Response to “First, Let’s Stabilize Home Prices”

With respect to the WSJ article titled “First, Let’s Stabilize Home Prices” (10/2/08), Messrs Hubbard and Mayer identify the forces destabilizing the credit markets as falling house prices. The authors believe that government action should be taken to stop this decline and recommend manipulating mortgage interest rates to achieve this goal. Such action would be a mistake.

The real problem facing our economy today is that house prices remain dramatically overvalued relative to the fundamentals that determine them. Falling housing prices are the solution to this problem and should not be restrained with inappropriate government intervention. The more quickly prices can return to fundamentally sound levels the better. Regrettably, the slow moving housing market, compounded by the extraordinary amount of leverage which we have attached to overvalued houses, will inflict unavoidable economic pain that is unlikely to subside for years.

The authors further assume that housing price declines can be stopped. Yes, “a home price is partially dependent on the mortgage rate”. But it is also dependent on factors including the supply and demand for houses, available credit, the pool of qualified buyers, the terms of available mortgages, perceived risk, expectations concerning future performance, inventory of units available for sale and the presence of foreclosures in the market.

Almost every fundamental determinant for the market value of houses today is less favorable than that which existed in the late 1990s, with the exception of population. The supply is higher as there are “more vacant houses than at any time since the Census Bureau started keeping such data in 1960”. The increase in housing stock has far outstripped the rate of population growth, more than offsetting any potential benefit from a larger pool of potential buyers. Demand is lower as a result of the decline in the availability of sub-prime mortgages. Credit is much tighter. The availability of highly leveraged and 100% loan-to-value mortgages, which had the effect of decoupling housing values from underlying fundamentals, are less available. Houses are no longer perceived to be safe investments. Potential buyers no longer expect houses to appreciate rapidly and are increasingly worried that prices may continue to fall. Changing expectations have eliminated the home’s value as a leveraged investment opportunity. Cultural and social values attached to homeownership are being eroded. And most importantly, with respect to the Hubbard/Mayer argument, marginal effective interest rates are MUCH higher.

Messrs Hubbard and Mayer correctly state that if you lower mortgage rates, housing prices rise. To this end they propose refinancing all mortgages to a government subsidized 5.25% rate. This solution ignores how prices were able to soar to unsustainably high levels. The authors ignore their own argument as the cause of this disaster. Teaser rates associated with ARMs and Option ARM payment choices lowered the marginal effective interest rate of many mortgages to as low as 1%. People with bad credit, could put nothing down and service a mortgage at a 1% rate for years. It was these extraordinarily low effective interest rates and the absence of capital requirements that caused the housing bubble and sustained such lofty valuations.

These factors in many ways reproduced the conditions which contributed to the crash of 1929 but were applied to the housing market rather than the stock market. In the 1920s the margin requirement to buy stock was 10% and interest rates were as low as 1%. The housing bubble was defined by 0% down payments and teaser rates as low as 1%. Given the relatively larger size and greater rate of participation in the residential real estate market, the impact of these conditions was in many ways more widespread and pervasive than that experienced during the stock market bubble of the 1920s.

Now that the market has recognized the excesses of the real estate bubble these affordability characteristics, which disguised dangerous leverage and distorted housing valuations, have disappeared. People with bad credit can no longer access mortgages in large numbers. Highly leveraged and 100% loan-to-value mortgages are no longer prominent. Home buyers are again required to make down payments to buy houses. The era of 1% teaser rates and optional payment plans has ended. Homebuyers are faced with the prospect of putting capital at risk, committing to service a mortgage at higher interest rates (even under the Hubbard/Mayer plan) in an environment where real estate values are high in historical terms and while faced with the prospect that those values may continue to decline. It is not difficult to see why prices are falling at record rates.

