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The President discusses housing in Albuquerque

Yesterday the President spoke about the economy at a “backyard discussion” in Albuquerque. He made some interesting comments on housing which I’m going to analyze today.

I like when the President does unscripted Q&A because I can learn how he thinks about an issue and sometimes figure out how his advisors have briefed him. This is one of those cases.

I will intersperse my observations within the President’s long comment. You might be surprised at how much I agree with the President’s remarks on this topic. I know I was.

Q: And I guess my question is, what are we doing to prevent people from losing their homes?

THE PRESIDENT: Well, the housing crisis helped to trigger the financial crisis.

I agree. There’s a difference between “trigger” and “cause.” I think trigger is right.

THE PRESIDENT: And it’s a complicated story, but essentially what happened was, banks started seeing money in peddling what looked like these very low-interest-rate mortgages, no money down. Started peddling these things to folks. A lot of people didn’t read the fine print, where they had adjustable-rate mortgages or balloon payments, and they ended up being in situations where they were in homes that they couldn’t necessarily afford.

Close but not quite. Mortgage brokers were providing much of the increased volume of new mortgages, especially adjustable rate mortgages (ARMs) to “subprime” borrowers. Some banks were on the front end of this increased volume, but to just say banks is incomplete and a bit inaccurate.

With the word “peddling” the President emphasizes the theme of unscrupulous and shady lenders taking advantage of unwitting and uneducated borrowers. This is correct in many cases but it’s far from the whole story. Your bailed-out neighbor with the home-equity-withdrawal-financed boat in his driveway is another part of the story, and he knew exactly what he was doing. I wonder if the questioner wants the government to subsidize that knowing neighbor as well as the unsuspecting lending victim. In practice a government policy cannot easily distinguish between the two.

I also wonder how much we should excuse from responsibility a borrower who “didn’t read the fine print.” If you’re borrowing several hundred thousand dollars from someone, I think you should read and make sure you understand the fine print. Similarly, I hold the view that you are primarily responsible for figuring out how much home you can afford, not your lender. Your lender has an obligation to disclose and explain the terms of the loan, to provide you with complete and accurate information, and to not deceive you. We didn’t have strong enough rules in place to require that, and we now know that was a mistake. At the same time, if the borrower has complete and accurate information, it is his responsibility to act in a financially prudent manner.

Please don’t think I’m excusing or minimizing the importance of corrupt and shady mortgage brokers and in some cases bankers – there were some really bad actors who helped create this problem.

THE PRESIDENT: The banks made a whole bunch of money on all these mortgages that were being generated. But what happened was — is that when the housing market started going down, then all these financial instruments that were built on a steady stream of payments for mortgages, they all went bust, and that helped to trigger the entire crisis.

True, but again he’s incomplete with “the banks.” Many firms and players at all points along the financial chain “made a whole bunch of money on all these mortgages that were being generated.” The banks were part of this chain, as were the mortgage brokers who initiated the loans, Fannie Mae and Freddie Mac that securitized many of them, as well as hedge funds, insurance companies, pension funds, university endowments, foreign investors, and everyone else who bought securities derived from these mortgages. Bankers are a more attractive political target than, say, pension funds or university endowments. The President’s statement is correct but incomplete, and in a politically convenient way.

The President says “when the housing market started going down … they all went bust, and that helped to trigger the entire crisis.” This isn’t quite right. Even before home prices started to decline, there were problems caused by the terms of Adjustable Rate Mortgages. Many subprime ARMs had a low fixed teaser rate for the first 2-3 years, after which the interest rate would “reset” upwards. Those borrowers who understood what they were buying hoped that their home would appreciate in value during that first 2-3 years, allowing them to refinance into a fixed rate mortgage before the interest rate reset, using the higher home value as equity to support the new mortgage. The President is therefore correct that housing prices were an important factor in the collapse in value of housing-related assets, but again it’s not the whole story. That story begins with interest rate resets in subprime ARMs.

We therefore had (1) housing problems triggered by the terms of a particular type of mortgage, and (2) housing problems caused by local housing construction bubbles bursting. (1) and (2) interacted – as subprime ARM homeowners began to default, it drove down the prices of their neighbors’ homes and amplified broader housing price declines. These two problems are interrelated, but they’re not the same problem. As an example, there were subprime ARM default problems in Michigan where there was a weak regional economy but almost no housing construction bubble.

