ed demarco, a senior fellow in residence at the Milken Institute's Center for Financial Markets, was the acting director of the Federal Housing Finance Agency and the post-crisis conservator for Fannie Mae and Freddie Mac.
Published October 19, 2016
The dream of homeownership remains alive and well in the United States. Despite the disastrous consequences of the Great Recession for millions of homeowners, polls suggest that Americans still want their names on deeds.
We have a long history of public policies that promote homeownership and few politicians are inclined to challenge them. This doesn't mean, however, that those policies achieve their intended outcome. Examining the policies today, especially in light of the recent financial crisis and the wreckage it left in its wake, raises important questions as to whether they encourage families to take on more risk in buying a home than in generations past. Indeed, while Washington struggles to put back together the secondary-mortgage market that led to the federal takeover of the big secondary-market lenders, we should also use this interlude to rethink our approach to promoting homeownership.
U.S. Housing Policy is a Debt Policy
At the federal level, the cornerstones of policy designed to promote homeownership are:
- The tax subsidy implicit in the mortgage interest deduction.
- The mortgage-guarantee programs operated by the Federal Housing Administration and the Veterans Administration and several smaller such programs.
- The subsidization of the mortgage market through explicit and implicit guarantees for the giant market makers – Ginnie Mae, Fannie Mae and Freddie Mac.
The common denominator of these policies is that all three use subsidies to encourage taking on debt to finance a home rather than subsidizing the process of building equity in a home. Granted, even wealthy households typically borrow to buy a house. But people don't aspire to own the mortgage, they aspire to own the house.
Ownership in the broader spirit of the American dream means having equity in a home. So why doesn't public policy focus more on helping families build equity rather than on taking on debt, especially in light of the damage wrought by millions of foreclosures during the Great Recession?
Leverage, using borrowed money to finance an asset purchase, enhances returns if things go well and increases losses if they don't. High leverage – extreme reliance on borrowed money relative to equity capital – led to both record bank failures and record foreclosures in the wake of the financial crisis. Banks subsequently responded by increasing their capital relative to their debt. Families did the same, often by reducing consumption until they brought their debts down to more manageable levels. By the same token, many families have deferred buying homes while undertaking this balance-sheet repair.
Thus it seems that banks and households have gotten the message. It is time to get public policy to adjust as well.
Wealth Building and Risk Management
With rental housing, the monthly payment goes to the landlord and that's that. But in paying a mortgage, as the principal balance is gradually paid down, the ownership stake increases. That has motivated millions of families to buy houses as a means of creating personal wealth. And it has motivated policymakers to make this possible – especially for low- and moderate-income families that would otherwise have a hard time saving.
This sounds great, and actually works out some of the time. But very few homebuyers live in their houses long enough to amass much equity before moving on. Moreover, the risks of taking on debt collateralized by housing are often given short shrift, while the benefits are exaggerated.
In view of some seven million foreclosures and forced sales in the past decade, we have been warned. Poor health or unemployment can drive homeowners into foreclosures in which they lose some or all of their equity. Meanwhile, house values can fall for reasons beyond the owners' control, vaporizing equity in the process.
The costs created by forced sales typically go well beyond the immediate loss to the seller. Foreclosure ruins personal credit, often for years. Health effects can be substantial as well, particularly in poorer neighborhoods. Antwon Jones and Gregory Squires of George Washington University and Cynthia Ronzio of Health Policy Initiatives document these stress-related impacts in an article in the Journal of Urban Affairs. They note moreover that the adverse health consequences may extend beyond the family facing foreclosure, into the surrounding neighborhood. Speaking of spillover effects, the foreclosure or short sale of one house will likely reduce the value of other houses in the neighborhood.
Other routine behavior undermines the wealth building capacity of homeownership. For one, withdrawing equity through cash-out refinancing, or even just extending the borrowing term by refinancing for a longer period than is left on the mortgage, lengthens the period needed to pay down the mortgage principal. Frequent change of residence also has this effect, both due to the costs involved in each sale and purchase and because it does not give the owner time to amass equity.
