Feb032012

More proposals to fix the housing market

There is a consensus that something needs to be done to fix the US Housing market. Of course, this consensus opinion is wrong, but everyone seems to have their pet idea on what form of market manipulation will produce a desired outcome — ostensibly to reflate the housing bubble.

I argue the pundits are trying to solve a problem that doesn’t exist. Sure banks, loan owners and true owners of real estate want to see prices stablize and go up because they want money. For them the current state of the housing market is a problem, but is it really something the rest of us should pay for though tax subsidies or higher real estate prices when it’s our turn to buy a home?

If house prices were lower, household debt would be lower, and the typical US consumer would have more money to spend and stimulate the economy. Low house prices are not a societal problem that must be fixed. Low house prices are a huge benefit that must be embraced.

3 Ideas to Fix the U.S. Housing Markets

John K. McIlwain — Feb 01, 2012

What Needs to Be Done to Revive the Markets?

1. Renting federally held REO.

The Fed’s white paper’s major recommendation is for Fannie Mae, Freddie Mac, and the Federal Housing Administration to develop a program that sells or transfers large blocks of foreclosed homes (real estate owned, or REO) to investors to hold and rent until housing markets stabilize. There are now over 250,000 such homes, a number expected to grow to a million or more in the months ahead.

The Federal Housing Finance Agency (FHFA) began considering such a program last August when it issued a request for information (RFI) (see McIlwain, Should the Administration Rent Its Growing Inventory of Foreclosed Homes?Urban Land, August 2011). It received more than 4,000 responses to the RFI, and the FHFA has said, somewhat obscurely, that it is now “proceeding prudently but with a sense of urgency to lay the groundwork for the development of good initial pilot transactions.”

I can tell you this is going to happen. I can’t reveal much more, but I can assure you it will be news this year that private equity firms will buy bulk portfolios of REO from major banks, the FHA and the GSEs.

I have long maintained this problem is best tackled by making it easier for individual investors to mop up this mess rather than giving sweetheart deals to crony corporations. Having done more research on this subject recently, I still believe the government should be focusing more attention on helping small investors, but the volume of REO is so large private equity deals are necessary to adequately absorb the inventory. There simply aren’t enough small investors to buy all these properties. And the activities of private equity groups won’t be crowding out the small investor. The scale of this problem is far too large.

Renting large blocks of homes is not without challenges as the Fed notes, but the alternative is to let them sit vacant or to dump them on an already soft market. The challenges noted by the Fed include:

  • Putting together portfolios of homes close enough geographically to be managed economically;
  • Finding a price to attract bulk buyers, but not offering a fire sale; and
  • Creating a source of financing for bulk sales.

Those problems are not the obstacles many have made it out to be.

The Fed, however, fails to address two fundamental issues. One is ensuring that homes sold in bulk do not create slums, and that large absentee landlords invest in proper maintenance. Without proper oversight and incentives, this program could create new suburban ghettos just as absentee landlords have done far too often in inner-city neighborhoods.

No matter who owns these properties, if they are not owner occupied, the landlords may not maintain them properly. Whether properties are sold piecemeal or in bulk, the same potential problem exists. Further, the idea that owner occupants care more for their homes than landlords care about the upkeep of their investments is not a given. I have profiled many run-down properties where the owner was a Ponzi who milked the property for money without improving it.

The second issue is the required holding period. Normally, investors want to turn their funds quickly to increase their internal rate of return (IRR). On the other hand, a program like this should be designed to keep these homes off the market until housing markets have fully stabilized, which could take years. How this tension is resolved will determine both the program’s success in stabilizing markets and the price that investors may be willing to pay for large blocks of REO.

This author is obviously not a finance guy. Turning the money quickly is not the only way to generate returns. Many properties make excellent cashflow investments. In fact, in the models I have seen, two-thirds of the returns during the holding period comes from cashflow, and the remaining one-third comes from appreciation. In the real world, bulk portfolio deals will get bid up to prices were quick flips don’t work.

