Monday, February 25, 2008

Housing Crisis: What is the Problem?

I've been putting off writing about proposed responses to the housing crisis, and new proposals keep popping up. So far, I see distinct proposals from Obama, Clinton, Bush, Alan Blinder, Larry Summers, and Dean Baker, and I'm sure there are lots of others out there. I'll write a brief description and evaluation of the proposals soon.

But first, in not too many words, what's the problem? Starting around 2000, residential housing prices skyrocketed. According to the Case-Shiller housing price index (which controls for quality and covers only major metropolitan areas), prices nationally in mid-2006 were more than double those in 2000, with even more spectacular growth taking place in LA, Miami, DC, and San Diego. (The index is normalized to be equal to 100 in January 2000.)
Now that the housing bubble has burst, prices are dropping precipitously. Over the long run, our best guess is that housing values will grow at a constant rate. Taking as a very, very rough guide to long run price growth the average annual growth rate of the Case-Shiller index between 1987 and 2000 (3.6%), and extrapolating forward from January 2000 (making the heroic but not crazy assumption that prices at that point were at their long-run level) we would expect that the recent value of the Case-Shiller index would be about 130 rather than 200. In other words, nationally, residential housing is about 50% overvalued. Assuming prices drop back to their long-term trend values, we expect a decline of 20-30% from current values over the next five years.

As prices have started to decline, many people who bought properties with the expectation that they could quickly sell them again for a profit are faced with mortgages that they are unable or unwilling to pay. A not mutually exclusive category consists of those who got mortgages with a variety of gimmicky payment plans--teaser rates, exploding adjustable rates, etc.--and now can't afford their payments.

At the risk of sounding like a cold-blooded economist, it's important to specify exactly why this is a bad thing. Those who were more prudent may find it hard to find much sympathy for those who gambled in the housing market and are now suffering for it. That said, there are reasons to think government should do something about the housing crisis.

First, some people truly didn't understand the risks they were taking, in part because mortgage companies skirted the laws requiring transparency and didn't inform them. It is the job of the government to regulate mortgages and enforce disclosure laws, and the government failed to protect those people.

Second, the empty houses that result from repeated foreclosures can have a large negative effect on nearby homes, leading to neighborhood decay, and accelerating the decline in housing prices.

Third, a quick drop in prices can bring a drop in consumer spending (through so-called wealth effects), which is not what we need at a time when recession clouds are brewing.

The second and third reasons are in economic parlance "externalities," which is every economist's favorite rationale for government intervention.

The options for dealing with the problem, as I see them, are 1) mandate a moratorium on foreclosures and/or a freeze on adjustable rates , 2) buy up some mortgages and refinance them, 3) provide limited government financial assistance to those having trouble paying their mortgages, 4) or make some tweaks to foreclosure and/or bankruptcy law. In my next post, I'll evaluate the main solutions and look at the Obama and Clinton plans in particular.


Dirk van Dijk said...

The other problem is the huge losses the banks are taking and the loss of capital that means. No capital, no lending, no lending no economic growth. I grant you the banks (and I banks) deserve to take it on the chin, but not at the expense of a total financial meltdown. However any bailout of the banks should include no payment of dividends for many years and no share repurchase. Maybe hard caps on exec comp as well.

lerxst said...

There's also, of course, monetary policy which is outside of the control of the candidates. Bernanke in recent months has cut interest rates sharply which has already had some effect on mortgage rates and helps replenish capital in the banking system.

Clearly, much more is going to be needed and the Fed is clearly limited in what it can do.

Anonymous said...

See what you think of this idea: Banks that need to unload houses acquired through foreclosure can offer 'rent to own' plans at zero interest, and the new owner acquires equity as their rent payments reduce the owner's debt to the bank.
Such a plan would reduce the number of empty houses, and create more capacity in the rental market, as renters moved up to 'rent to owners'. This would also reduce rents for those who must move down the economic ladder, due to job loss, etc.