Finally, even if the homebuyer stays in the house long term, makes timely mortgage payments and does not refinance, the economic returns to ownership usually fall well short of those from other investments. Owning a home is an expensive proposition; every house requires a lot of maintenance. Moreover, unbeknownst to most Americans, average price appreciation is just slightly greater than the rate of inflation. Compared to long-term investments in financial assets such as stocks and bonds, the real return on residential real estate in most areas has fallen well short.
Families do, of course, derive substantial benefits from being masters of their own domains. Just don't look for those returns on the bottom line. For most people, the returns from owning a home derive primarily from the gratification and independence that ownership brings.
Rethinking Housing-Debt Policy
As noted above, federal policies to promote homeownership largely consist of making it easier for buyers to leverage their purchases. Let's reconsider each of the cornerstones.
The mortgage interest deduction lowers a homeowner's personal income tax by allowing mortgage interest payments to be a deductible expense. The larger the interest payment and the higher the homeowner's marginal tax rate, the greater the value of this deduction. The mortgage interest deduction thus lowers the cost of financing a home, creating incentives to purchase more-expensive homes – as well as homes purchased with more debt financing – than would otherwise be the case. Moreover, the benefit accrues mainly to higher-income homeowners. Most middle-income families utilize the standard deduction even if they have a mortgage, so this tax benefit's perceived value may have a larger effect on homeownership rates than its actual value. But it surely increases leverage among homeowners and subsidizes more consumption of housing relative to other goods or savings.
The FHA, the VA and other mortgage-guarantee agencies also promote homeownership by affecting the availability and cost of mortgage debt. By insuring creditors against loss in the event of borrowers' defaults, they use the federal government's pristine credit to lower borrowing costs. They also promote homeownership by offering mortgages with little or no money down. While they have different underwriting standards, the effect is to make the cost of mortgage credit lower and its availability greater than it would otherwise be, and to encourage purchases with minimal down payments.
Finally, over the past several decades, the secondary-mortgage market has become critical in maintaining the flow of credit into housing. Replacing traditional lenders, such as savings and loans – which financed mortgages with their depositors' money – the secondary market gives banks, thrifts and mortgage bankers the option of originating and then selling mortgages to investors. Mortgages are pooled and packaged into mortgage-backed securities and sold to institutional money managers around the globe. Most of these securitizations are carried out through a government corporation (Ginnie Mae, which securitizes FHA and VA mortgages) and two government-sponsored enterprises (Fannie Mae and Freddie Mac, which have been operating in taxpayer-backed government conservatorships since 2008). The liquidity of mortgage securitization is enhanced by the taxpayer-backing of the securities, which ultimately leads back to lower borrowing costs.
Taxpayer-backed securitization contributed to the dominant role of 30-year fixed rate mortgages in U.S. housing finance. Without taxpayer support, shorter-term mortgages and adjustable rate mortgages that are less risky for lenders would likely be more common.
While many argue this package of explicit and implicit government benefits is needed to make homeownership more affordable, those benefits have the cumulative effect of driving up house prices, thereby offsetting some or all of their presumed benefit – especially to first-time buyers. The combined effects also create costs borne by the broader economy. The more we borrow to finance homeownership, the less is available to finance productive investment or other consumption. In economic terms, there is an opportunity cost from the foregone activities that may have otherwise been financed.
In sum, these housing policies result in increased leverage and extended repayment terms while driving up house prices. The increased leverage adds risks to household balance sheets, which leads to more foreclosures with their attendant costs than would otherwise result.
The Equity Alternative
Can we reorient public policy so it continues to foster homeownership, especially for lower- and middle-income households, while reducing these associated risks and increasing the likelihood that ownership helps families build wealth?
Let me stipulate here that I am accepting the view that promoting homeownership, particularly for lower-income families, remains a desired goal of public policy. That stipulation would be worth re-examining. But here, I'm limiting my analysis to asking how it would be possible to give such families a chance to build wealth in housing over their working lives while reducing the risks associated with high leverage.
