Thursday, June 12, 2008

The Dirt on Housing

The public and politicians alike have cast accusatory aspersions on a myriad of people, groups, and companies for the current state of the housing market. In an attempt to add to the noise, let’s examine some of the primary factors that have fueled the boom and precipitated the bust in housing.

The Federal Reserve

Home of the celebrated Alan Greenspan and his replacement Ben Bernanke, the Federal Reserve has probably done more to precipitate the boom and bust in housing than any other source. Their actions provided the raw fuel – easy money – that their coconspirators needed to set the wheels in motion. As the economy strengthened following the recession of the early 1990s, the Fed raised rates to a range of 5-6% for much of the decade. The technology boom was creating vast “wealth” and Greenspan was warning of “irrational exuberance”. Following the inevitable collapse of the tech bubble, the Fed attempted to mitigate the impact on the economy by cutting rates aggressively to 1%. Thus, the housing boom was born.

Figure 1 – Fed Funds Target Rate (Source: Bloomberg)

Banks & Mortgage Brokers

The rapid decline in short term rates instigated by Fed policy led to a significant steepening in the yield curve thereby increasing the appeal of adjustable rate mortgages. The availability of very low introductory rate mortgages greatly reduced perceived monthly costs of owning a home and led to a dramatic spike in home price appreciation. Financial market innovation enabled a boom in the mortgage brokerage industry as small shops could sell their pipeline of loans to investment banks to be pooled and securitized. These smaller shops operated with very little capital, minimal regulation, and had limited reputational risk resulting in a higher incidence of churning and abusive sales practices.

As the mortgage sales network expanded, banks developed new securitized products that further reallocated risks and enabled banks to reap huge rewards. The subprime loan market burgeoned as banks were convinced they could slice and dice risk with surgical precision, accommodating sales of complex instruments to investors at premium prices. This house of cards was based on the borrowers’ ability to readily refinance their loans and continue to extract equity against the appreciation in their homes. Ultimately, the strong HPA led to low realized credit losses which further supported the marketing of securitized products. Additionally, the rapid home price appreciation veiled any association between down payments and credit losses in the minds of lenders, bond rating agencies, and investors allowing home owners to borrow at incredibly low levels of equity. These borrowers were effectively renters with a call option on home prices.

Figure 2: Home Price Appreciation Year over Year (Source: Bloomberg)

Government Incentives

Government incentives for home ownership significantly influence home prices and exacerbated the excessive rise in home prices. The tax deductibility of interest alone leads to significant market distortions by encouraging borrowing against home equity, which is directly correlated with the current foreclosure rates. By enabling borrowers to use their home as collateral with tax advantaged treatment, the government has promoted excessive consumption by reducing the after tax cost of funds for spending on purchases that were often depreciable assets unrelated to housing (e.g. cars, electronics, vacations, etc). As home prices began to decline, many borrowers were quickly under water on their mortgages and had strong incentives to default on their loans.

The exemption of capital gains on a primary residence also induced greater investment and speculation in housing. After two years, the government enables home owners to extract up to $250,000 in capital gains for singles (twice as much if you are married) tax free. Targeted tax credits and deductions like this lead to significant market distortions as people began view their house as a leveraged tax favored investment which, at the time, seemed more favorable than conventional investments.

TV and the Media

It is no secret that the media looks to dramatize and sensationalize the mundane for the sake of ratings. The vast coverage of the housing boom combined with an overwhelming replication of “Flip This House” and other home design television shows made it fashionable to deplete your home equity loan at Lowe’s in an attempt to replicate the abode recently seen on HGTV. While the home improvement stores experienced dramatic earnings growth, Americans were exhausting the equity in their home while increasing their debt burden. Clearly homeowners resisted obvious indications, either due to naiveté or self-denial, which suggested that the rate of home price appreciation could not persist indefinitely.


Congress, despite its complicity in creating the current housing “crisis”, is quick to cast blame upon unscrupulous mortgage lenders, greedy investment bankers, and a dearth of regulation. The solution, however, is not further intervention by Congress through additional market distorting tax credits or an expansion of government agencies that transfer the credit risk from private investors to the public. Increasing Fannie Mae and Freddie Mac’s loan limits and instituting new mandates for the Federal Housing Authority (FHA) places at risk public funds that will be required to cover the inevitable defaults. Fannie and Freddie’s extremely low capital levels and current credit losses should dictate a contraction of their mortgage portfolio instead of greater credit guarantees.

Ultimately, the market will absorb the losses efficiently and home prices will adjust to market clearing levels without government intervention. In fact, further government intervention will likely forestall the necessary adjustments and only lead to more pain and losses in the future. Let us not forget that a previous attempt to bailout the technology bubble ultimately resulted in boom-and-bust in the housing market. Alas, the politicos cannot resist “coming to the aid” of the struggling home owner, especially in an election year. Be prepared for the inevitable destruction that is sure to ensue.