To fix the economy, fix the housing market

By Lawrence H. Summers

The central irony of financial crisis is that while it is caused by too much confidence, too much borrowing and lending and too much spending, it can only be resolved with more confidence, more borrowing and lending, and more spending.  Most policy failures in the United States stem from a failure to appreciate this truism and therefore to take steps that would have been productive pre-crisis but are counterproductive now, with the economy severely constrained by lack of confidence and demand.


Thus even as the gap between the economy’s production and its capacity increases and is projected to increase further, fiscal policy turns contractionary, financial regulation turns towards a focus on discouraging risk taking, and monetary policy is constrained by concerns about excess liquidity.   Most significantly the nation’s housing policies especially with regard to Fannie Mae and Freddie Mac–institutions whose very purpose is to mitigate cyclicality in housing and who today dominate the mortgage market–have become a textbook case of disastrous and procyclical policy.
Annual construction of new single family homes has plummeted from the 1.7 million range in the middle of the last decade to the 450 thousand range at present.  With housing starts averaging well over a million during the 1990s, the shortfall in housing construction now projected dwarfs the excess of construction during the bubble period and is the largest single component of the shortfall in GDP.
Losses on owner-occupied housing have reduced consumers’ wealth by  more than $7 trillion over the last 5 years, and uncertainty about the future value of their homes, as well as the inability to refinance at reasonable rates, deters household outlays on durable goods.   The continuing weakness of the housing sector is a major source of risk for major U.S. financial institutions raising significantly the costs of the loans they offer.
In retrospect it obviously would have been better if financial institutions and those involved in regulating them–especially the FHFA–recognized that house prices can go down as well as up; if more rigor had been applied in providing credit; if the GSEs had been more careful in monitoring those originating and servicing loans; and if all those involved had been more vigilant about fraudulent behavior.
The question now is what should be done to address the housing market, given the drag it represents on the national economy.  With virtually all mortgages in the United States provided by the Federal government or guaranteed by the GSEs, this is inevitably a matter of government policy.
Unfortunately, for the last several years policy has been preoccupied with backward-looking attempts to address the consequences of past errors in mortgage extension by addressing homeowners on a case-by-case basis, and decisions regarding the GSEs have been left to their conservator FHFA which has taken a narrow view of the public interest. FHFA has not acted on its conservatorship mandate to insure that the GSEs act to stabilize the nation’s housing market, and taken no account of the reality that the narrow financial interest of the GSEs depends on a national housing recovery.  Instead of focusing on the stabilization of the housing market, its focus has been on reversing its previous policies heedless of changes in the environment, and in treating mortgage finance as a morality play involving homeowners, financial institutions and banks rather than an important component of national economic policy.  A better approach would involve a number of changes in policy.
First, and perhaps most fundamentally, credit standards for those seeking to buy homes are too high and rigorous in America today. This reduces demand for houses, lowers prices and increases foreclosures, leading to further tightening of credit standards and a vicious growth-destroying cycle.  Publicly available statistics suggest that the characteristics of the average applicant in 2004 would make an applicant among the most risky today.  Of course the pattern should be opposite, given that the odds of a further 35 percent decline in house prices are much lower than they were at past bubble valuations.
Second, as President Obama stressed in presenting his jobs bill, there is no reason why those who are current on GSE guaranteed mortgages should not be able to take advantage of lower rates.  From the point of view of the guarantor as distinct from the mortgage holder, lower rates are all to the good since they reduce the risk of default.  Yet, at least until now the GSEs have made refinancings very difficult by insisting on significant fees and by requiring that any new refinancier take on all the liability for errors in underwriting the original mortgage, at a cost to American households of tens of billions a year.
Third, stabilizing the housing market will require doing something about the large and growing inventory of foreclosed properties. The same property sold in a foreclosure sale nets about 30 percent less than if sold in the ordinary way and the knowledge that that there is a huge overhang of foreclosed properties deters home purchases.   Aggressive efforts by the GSEs to finance mass sales of foreclosed properties to those prepared to rent them out could benefit both potential renters and the housing market.
Fourth, there is the issue of preventing foreclosures which was the initial focus of housing policy efforts.  The truth is that it is far from clear what the right way forward is.  While the Obama administration HAMP effort has been widely criticized for overly restrictive eligibility criteria, the reality is that a large fraction of those receiving assistance have ultimately been unable to meet even their reduced obligations.  This suggests that the task of helping homeowners without either damaging the financial system or simply delaying inevitable outcomes is more difficult than is often supposed.  Surely there is a strong case for experimentation with principal reduction strategies at the local level.  The GSEs should be required to drop their current posture of opposition to experimentation and move on a more constructive posture.
Fifth, there were clearly substantial abuses by major financial institutions and most everyone in the mortgage industry during the bubble period.  Just compensation to the victims is a legitimate objective of public policy.  But allowing negotiation over the past to be the dominant thrust of present policy creates overhangs of uncertainty that impose huge costs on the financial system and inhibits current lending.   It is equally in the interests of bank shareholders and the housing market that a rapid resolution of disputes be achieved.  The FHFA should be striving to bring the current period of uncertainty to a rapid conclusion.
While the GSEs are by far the most important actors in the mortgage space (and hence the FHFA that serves as their conservator is the most important player in housing policy), there are others who can make a constructive difference.  Bank regulators could facilitate inevitable restructuring of underwater mortgages by requiring banks to treat second mortgages and home equity loans in realistic ways.  The Fed could support demand and the housing market by again expanding purchases of mortgage backed securities.
With constructive approaches by independent regulators, far better policies could be in place six months from now.  The anticipation of a change to supportive policies could change the tone of the market even sooner.  There is nothing else on the feasible political horizon that can make as a large a difference in driving American economic recovery.