How might a focus on equity work? Consider the key building blocks of the current debt-focused policy and how we could give greater weight to equity.
Current policy works to minimize down payments and rewards borrowers with the bonus of larger interest deductions. FHA-guaranteed mortgages require 3.5 percent down, but offset even that by allowing buyers to finance closing costs. The VA, for its part, requires no down payment. And my own modest effort to increase Fannie Mae and Freddie Mac down payment requirements from 3 percent to 5 percent (when I was the acting director of the agency overseeing them) has already been reversed.
It was not always this way. In its early decades, the FHA program had strict underwriting rules and down payment requirements. A generation ago, saving for a down payment was an accepted discipline for young families seeking mortgages, and 20 percent down was the basic rule of thumb. No longer, of course.
This seems both curious, given the wealth-building policy objective at stake, and dangerous, given the risks involved. For anyone who doubts these risks, consider that the default rates in the FHA program often exceed 10 percent and during the crisis reached 33 percent. More generally, negative equity (that is, a loan balance exceeding the value of the house) at the time of default is a powerful predictor of the likelihood of foreclosure, particularly if the borrower's ability to repay has been diminished.
To be fair, the VA program, with its even-weaker down payment requirement, has better loan performance than the FHA program. As a recent Urban Institute study points out, though, this is likely due to the VA's use of a more conservative income-based underwriting test and the limit on the maximum size of its guarantee.
There is a way out – indeed, multiple ways to make it easier to own a house without resorting to high leverage. Let me give one example of a subsidy that focuses on building equity, not debt.
The Federal Home Loan Banks, which provide liquidity for mortgage lenders, are required by law to set aside 10 percent of their income to fund affordable-housing. A portion is set aside by each Bank to subsidize low- and moderate-income first-time homeowners. This subsidy is provided directly to the homebuyer in the form of a matching payment to the buyer's own down payment.
In some cases, the match is 3 or 4 times the borrower's contribution. These combined funds are then available to the homebuyer to make a down payment and pay closing costs. The program also requires borrowers to attend a homebuyer education program. Not surprisingly, mortgagees benefiting from set- asides proved to be more likely to weather the financial crisis.
State housing finance agencies offer similar programs and are leading sources of down payment assistance, especially for first-time buyers. And numerous other local programs exist as well to supplement down payments.
There are two bonuses with this approach. First, it is simple to establish and enforce eligibility guidelines, such as income restrictions, for the program. That means the subsidy is actually delivered to the intended beneficiaries. It can be narrowly targeted at first-time homebuyers. Subsequent steps up the ownership ladder could be unsubsidized.
Second, enhancing the credit quality of borrowers lowers their cost of credit. What's more, lenders' requirements for borrowers to pay for private mortgage insurance if they are highly leveraged may be waived sooner if the assistance gets the borrower to a 20 percent equity stake faster.
DownPaymentResource.com provides a clearinghouse for researching such programs. In June 2016, it had 2,500 down payment assistance programs in its database, with an average down payment benefit of $8,260. In 82 percent of the 513 counties it studied in conjunction with RealtyTrac (a private firm that provides information on the foreclosure market), the average down payment assistance available exceeded 3 percent of the price of the median-valued house in that area.
Not all down payment assistance programs work equally well. The FHA suffered substantial losses from a program focused on seller-funded down payment assistance. But the flaws in that approach are now well understood.
Down payment assistance, by the way, need not come at the time of purchase. It could be provided over the first several years of ownership, contingent on the borrowers' staying current on their payments. Should a borrower become delinquent, the subsidy could be redirected to offset losses to the lenders.
The cost (personal and political) of shifting toward equity subsidies is that families can't buy houses until they have enough savings for a down payment. But isn't that better than watching families hit a personal or financial bump in the road and then try to avoid foreclosure when they have no equity in their homes? Promoting more of a savings culture shouldn't hurt either – millions of Americans are failing to plan adequately for their children's college education, not to mention their own retirement.