Owners of homes, who will directly benefit from the Hubbard/Mayer refinancing plan, will not determine present or future housing prices. It is the homebuyers that will set the market; especially given present supply/demand disparities and the presence of significant foreclosure volumes in the market. The government would have to extend the proposed favorable interest rates to future borrowers to see interest rate related valuation benefits. In fact, a better idea might be to provide subsidized low interest rates only to new homebuyers to encourage transactions, promote liquidity and speed up the housing market’s search for equilibrium.

While proposed refinances would save some current homeowners from default, the majority of foreclosures result from people who bought more home than they could afford. Many buyers could only service the teaser rate or minimum payment on their mortgage and expected to be able to refinance or sell their houses based on an assumption of continued price appreciation. Many borrowers overstated their incomes. Others are now losing their jobs. These people will not avoid foreclosure based on the proposed plan.

Housing transaction volumes are already restrained by a growing number of homeowners who can’t sell their houses because current values are lower than their mortgage balances. Giving subsidized, low interest loans to homeowners will lock the market up further. Some owners won’t sell their houses because the government mortgage interest rate would be lower than that available on the open market. The proposed plan would further prevent the market from clearing by distorting the value of homes for sale as perceived by homeowners who benefit from government subsidized mortgages relative to the perception of wary potential buyers who would pay market mortgage rates. The proposed system would reduce transactions and slow the market’s inevitable march towards equilibrium.

I have not read Mr. Mayer’s recent study of housing costs versus comparable rents, but I agree that relative rental rates have historically been an excellent determinant of fundamental housing value. During the housing bubble rents increased with rising home values. Furthermore, the forces which distorted house prices also influenced the total and relative supply of rental units. Now that housing prices are falling, rents are also decreasing. As such, the current relationship between prices and rents is not a valid justification, in and of itself, for existing house prices. The full continuum of factors affecting value will determine where house prices ultimately stabilize.

Housing prices generally increase with the rate of inflation and income growth. An analysis of real estate price appreciation during the bubble relative to these metrics indicates that housing prices continue to be overvalued. In many areas house values would have to fall by more than 50% to return to levels before appreciation rates decoupled from fundamentally justifiable levels. Such a decline sounds extraordinary considering our overall historical experience, but it is no more extraordinary than the decade of appreciation which caused our current predicament.

We are presently in a period where housing as an asset class is depreciating. Rational potential buyers will not borrow large sums of money to buy overvalued assets when the expectation is that values will continue to fall, irrespective of artificially low interest rates.

Before we manipulate mortgage interest rates in an attempt to solve problems caused by falling prices, consider the stock market which has declined by more than 20% this year. These falling prices are causing economic pain and are disruptive to the credit market. A comparable solution would be to have the government subsidize margin rates for stock buyers. This would be a terrible idea. In 2001 we experienced another stock market crash which was admittedly complicated by the attacks on September 11th. The government responded by reducing interest rates to generational lows. This action further exacerbated the housing bubble and directly contributed to our current situation. Government manipulation of interest rates with the intentional or unintentional effect of materially influencing asset prices is a bad idea.

It was government intervention designed to realize a social agenda that principally contributed to the current problem of overvalued houses. Proposing further government intervention with the goal of supporting prices at an arbitrary level can not and will not work. The only solution to our present predicament is to allow the markets to clear. We must let housing prices reach an equilibrium relative to the supply, demand, credit availability and more conservative mortgage characteristics of the post-bubble economy, as well as the new risk premium perceptions and performance expectations of potential buyers. Much of the housing gains seen since the late 1990s, when sub-prime and affordability mortgages began to distort the market, will be reversed.

There are steps that the government can take to facilitate the stabilization of the housing market and limit collateral damage to both the credit markets and the broader economy. Any action which would attempt or have the effect to prop up housing prices at an artificial value, though, is counterproductive. Such initiatives will only lengthen, deepen and increase the damage caused by the inevitable march to a sustainable equilibrium. The Japanese have provided us with a useful case study on this subject. Don’t stand in the way of the markets clearing. Any government action should be undertaken with a design to facilitate this clearing process and an understanding that substantial economic pain is unavoidable.