2. Creating a mortgage interest credit.

The most powerful – and controversial – thing that Congress could do to stimulate the housing market would be to adopt a proposal along the lines of one offered by President George W. Bush’s 2005 Advisory Panel on Federal Tax Reform. This proposal would:

  • “Replace the deduction for mortgage interest with a Home Credit available to all taxpayers equal to 15 percent of interest paid on a principal residence.
  • “Establish the amount of mortgage interest eligible for the Home Credit based on average regional housing costs.
  • “Lengthen the time a taxpayer must own and use a principal residence before gains from the sale of the home can be exempt from tax.” (Page 73)

A housing credit along these lines would provide an incentive for the 82 million members of generation Y to become homeowners. Today, the benefits of the mortgage interest deduction are targeted almost exclusively to those with incomes above $100,000, far more than most in generation Y will earn for years.

First, I think this idea is dumb because it merely substitutes one market subsidy for another. All market subsidies should be removed, and prices should be allowed to stabilize where supply and demand meet. Second, this idea will be strongly opposed by high wage earners who currently enjoy the home-mortgage interest deduction. And third, by shifting the subsidy down the housing ladder, prices at the low end will go up, and prices at the mid to high end will drop with the shifting subsidy. Perhaps it is better public policy to support low-end housing, but once prices establish a new equilibrium, prices won’t be any more affordable for the buyers the program targets because buyers will bid up prices based on the subsidy.

3. Divide mortgages for underwater homeowners to a paying first and a delayed second.

Underwater homeowners are at high risk of strategically defaulting on their current mortgages. Instead of waiting for this, Fannie Mae, Freddie Mac, and the FHA can create programs that would split the mortgage of an underwater homeowner into a first mortgage that pays currently, and a deferred, nonpaying second mortgage. The new first would be in an amount no more than 80 to 90 percent of the value of the home. The second mortgage would be payable only upon sale of the property and only from some percentage of the net sales proceeds in excess of the first and any costs, say 50 percent. The homeowner would be allowed to refinance the first mortgage once, but only to reduce the interest rate to take advantage of today’s low rates.

Whether these three are the best solution for the housing crisis or not, the real point is that it is past time to take action at a level far beyond anything yet considered in Washington.  Resolving the housing crisis is central to restoring the U.S. economy, as Chairman Ben Bernanke noted in his cover letter to the Fed’s white paper, a position supported by a growing number of leading economists of all stripes. Without action at this scale, housing will drag on the economy and damage the lives of millions of more Americans for years to come.

Reprinted with permission from Urban Land, the online publication of the Urban Land Institute; copyright 2011 by the Urban Land Institute.

This idea is another version of a zero coupon bond I discredited back in 2007 in How Homedebtors Could Avoid Foreclosure.

As much as it pains me to write this, there is a short to medium term solution to the foreclosure problem: convert part of the mortgage to a zero coupon bond. For those of you not steeped in finance, a zero coupon bond is a bond which does not make periodic interest payments. Think of it a zero amortization loan. You don’t pay either the interest or the principal, and both accumulate for the life of the loan. The loan would be due upon the sale of the house.

Here is how it would work for our typical homedebtor: Assume our financial genius utilized 100% financing and took out a $500,000 interest-only mortgage with a 2% teaser rate that is due to adjust to 6%. Let’s further assume his real income (not what he reported on his liar loan) could support a $1,500 payment on a $250,000 conventional 30-year mortgage at 6%. The bank could convert $250,000 to a conventional mortgage, and convert the other $250,000 to a zero coupon bond at 6% due on sale. The homedebtor can now make their payment, and they get to keep their house. But here is the catch: when they sell their house, they will owe the bank a lot of money. If they sell the house in 20 years, they will owe $800,000 on the zero coupon bond note. In other words, all the equity gain on the value of the home will go to the bank.

This would solve a multitude of problems: First, it would provide a mechanism whereby people who were victims of predatory lending could keep their homes. This would make the homedebtor happy, and it would get government regulators out of the bank’s business. Second, it would make the banks more money in the long run because they are still making their interest profit even if they don’t see it until the homedebtor sells the home (many may not be aware of it, but lenders book income on the increase in principal on a negative amortization loan). Third, since foreclosures would be the primary mechanism facilitating the crash, it would keep home prices from crashing by reducing the number of foreclosures.

There are many problems which would result from implementing a zero coupon note solution, but the biggest of these will be pissed of loan owners who realize when they sell their homes that the bank ended up with all the appreciation. Go back and read the old post for a more detailed examination of the pratfalls of the zero coupon idea.

There is a reason nobody has been able to come up with a good “fix” for the housing market. It’s not broken. There are no problems with the housing market and the economy that aren’t taken care of by foreclosures and lower house prices.