One reason, apart from lower monthly payments, that the 30-year mortgage endures in an increasingly volatile economy is that the government-backed secondary market supports this product. So, we find interest groups, ranging from non-profits promoting affordable housing for marginal buyers to realtors to the big participants in the secondary market all pushing for government support. But it is surely time to challenge our devotion to the path of least political resistance, particularly because the 30-year mortgage is often a bad fit for borrowers today.
Many first-time buyers remain in their houses for five years or less. That's a period in which loan amortization on a 30-year mortgage may not even be enough to pay the closing costs when the house is sold, much less leave an equity cushion. After five years at today's rates for a 30-year mortgage, just 9 percent of the mortgage is paid off. And even a thin equity cushion is not assured, since it depends on house prices remaining stable. Yet typically, it can cost a family 8 to 10 percent of the value of the house to sell and relocate.
More broadly, according to the National Association of Home Builders, the average owner changes houses every 13 years. After 13 years, a homeowner may have paid down a bit more than 30 percent of the original loan amount – a better cushion, but one still leaving nearly 70 percent of the loan unpaid. Note, moreover, that there is reason to believe that the turnover rate in ownership could increase because younger workers appear more apt to change jobs, and even careers, than their parents or grandparents.
To be clear: a 30-year amortization schedule is not good or bad per se, and I am not advocating its elimination as a contractual option. I am suggesting we be more thoughtful about using public policy to steer buyers toward 30-year obligations.
Shorter-term mortgages, by the way, can be made more attractive to buyers with limited means. Two years ago, Edward Pinto, a fellow at the American Enterprise Institute (and earlier in his career, the chief credit officer for Fannie Mae), introduced something he calls the "Wealth Building Home Loan." This is simply a 15-year mortgage, with little or no money down and some combination of subsidy to "buy down" (that is, to lower) the interest rate and prudent underwriting standards that make it possible to bring the monthly payment within shouting distance of the payment on an equivalent 30-year mortgage.
The rapid amortization offsets the lack of initial equity and the low interest rate means both that the loan is unlikely to be refinanced and that most of every payment pays down principal. After 15 years, the loan is paid off and the family has that monthly payment amount to deploy for a child's college education or to plow into retirement savings.
That is just one idea; here's another. Suppose a 30-year mortgage were divided into two distinct payment obligations, one with a monthly payment needed to amortize up to 80 percent of the house cost in 30 years, the other a monthly payment calculated to amortize the remaining portion of the total loan in five years. That way, in five years the borrower would have more than a 20 percent equity stake to rest on, provided house prices did not decline. And the borrower would get the equivalent of a pay raise at the five-year mark because one payment stream would be completed. It would be like saving for a 20 percent down payment after buying the house.
Even more simply, borrowers could be educated on the equity-building benefit of making additional principal payments each month on a 30-year loan, or of obtaining a 15- or 20-year mortgage rather than a 30-year one. Or lenders could promote 5/1 or 7/1 or 10/1 adjustable rate mortgages – mortgages in which the interest rate is fixed for an initial period (here, five, seven or 10 years) and then turn into adjustable rate mortgages for the remaining term. The idea would be to appeal to borrowers not intending to live in the same house for more than five to ten years. Such a loan would have lower interest rates and faster equity accumulation than 30-year fixed rate mortgages.
I hear the objections – shorter amortization would still mean higher monthly payments. It might even mean that people buy slightly less expensive houses and market prices don't inflate quite as much as when they are dominated by high-leverage, 30-year financing. But the benefits are substantial: equity would build faster and, over a working life, families would have a lot more money to finance other consumption or to save for retirement or health care or education. Note that financial markets, which process enormous volumes of securitized mortgage debt, would be less risky, too.
The FHA, rather than being the government's poster child for highly leveraged housing finance, might take a leadership role in exploring such options.
