan. It’s time we stopped these subsidies, allowed housing prices to fall to their natural market levels, and released trapped capital currently tied up in real estate to more productive uses.housing_consumer

We Can’t Afford This House

Christopher Papagianis and Reihan Salam — July 20, 2010

Part 2 —

Admittedly, ending the subsidies would probably depress housing prices overall. Since most homebuyers base their purchase decisions on the monthly after-tax cost of housing, reducing the deduction for mortgage interest would mean that the same monthly payment would buy “less house.” For example, a 25 percent deduction for mortgage interest allows buyers with a 6 percent mortgage to spend an extra $30,000 on a house without seeing any increase in their monthly payments.

There is a much easier way to figure out how much eliminating the home-mortgage interest deduction would cause prices to drop. What is the marginal tax rate of the borrower? Assume that most buyers borrow the most they can afford on a monthly payment basis, and further assume intelligent ones have already factored in the tax savings. If you eliminate the tax savings, people will need to bring their payment down accordingly. This won’t have much effect on the lower priced homes because many of those borrowers don’t itemize, but in cities like Irvine, elimination of this deduction would cause loan balances to shrink by 25% to 40% to keep the same payment. Since about 80% of the house price is usually financed, this will lower prices 20% or more.

Similarly, an increase in down-payment requirements from the current 3.5 percent to 20 percent would mean that $20,000 of savings could be used to buy only a $100,000 house, rather than one priced at $570,000.

Increasing the down payment requirement won’t directly impact prices, but it will have a major indirect effect. For instance, trustee sale prices are 15% to 20% lower than resale prices because the down payment requirement is 100%. Very few people have the entire purchase price in cash, so the limited buyer pool makes prices much lower. The same principal holds when evaluating what would happen if down payment requirements went from 3.5% to 20%: they buyer pool would get so much smaller that bids would be lower and prices would go down, probably quite a bit. The people who can put 20% down can still borrow plenty at low interest rates, but there are fewer of these people, so the law of supply and demand suggests that prices would go down.

A general decline in housing prices would constitute a one-time wealth transfer from current homeowners to future ones — but this would be well worth it if phased in over a period of years.

That isn’t really true. A general decline in housing prices would constitute the evaporation of the illusory wealth that current home owners believe they have but really don’t. The housing bust didn’t witness a transfer of wealth, and further price declines necessary to get off the government stimulus won’t either.

In 2007 (the last year of the bubble), households’ primary residences accounted for only 31.8 percent of total family assets. While primary residences make up a larger share of the assets of lower-income than of higher-income households, housing subsidies are less significant for the former because their tax rates are lower, which makes the value of deductions smaller. Because the value of subsidies provided by the FHA and the GSEs accrues to the borrower on a per-dollar-of-debt basis, their reduction is unlikely to be felt as strongly by lower-income households. The well-off take out bigger mortgages, pay more interest, and have bigger income-tax bills against which to apply a deduction: The median house value for households in the 40th through the 59th income percentiles is just $150,000, compared with $500,000 for households in the top income decile.

According to the Office of Management and Budget (OMB), the mortgage-interest deduction is expected to cost $637 billion over the five years ending in 2015. The exclusion of capital gains on primary residences is expected to cost another $215 billion over the same five years, with the deductibility of state and local property taxes on owner-occupied homes adding $151 billion. In total, these subsidies will reduce federal revenue by well over $1 trillion over a decade during which the federal government is expected to run a $9 trillion deficit. A gradual phase-out of these subsidies is therefore not only smart economics, but a fiscal necessity.

The financial argument is difficult to ignore. We spend a great deal of money inflating house prices in places like Irvine, and we obtain no observable benefits from the investment — unless you consider Irvine Ponzis something you want to see more of.

Over the years, tax experts have also zeroed in on how some of these subsidies are distributed. Under the status quo, 80 percent of the benefits from the mortgage-interest deduction go to the top 20 percent of households in terms of income. The deduction helps only those taxpayers who itemize deductions on their tax returns, which is much more common among high earners, and the value of the subsidy rises as one moves up the tax brackets. Further, as Joseph Gyourko and Todd Sinai of the University of Pennsylvania have documented, the subsidies are unevenly concentrated, with net benefits going to only 20 percent of states and 10 percent of metropolitan areas. Not surprisingly, over 75 percent of these benefits go to three high-cost metropolitan areas: New York City–Northern New Jersey, Los Angeles–Riverside–Orange County, and San Francisco–Oakland–San Jose.

A better approach would be to provide a flat tax credit to all homebuyers. This would preserve an incentive for people to buy a home but would not provide a larger incentive for people who buy bigger homes or take on outsized debts. The size of the credit could be reduced over time. Under this sort of policy, the federal government could aid middle- and working-class homebuyers at a small fraction of the cost of the current mortgage-interest deduction.

There is a better and more politically feasible alternative that changing the home-mortgage interest deduction to a flat tax. Rather than changing anything about the deduction, it could be rendered worthless by simply raising the standard deduction.

Whenever we estimate the tax benefits for an Ideal Home Brokers client, we take their estimated marginal tax rate at tax 10% off it. Anecdotally, a those that have run simulations through their tax software report that the cost of losing the standard deduction makes the home-mortgage interest deduction significantly less effective that most assume it is. Someone in the 35% tax bracket only gets about a 25% net tax advantage.

