It has been six years since U.S. housing markets peaked and began their tumble, yet housing prices continue to fall despite the few markets that have stabilized. Foreclosures continue at historic levels and housing starts are at their lowest level in decades. Meanwhile, nothing the federal government has done to address the situation to date has had much impact.

The crisis has devastated millions of American families, but it also has stalled the recovery of the economy as a whole. Despite this, the gravity and magnitude of the situation have yet to sink in among leaders in Washington.

Even President Obama made only passing mention of the housing crisis in his State of the Union address. His proposals—yet another investigation of mortgage fraud and yet another mortgage refinancing program—will do no more to revive housing markets than similar efforts in the past have.

Little on the horizon promises change. Jobs are returning, but at a rate that will take years to bring back full employment and with it strong demand for new housing. Despite historically low interest rates, banks continue to constrict mortgage financing while the residential mortgage–backed security (RMBS) market remains dormant, leaving the federal government the primary source of mortgages.

There are ways the federal government could revive housing, three of which are discussed below. But as will be evident, the two most significant iedeas are politically controversial and would require stronger leadership than has been shown on housing to date.

Where We Are Today

The extraordinary cost of this crisis was laid out by the Federal Reserve in a white paper released on January 4, 2012, titled, “The U.S. Housing Market: Current Conditions and Policy Considerations”:

  • “House prices for the nation as a whole . . . declined sharply from 2007 to 2009 and remain about 33 percent below their early 2006 peak . . . . For the United States as a whole, declines on this scale are unprecedented since the Great Depression.
  • “In the aggregate, more than $7 trillion in home equity . . . more than half of the aggregate home equity that existed in early 2006—has been lost.
  • “Currently, about 12 million homeowners are underwater on their mortgages . . .—more than one out of five homes with a mortgage. In states experiencing the largest overall house price declines—such as Nevada, Arizona, and Florida—roughly half of all mortgage borrowers are underwater on their loans.”
  • The total negative equity in underwater homes approaches $700 billion, according to the Fed.

Only 429,000 single-family homes were started in 2011, down 9 percent from 2010, the lowest rate in 60 years. Yet even this surpasses the rate of household formation. The U.S. Census reports that only 357,000 new households were formed in the 12 months ended in March 2011 despite population growth of some 2.5 million in the same period.

Nor will the resumption of household formation help immediately. Generation Y, the largest group of young, potential first-time homebuyers in U.S. history, is tapped out, carrying the highest level of school debt ever recorded coupled with the highest unemployment rate of any age group today; they will be renting for most of the decade.  In short, the housing recovery—when it comes—will not be robust.

McIlwainFixing_1_351What Needs to Be Done to Revive the Markets?

1. Renting federally held REO.

The Fed’s white paper’s major recommendation is for Fannie Mae, Freddie Mac, and the Federal Housing Administration to develop a program that sells or transfers large blocks of foreclosed homes (real estate owned, or REO) to investors to hold and rent until housing markets stabilize. There are now over 250,000 such homes, a number expected to grow to a million or more in the months ahead.

The Federal Housing Finance Agency (FHFA) began considering such a program last August when it issued a request for information (RFI) (see McIlwain, Should the Administration Rent Its Growing Inventory of Foreclosed Homes? Urban Land, August 2011). It received more than 4,000 responses to the RFI, and the FHFA has said, somewhat obscurely, that it is now “proceeding prudently but with a sense of urgency to lay the groundwork for the development of good initial pilot transactions.”

Renting large blocks of homes is not without challenges as the Fed notes, but the alternative is to let them sit vacant or to dump them on an already soft market. The challenges noted by the Fed include:

  • Putting together portfolios of homes close enough geographically to be managed economically;
  • Finding a price to attract bulk buyers, but not offering a fire sale; and
  • Creating a source of financing for bulk sales.

The Fed, however, fails to address two fundamental issues. One is ensuring that homes sold in bulk do not create slums, and that large absentee landlords invest in proper maintenance. Without proper oversight and incentives, this program could create new suburban ghettos just as absentee landlords have done far too often in inner-city neighborhoods.

The second issue is the required holding period. Normally, investors want to turn their funds quickly to increase their internal rate of return (IRR). On the other hand, a program like this should be designed to keep these homes off the market until housing markets have fully stabilized, which could take years. How this tension is resolved will determine both the program’s success in stabilizing markets and the price that investors may be willing to pay for large blocks of REO.

2. Creating a mortgage interest credit.

The most powerful—and controversial—thing that Congress could do to stimulate the housing market would be to adopt a proposal along the lines of one offered by President George W. Bush’s 2005 Advisory Panel on Federal Tax Reform. This proposal would:

  • “Replace the deduction for mortgage interest with a Home Credit available to all taxpayers equal to 15 percent of interest paid on a principal residence.
  • “Establish the amount of mortgage interest eligible for the Home Credit based on average regional housing costs.
  • “Lengthen the time a taxpayer must own and use a principal residence before gains from the sale of the home can be exempt from tax.” (Page 73)

A housing credit along these lines would provide an incentive for the 82 million members of generation Y to become homeowners. Today, the benefits of the mortgage interest deduction are targeted almost exclusively to those with incomes above $100,000, far more than most in generation Y will earn for years.

3. Divide mortgages for underwater homeowners to a paying first and a delayed second.

Underwater homeowners are at high risk of strategically defaulting on their current mortgages. Instead of waiting for this, Fannie Mae, Freddie Mac, and the FHA can create programs that would split the mortgage of an underwater homeowner into a first mortgage that pays currently, and a deferred, nonpaying second mortgage. The new first would be in an amount no more than 80 to 90 percent of the value of the home. The second mortgage would be payable only upon sale of the property and only from some percentage of the net sales proceeds in excess of the first and any costs, say 50 percent. The homeowner would be allowed to refinance the first mortgage once, but only to reduce the interest rate to take advantage of today’s low rates.

Whether these three are the best solution for the housing crisis or not, the real point is that it is past time to take action at a level far beyond anything yet considered in Washington.  Resolving the housing crisis is central to restoring the U.S. economy, as Chairman Ben Bernanke noted in his cover letter to the Fed’s white paper, a position supported by a growing number of leading economists of all stripes. Without action at this scale, housing will drag on the economy and damage the lives of millions of more Americans for years to come.