THE PRESIDENT: So the housing issue has been at the heart of the economic crisis that we’re in right now. It is a big problem because part of what happened over the last several years is, is that we built more homes than we had families to absorb them. And what’s happened now is, is that housing values have declined around the country, in some places worse than others. In Nevada, in Arizona, they’ve been very badly hit. In New Mexico, I don’t think we had the same bubble, and so prices have not been as badly affected here. But overall across the country, housing lost a lot of value.

This part is really good: “We built more homes than we had families to absorb them.” He’s absolutely right. The problem was not just mortgages, it was the actual buildings we live in. We had a housing bubble in some markets, and we still have an oversupply of homes relative to demand. As long as supply >> demand, prices will fall. That’s why I was taught by experts to watch the inventory of unsold homes. As long as that inventory remains significantly higher than the historic average, we still have an imbalance and the housing market won’t recover.

The President also knows which housing markets saw the biggest bubbles. Kudos to his staff. The big four were California, Nevada, Arizona and Florida. I still have seen no good explanation of why these four markets were so much more extreme than others.

THE PRESIDENT: Now, this is a multitrillion-dollar market, so there’s no government program where we can just make sure that whoever is losing their home that we can just pick up the tab and make sure that they can pay. And frankly there are some people who really bought more home than they could afford, and they’d be better off renting, or they’re going to have to make adjustments in terms of their house.

This part is excellent. The President is right – the housing market is so big that we can’t bail out every homeowner who lost value. And while the President is gentle about it, I can be more direct since I’m not in campaign mode. I don’t think the government should bail out someone who bought a bigger house than they can afford, especially if they had no down payment. I think doing so is unfair to the taxpayers who finance that bailout, and unfair to responsible homeowners who didn’t borrow recklessly.

THE PRESIDENT: What we have tried to do, though, is to make sure that people who had been making their payments regularly, who are meeting their responsibilities, if they could have a little bit of an adjustment with the banks, if some of the principal was reduced, if some of the interest was reduced on their mortgage payment, they could keep on making payments. The bank would be better off than if the home was foreclosed on, obviously they’d be better off, and as the housing market starts picking back up again — which it will do over time, although not in the same trajectory as it used to, right; it’s going to be more much gradual — then potentially the bank could recoup some of the money that it had lost by making the adjustments on the mortgages.

This is correct in theory, and every reporter can find cases where this is true and makes sense. But it’s really hard to scale this up. Also, advocates for these policies often conflate their justifications – should we do this because we want to help these particular homeowners, or because we believe doing so will have broader benefits for the economy?

I feel empathy for the homeowner hoodwinked into a ARM by an unscrupulous mortgage broker. To the extent we believe that many borrowers were unfairly surprised by their interest rate resets from deceptive lenders, and to the extent we feel some governmental responsibility for that surprise / bad news, then it makes sense to help them. This is the genuinely deserving case that the media likes to show us, leading us to mistakenly conclude that everyone at risk of losing his home is a victim deserving of taxpayer help.

Depending on the numbers, I can be comfortable using some taxpayer funds to help move that person into a more affordable mortgage. But since we can’t distinguish between this deserving case and the savvy-for-profit-flipper, any subsidy program will also mean we’re subsidizing people whom we all can agree don’t deserve empathy or subsidies. This is a thorny problem to which there’s no easy answer.

Then we get to the place where I disagree not just with the President’s comment, but with much of the accepted wisdom in Washington about which homeowners we should help. Remember that a homeowner with a fixed rate mortgage doesn’t see his monthly mortgage payments change, even if the market value of his home drops so far that he is underwater on his mortgage.

Example: At the height of the housing bubble, Fred bought a $500,000 Florida home with a $475,000 fixed rate mortgage. He has been making fixed monthly mortgage payments since he moved in. Now the Florida housing bubble has collapsed.Fred has $450,000 left on his mortgage, but today he could sell his home for at most $400,000. He is “underwater” $50,000, and it will take years for him to recoup that loss.

Many in Washington want to subsidize Fred, to bail him out. Some talk about paying the lender to reduce the principal on his mortgage. Others want to force his lender to write down the value of his mortgage. But while Fred has taken an enormous paper loss, he is at zero risk of involuntarily losing his home. Since his mortgage is fixed rate, his monthly mortgage payments haven’t changed, so he’s not at risk of foreclosure. He is no worse off than his cousin George in Iowa who lost $100K investing in tech stocks back in the late 90s. In fact, Fred has an option that George did not have – if he wants he can default on his mortgage, leave the house to the bank, and take the long-term hit to his credit rating. That sucks for Fred, but that’s an option George the bad-stock-investor didn’t have.