Consider what would happen if the standard deduction were raised to $50,000. The lower-middle class would receive a substantial tax break, and the upper-middle class would see a greatly reduced benefit from itemizing. In fact, this would simplify tax preparation significantly because very few people would bother to itemize. The net effect would be to shift the tax burden from low wage earners to high wage earners, and in the process, it would render the home-mortgage interest deduction worthless.

Raising the standard deduction would be much easier politically than trying to mess with the tax code to eliminate the home-mortgage interest deduction. Most people wouldn’t even recognize how their deduction became worthless, and politicians wouldn’t be blamed.

Dismantling the GSEs is a more difficult proposition. Taxpayers have already committed roughly $150 billion to the bailout of Fannie and Freddie. The Congressional Budget Office projects that losses could balloon to $400 billion over time, while other analysts suggest the taxpayer hit could be closer to $1 trillion if default and foreclosure rates stay high. The reason these estimates vary so much is that taxpayers can expect three different kinds of losses from the GSEs:

  1. those linked to the $5 trillion of mortgage-backed securities and loan guarantees that they are responsible for;
  2. those that will continue to occur as a result of regular, ongoing operations in a declining housing market; and
  3. those that may result from their being used as de facto government agencies, subsidizing foreclosure-prevention efforts.

Fannie and Freddie function today as off-balance-sheet conduits for taxpayer spending on housing, and there is no mechanism in place to end this practice. What’s particularly disappointing is that Congress is on the verge of sending the president a sweeping financial-reform bill that doesn’t account for Fannie and Freddie, the most expensive part of the bailouts.

There is no chance of anything being done with the GSEs until the housing bust is over, and we are less than 50% of the way there. The various government props has done nothing but delay the inevitable and promote a great deal of market denial. People cannot afford their homes, and these homes — along with the loans that purchased them — must be liquidated. The liquidation process will cause staggering losses, and the GSEs are the only conduit banks have for dumping these losses on the US taxpayer. That is the only reason Congress did not address them in the financial reform package.

A lot of thoughtful proposals for reforming Fannie and Freddie have been issued over the past year. In late May, Donald Marron and Phillip Swagel of Georgetown University put forth one of the more balanced and straightforward plans. The crux of it is to make the GSE guarantees explicit rather than implicit, and to charge an appropriate fee for them. Marron-Swagel would turn Fannie and Freddie into private companies and force them to compete with other firms. These new businesses would have a narrow mission: to buy conforming mortgages and bundle them into securities that are eligible for government backing. The key is that the federal guarantee would be transparent, and offered only in exchange for the firms’ paying the government an actuarially fair price for what would amount to insurance.

This sounds like the kind of idea an academic would come up with. There is no way the government would ever charge a fair-market actuarial price for this insurance. We all know it would be subsidized at pennies of its value, and the government would be on the hook for the next massive bailout once lenders know all the risk has been shifted to them. This idea will not work.

An explicit government backstop might seem an unwarranted interference in housing markets, but recent experience suggests that it is unrealistic to believe that the government will stand aside next time.

To even suggest the GSEs have anything other than an explicit government guarantee is a joke. We tried the implicit guarantee nonsense for about 40 years, and everyone knew the government was going to step in when times got tough. Now that it actually happened, everyone in the market knows the guarantee is explicit. For anyone in the government to even suggest otherwise is a lie more transparent than most lies they tell us.

Some government backstop will always be implicit; better to make it explicit and price it. Once a price is established under the Marron-Swagel plan, the government would have the option of raising it, thereby reducing its support for the market, slowly and over time. The government could also reduce its footprint in the housing market by putting a ceiling on the size of the mortgages eligible to be packaged into government-backed securities. If the loan limit were capped in nominal terms, then future inflation and house-price increases would, over the course of several years, work to reduce the government’s presence in the marketplace.

If you really want to lower the government’s footprint, lower the conforming limit. Change the formulas. Why do we allow jumbo conforming? Why not cap all GSE and FHA loans at $417,000, and make everything else private-label jumbo loans? If you lowered the conforming limit, over time only low-income borrowers would utilize these loans. And that is why these programs were begun. We lost our way and began subsidizing mortgages of high wage earners and inflated house prices everywhere they congregate.

Likewise, other subsidies, such as the mortgage-interest deduction, can and should be gradually eliminated.

Reforming the housing sector won’t miraculously restore robust economic growth. It will, however, help stanch the bleeding of productive resources into a sector that has been distorted for decades by misguided government subsidies. And over time, that will give workers and entrepreneurs the tools they need to build a stronger and more sustainable economy.

We spend way too much money on housing in the country, and we get little in return for that investment. Think about it. What does a house produce after it is built?

When we invest in factories, the completed factory produces goods and services and employs people. When we invest in infrastructure, the new transportation system increases commerce and stimulates the economy. When we invest in housing, we get a temporary boost from the construction itself, but the house does nothing but require additional resources for upkeep. It produces nothing.

So why are we subsidizing housing?

In California we subsidize housing because our entire economy is a Ponzi Scheme dependent upon rising home values. Rising prices generates local tax revenues that keeps governments afloat, and more important than that, it provides HELOC money to all homeowners who spend this in the local economy. Without this HELOC spending, the California economy sputters, governments teeter on the brink of bankruptcy, and Ponzis everywhere suffer the loss of their borrowed existence. I don’t see things changing any time soon because we lack the understanding or the will. California seems to like its Ponzi economy. Someday it will blow up. It may already have.