A better fix for housing

December 3, 2008

Trillions have been spent to prop up the banks, but little has been done to address the other side of the problem: home prices keep falling and foreclosures climbing.  Obama is right to keep bringing this up.  The crisis must be attacked from both sides.

Paulson has introduced some programs, to be sure, but the money allocated is a drop in the bucket compared to bank bailouts.  Much more was spent just saving Citi in one day than on all the homeowner help programs so far.

However the issue is not just one of funding.  All programs put in place or proposed so far (even Sheila Bair’s) miss the point entirely because they deal with a symptom (foreclosures) rather than the cause (falling home prices). Today we hear Treasury may start a new plan to reduce new mortgage rates, which is encouraging, although costly, and just like previous ones, difficult and slow to implement.

My thesis is simple: The market is broken because buyers are on the sidelines, as they expect prices to keep falling and are clearly waiting for a bottom.  Speculators and even most borrowers with aggressive ARMs have already defaulted (and learned their lesson).  Most foreclosures nowadays stem first from owners being underwater and simply giving up, and second from those in dire financial straits (due to sickness, job loss, etc.) who aren’t able to sell their house and move to a more affordable one (or rent).  Both of these affected groups will grow as prices continue to decline.

Some say homes are now undervalued.  No one knows where the bottom is, but one thing is for sure, unless we take proactive action we are going to overshoot on the way down just as badly as we did on the way up.

Clearly the fall in prices must be contained at some point.  I think the time is now.

Here is a proposal to do just that which has minimal upfront cost (potentially no costs at all), can be implemented quickly, gives no preferential treatment to anyone, and carries no moral hazards:

Have the US government guarantee primary home purchases against loss of value as long as the buyer lives in it for four years.  If after 4 years the home is sold for 10-30% less than purchase price the government will cover 50% of the loss.  66% if over 30%.  Participating home buyers pay an additional 0.5% over mortgage rate (Price Protection Fee) to participate, which pays for program costs and builds fund to cover at least some of the potential guarantee payouts.  Buyer can opt out of guarantee at any time and stop paying PPF, but contributions are non-refundable.

This plan would:

– Reduce risk and inject confidence in the market so people on the sidelines waiting for a bottom are much more likely to jump in, increasing demand and helping prices stabilize.

– No approval process, so it can be implemented by lenders in a matter of days.  A simple ‘checkbox’ while applying for loan will do.

– If prices stabilize no claims will be made and taxpayers will make money.

– If they don’t it is still helpful as banks include the government guarantee in their books when valuing the notes, reducing pressure on their balance sheets.  Also, any costs due to payouts over contributions will be deferred and incurred over time (most participants won’t sell exactly after 4 years).

– Program can be ended abruptly as soon as prices level-off, or if it fails to stabilize prices in a timely manner, to minimize further loss exposure to the Treasury.

– Simple limits such as 1 million maximum property value, and one property guarantee per person or married couple (no corporations, foreigners or trusts) will minimize speculation and abuse.

– None of the moral hazard involved with direct foreclosure prevention, i.e. if my neighbor gets reduced rate due to hardship I will apply to program as well (and lie on application if necessary) even if I don’t need it because who doesn’t like a lower rate!

– Everyone is eligible automatically, so no preferential treatment.

UPDATE 12/13/08:  A reader correctly points out the potential for fraud.  I address it here.

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9 Responses to “A better fix for housing”

  1. chacha Says:

    You know who this is. I blog under this pseudonym. I guess I am outing myself to you guys. Don’t blow my cover. Ha! Now you get to read my crap as well.

    Anyway. Conservatives would call this socialism. I think it could work. And it should be retroactive. There are lots of people like us who are upside-down after buying with almost 20% down. We are 50K upside down and we put down 12% when we bought. We were very responsible buyers. If one of us (or both) lost our job and it took too long to find another, we could be just another statistic in the long line of prime mortgage foreclosures.

    So, yes. Something needs to be done on the consumer side because we control the demand for homes and, ultimately, the home values.

