Making the Housing Market Work Again
Papagianis, Christopher, Gupta, Arpit, Policy Review
TRENDS IN THE housing sector have been a driving force behind the recent financial crisis and associated recession. According to the Case-Shiller/S&P Indices, housing prices fell over 30 percent from the height of the housing bubble to August 2011 across a twenty-city composite, with prices in some markets down by nearly 60 percent. This plunge in housing prices was accompanied by a wave of household defaults and foreclosures, which has led to millions of property owners losing their homes over the last three years. The foreclosure crisis hit hardest in areas that had the largest bubbles, notably parts of Arizona, California, Florida, and Nevada.
The collapse of housing prices plays an important role in spurring foreclosures since "underwater" borrowers, who owe more on their mortgage than their home is worth, have a substantial incentive to walk away. According to CoreLogic, almost one in four borrowers were underwater as of the first quarter of 2011. Households with negative equity perceive their house to be a negative contributor to net worth, resulting both in a higher future default probability as well as lower current consumer spending. The decline in house values has also badly damaged the balance sheets of even above-water borrowers, as housing-related assets still remain the primary form of savings for many households. This link works in both directions: The wealth impacts of lower home prices weaken consumer and business spending while the weak economy in turn feeds into housing price declines. Prices have continued declining in many areas, with downward pressure exerted by the overhang of millions of properties in foreclosure. The problem of elevated foreclosures is now in its fourth year, with the initial wave of subprime-related problems replaced by more traditional foreclosures that reflect the weak economy. In short, the presence of millions of properties in the foreclosure process represents an overhang of supply and remains a major stumbling block for housing price recovery.
Mortgage-related defaults and associated declines in the market value of residential real estate collateral have been responsible for large losses in the financial sector, which led to the collapse of major financial institutions and widespread economic losses. The role of the housing sector as a source of systemic risk throughout the economy has made federal housing responses one of the central aspects of government economic policymaking during the last several crisis years. Indeed, given the large role that the federal government plays in mortgage finance today, it would be basically impossible for policymakers to simply step aside completely. The government provides massive financial assistance to homeowners through tax deductions on mortgage interest and property taxes paid to state and local governments, and through the ongoing sponsorship of Fannie Mae and Freddie Mac. In many ways, the historical roles of the Federal Housing Administration in providing mortgage guarantees and Fannie Mae and Freddie Mac in securitization are responsible for the spread of the 30-year, fixed-rate mortgage, which is now seen as the default mortgage contract.
Yet the housing crisis saw a dramatic escalation in the role played by the federal government. These new interventions can be broadly placed in two categories: First, policies aimed at boosting the demand for housing generally and thus supporting sales and prices; and second, supply-management policies assisting distressed homeowners in avoiding foreclosure.
As the depth of the housing crisis demonstrates, these policies--pursued by both Republican and Democratic administrations--have failed to stem large-scale housing losses. In large part, this failure reflects the magnitude of the housing problem in which tens of millions of American families got into homes they could not afford. Policymakers were consistently behind the curve in estimating the extent of problems in housing, and were unable to tackle the core issue of excess mortgage debt, which was made worse by a precipitous fall in home prices. …