Note also the President’s “If they could have a little bit of an adjustment with the banks” language. When you look at borrowers you can divide them into three groups: (1) those who don’t need help to stay in their home, (2) those on the bubble who cannot afford to keep their home without help, but could with just a little bit of assistance, and (3) those who would need so much help from the bank or taxpayers that it’s unreasonable to assume they can ever dig out. You don’t want to spend money on group (1), and money spent on group (3) is a waste. So you try to target your policies at just group (2). That’s hard to do.

THE PRESIDENT: So we’ve set up a number of these mortgage modification programs that are out there. But I don’t want to lie to you — we’ve probably had hundreds of thousands of people who’ve been helped by it. I think there have been a couple of million who’ve applied. But that doesn’t meet the entire need because this is such a huge housing market.

Translation: The quantitative results for these mortgage modification programs are terrible. In the President’s defense, we the Bush team didn’t have much success in this either. It’s very hard for government to effectively influence mortgage modification on a large scale. Q: If a program is directionally correct and politically useful, but ineffective and inefficient with taxpayer dollars, and if you cannot design a better alternative, do you continue it or kill it?

THE PRESIDENT: And what really is probably the most important thing I can do right now to keep people in their homes is to make sure the economy is growing so that they don’t feel job insecurity. That’s probably the thing that’s going to strengthen the housing market the most over the next couple of years. If we’ve got a growing economy, unemployment is gradually being reduced, then people are going to feel more confident; they’re going to be able to make their mortgage payments; new — homeowners, people who are potentially buyers of homes, are going to say, you know what, I don’t mind entering the market because I think things have sort of bottomed out — that starts lifting prices and that gets us on a virtuous cycle instead of a negative cycle.

Good again, but I’d add something else. The foreclosure prevention programs and other housing-related interventions are helping some people keep their homes. At the same time, these programs have the side effect of slowing down the painful but necessary adjustment in housing supply. Especially after witnessing the past three years of struggling housing policy interventions, I lean toward applying the Band-Aid philosophy. Every child knows there are two ways to pull off a Band-Aid: slow and really fast. And every child learns that really fast means less total pain, but it’s scary and difficult to do.

It would be painful in the short run and politically risky to stop intervening in housing markets and let housing prices continue to fall until the excess housing supply is finally bought by bargain hunters. But once this happens we’ll be back on a gradual upward trend. It may be better for us to get the pain out of the way as quickly as possible so the healing can begin, rather than trying to artificially “bridge the gap” with ineffective policies, in hopes that we can protect a few more tens of thousands of homeowners from losing their homes. Dozens of smart people have suggested alternative policies to avoid or mitigate further housing price declines, and there is an argument that government needs to intervene to stop a self-reinforcing downward spiral. I don’t buy this argument.

This is a harsh numbers game with no easy answers. My instinct is for government to stop trying to fix the problem and just let the darn housing market find its natural bottom. I think this means more pain now, but less total pain over time. I think the recovery will come sooner and stronger if we stop trying to patch the housing market and get the painful adjustment behind us.

THE PRESIDENT: But it’s going to take some time. We’re working our way out of overbuilding in the housing market, a lot of not very sensible financial arrangements in the housing market. And we’ve got to get back to sort of a traditional, more commonsense way of thinking about housing which is, if you want a house you got to save for a while. You got to wait until you have 20 percent down. You should go for a mortgage that you know you can afford. You’ve got to — there shouldn’t be any surprises out there, right? That kind of traditional thinking about saving and thinking about the house not as something that is always going up 20 percent every year and you’re going to flip and take out home equity loans and all that — we’ve got to have a different attitude, which reflects what you talked about, more of an attitude that this is your home. This is not just a way to make quick money.

I strongly agree with the President here. I hope he’s willing to tell Members of his party that this means they have to stop insisting that the Federal Housing Administration facilitate zero down payment loans and seller-funded down payments. All homeowners need to have some skin in the game, even if this means that some people won’t be able to afford to buy homes. Certain important Congressional Democrats are the roadblock here.

While at the beginning of his answer the President focused on unscrupulous lenders, here he focuses on the gamblers/flippers. This is a different thought process than the “Banks did it to the people” model with which he began. I think there’s some truth in both stories.

I’m impressed by the depth of the President’s understanding and his thought process. I disagree with his Administration’s policies in many cases, and that includes his housing policies, but I think he gave a good answer yesterday in this Albuquerque backyard conversation.

(photo credit: Moth)

By | 2017-05-23T19:06:22+00:00 Wednesday, 29 September 2010|