  2. I'll think one up later Says:

    My thesis is even more simple. The market is not broken. Buyers waiting on the sidelines for a bottom is exactly what buyers are supposed to do. The more the government messes with the market the longer they’ll sit waiting for another program to petter out. It is the slowness of the decline that’s the biggest risk to the economy. The money sits unproductively longer, the upside-downers are curtailing their discretionary spending to pay the mortgage longer. Foreclosures may not be fun psychologically, but it actually results in better living standards as renting is much cheaper than the outsized mortgage payments. While the new buyers will find their payments on the greatly reduced principle possibly cheaper than the rent they were paying. Who gets screwed the most in this payment deflation are the banks and bond holders. Which is their fault for not pricing the risks correctly. The market has a natural bottom: as soon as it becomes cheaper to buy than to rent, demand will skyrocket. The level has already been reached in some markets, that’s why November sales almost doubled in some California areas compared with last year. That said, would our hero’s loss mitigation spur sales before that bottom is reached or to a greater degree? According to his own thesis, no. If the buyers are sitting on the sidelines waiting for a bottom they are not doing that to loose money in 4 years. They are going to wait until they are sure they’ll make money in 4 years. This might nudge people with changing circumstances, like a new baby (wonder who might that be?), but is there enough of them to move the market? I doubt it. Plus it creates such a fertile ground for fraud. Instead of selling his place for 300k L sells it to M for 260k, collects 20k compensation from the government and another 30k kickback from M. L got 310k, M got the place for 290k, and me, Khaim the taxpayer, is stuck with 20k bill.
    As for Chacha’s idea of making it retroactive, I’m all for it. As long as I can buy a place, ‘retroactively’, at 1998 prices. Or, better yet, buy last week’s lottery ticket. There a few lucky numbers I’d like to try. The ‘responsible’ buyer argument is not an argument at all. It’s like someone complaining about losses on ’00 Yahoo stock. “It’s not like I bought some Pets.com crap, I invested in a legitimate company!” Just because something has value, doesn’t mean it’s properly valued at the moment. Nobody made you buy the house when you did, you could have waited. Even with the pooches, you could have rented one, but you didn’t. Now I’m realistic and there’s no way to stop the bailout nation. So when the One starts raining money upon the plebes I hope as much of it goes to the slightly neurotic thirty somethings as possible. In the meantime, I’ll do what I do best and wait on my bottom. I mean the real estate bottom as I see it.

  3. maristi Says:

    I’ll-think-one-up, there are several problems with the market-heal-thyself approach:

    First, a continued fall in asset prices wouldn’t just take out banks and bond holders. It would affect insurance companies, hedge funds, endowments and many corporations that have CDSs and other derivatives in their books. For those that don’t go bankrupt altogether their weakened balance sheets would make it harder to get credit, and any income would be used to offset investment losses instead of for expansion or R&D. Just like Japan in the 90s, except worse given the size of our problem (50 trillion in derivatives some estimate, though noone knows exactly).

    Second, prolonged home price deflation would most certainly lead to general price deflation. Deflation is terrible because it makes it hard to pay one’s debt, compounding the problem above, and because it renders most of the Fed’s market control instruments useless.

    Third, current rent prices can’t be used as the equilibrium point because they will start falling soon as well. Why? Because in a protracted depression with 10% unemployment or more people will change their living habits out of necessity, just like they changed their driving habits under $100+ oil: College graduates will move back with parents, singles will room four to a house, retirees will go to Mexico instead of Florida, empty-nesters will rent out rooms, wealthier individuals will sell their second homes, etc. etc. This will lower demand for housing in general (not just owner-occupied).

    Ultimately you have to ask yourself what is the objective: Is it to return the market to some sort of arbitrary price equilibrium, even if it means millions unemployed and global negative growth and unrest for a decade? Or is it to get investment dollars flowing, companies earning and people employed, soon? For me it’s the latter.

    As a renter I’m with you: the lower the price the easier I can buy a house soon. But I’m more concerned about keeping my job and having my company continue to sell and not fail.

    Lastly, perhaps you misunderstood my plan. Of course if would spur demand. The whole point of it is to create a bottom, right now, at current prices. It does so because it guarantees prices for buyers. So those waiting on the sidelines could start investing now.

    Oh and good point about fraud. I’m updating the post with a change to address that.

  4. Still haven't thought of one Says:

    See, here’s where this polemic breaks down. You say further housing price declines will result in a depression/deflation cycle which erode any inherent bottoms and innate values by completely altering life style choices and thus removing points of reference used to make current economic calculation. I say the economic downturn, while greater than last time would be more on par with what happened in the early 80s rather than 30s and it’s just fashionable for everyone to panic right now just like 3 years ago everyone kept saying that the ‘changing economic fundamentals’ will keep the boom going for another 10 years. Neither of us have anything to back our opinions. If we were distinguished economists so often dragged on various news shows we would be throwing around fancy terms and numbers, but still be just as full of shit, because nobody really knows what will happen. That’s why it is my philosophy to do nothing until you’re at least somewhat certain about what’s going on. Clearly, our gov’t disagrees. I will never be proven right. Cannot be. When the guy in charge of TARP was told that his programs are a fraud and 350 billion didn’t make a slightest difference, he replied that if he didn’t do what he did things would be much worse. The only thing that can disprove that statement is a time machine. You will hear that excuse given for every gov’t program that will be enacted and have no or negative effects. “Things would have been much worse if not for ___”. Anyways, what happens is beyond my influence. I’ll do my best to take advantage of whatever market conditions/gov’t programs come up for it appears that the mark of a successful individual in this country has become the ability to take out more dollars in gov’t services/programs than he/she paid in taxes 😉


  5. Interesting plan. If I understand it right the federal government will provide insurance for home buyers. The obvious challenge is that it breaks with the insurance model. Either nobody will be collecting or everybody will, which makes no sense for a normal insurance company. (AIG ended up in that situation.) (This also touches on one of my complaints about “Health insurance”, but that’s a different story.)

    The federal government is not a normal insurance company. If housing prices continue to go down, the government will have to intervene with some sort of stimulus package anyway, so maybe the insurance approach is a good approach.

    Will it work? We still ask the buyer to accept 34%-50% of the potential loss. The buyers we target will still consider the proposition a gamble. The target buyer puts his or her future on the line anyway, so they will only do it if they truly believe in the value will go up. Making the proposition more appealing would be good, but pretty soon we end up giving all the money to the reckless lender anyway. Let me explain after a quick detour.

    Another federal insurance scheme that works well is the deposit insurance (FDIC). It protects the account holder if the bank goes under. The situation here is almost the opposite of the FDIC use case. The guarantee helps the lender by not allowing the homeowner to go under. In other words we will encourage banks to be reckless in their lending practices again.

    Another effect of this proposal seems to be that the government is arbitrarily setting the floor for housing prices. It only makes sense if the housing market is indeed undervalued. Some experts claim the market should stabilize 30% down from today’s levels. (Give/take all the local variations of course.) Assuming that is true this proposal may not much other than subsidize a few home buyers that are buying in the near future. It could be considered unfair by those buying next year or last year.

    In conclusion I’m not convinced this would be a good plan, but it still might be the best plan.

    • maristi Says:

      No question about it, what I am proposing is specifically to call a bottom artificially. I think that is exactly what is needed, because otherwise a) we will most definitely overshoot on the way down, and b) a continuing depression would move that ‘natural bottom’ down because even rents would go down.
      As far as whether buyers will take the gamble, I think most buyers are not sure that they will lose, or sure they will gain. They just don’t know, so if they can have any confidence that the downside exposure is much lower (while the upside is the same), it changes the equation.
      All we need is a spark. If a small portion of the buyers on the sidelines jump in prices will stabilize. Most buyers are not looking for another bull market, they just don’t want to be underwater the minute they move in.


  6. Stability is the 30 year fixed mortgage. Falling home prices is a symptom of an over leveraged housing market. To fix the cause the prices need to go down.

    By setting a bottom we (a) make it easier for some people to avoid foreclosure, which is fair. I wonder what percentage of mortgages we’re talking about here. (b) It may artificially prop up the value for all homeowners, which is unfair.

    This makes sense if we’re already overshooting on the way down, but if we’re not… Will the problems outweigh the benefits? I don’t know.


  7. […] prices must be stabilized, one way or another.  I hope the rest of the TARP is used this way to a large extent. Posted by maristi […]


  8. […] I suspected, rents are going down, same as home prices, although at a slower […]


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