Today, you hear complaints about pricing mortgage credit risk – the insurance premium built into the mortgage rate to compensate the lender for default risk. Some say that the FHA charges too much for mortgage insurance or that Fannie's and Freddie's guarantee fees are too high – notwithstanding that mortgage rates (including the fees) are lower than most of us thought we would ever see in our lifetimes. So how should these fees be set, and how is this relevant to the debate over leverage?
Government-backed lenders should differentiate among borrowers in a manner compatible with taxpayers' interests and sound financial practice. That is, eligible families should pay rates commensurate with their individual risk profiles. Those with lower credit scores and higher debt loads should pay higher rates, other things equal, than borrowers with stronger credit records and lower debt loads. That would ensure taxpayers and credit-risk-bearing investors are protected. It would also help families and neighborhoods because it would reduce the incidence of default and the consequent spillover costs.
The previous paragraph is heresy to housing-policy specialists who aren't wed to market-driven pricing. But I expect most Americans would read it and say "duh." If we substituted autos for houses, housing specialists would mostly say, well of course, riskier drivers should pay more for auto insurance than safe drivers. Yet, for reasons of inertia and political expedience, we use housing finance as a hidden vehicle for income redistribution based on creditworthiness, with the least creditworthy getting the biggest benefit.
Prudent insurance pricing and underwriting standards aren't meant to punish, nor are they meant to deny access to homeownership. They can serve as a means of signaling qualifications that give people clear information as to what they need to do to get into a sustainable homeownership position. But asking families (including lower-income families) that manage their money prudently to pay the costs for families that do not do so seems arbitrary and unfair.
This is an essential problem in housing policy. The entrenched interests relying on the hidden income transfers embedded in charging low-risk borrowers more for mortgages so higher-risk borrowers pay less than their costs are numerous. Not surprisingly, we end up with more high-risk borrowers and more defaults. If we really want to help less creditworthy borrowers on a path to homeownership, let's start with better financial education, budgeting, and fixing credit problems, while improving credit scores. Then help them save for a down payment and perhaps provide matching funds as a subsidy.
A 1982 federal law precludes holders of first liens from limiting second liens – that is, claims against the house that are subordinate to the first mortgage. Given the enormous losses of the past 10 years resulting from house owners extracting equity from their properties by means of second mortgages and then defaulting, it seems clear this restriction should be reconsidered. I am not aware of another lending arena in which a secured holder of a senior lien has no say in subordinate liens that may affect the quality of its collateral.
In a free society, people should be able to make decisions about how to use their wealth, including their home equity. But our legal framework governing mortgage lending should not create incentives for families to put themselves at greater risk; nor should it allow borrowers to freely put lenders and taxpayers in a worse credit position after the fact. Surely we could construct some sensible, prudent guidelines governing second liens, particularly when taxpayer-supported lending mechanisms are being used.
A Role for State and Local Governments
While I've been writing exclusively about federal policy, state and local governments also have a significant impact on homeownership. As already noted, state and local housing agencies are a key source of down payment assistance. Cutting the other way, though, states and localities impose sizeable taxes and fees on residential real estate transactions, adding to closing costs for buyers and sellers. As Larry White of New York University noted in the Second Quarter 2016 issue of the Milken Institute Review, they also add to homeownership (and rental) costs through land-use restrictions and building ordinances that are not justified by the public interest.
Even Equity Supports Should Have Limits
Even families that save enough for reasonable down payments need to be able to afford the monthly payments while withstanding the financial bumps everyone faces along the road. For those with low or unstable income, homeownership can pose stark risks. We do these families no service by encouraging them to stretch their limited or volatile income to buy houses, then leave them to turn slowly in the wind when they must sell but are unable to sell without a loss.
To put a finer point on it, policymakers on both sides of the aisle should temper their impulses to promote homeownership because ownership is not for everyone. Ownership limits one's options to easily relocate – whether to change jobs, respond to new family circumstances or reduce monthly expenses. And housing investments in low-income neighborhoods tend to have lower rates of return and greater price volatility than in other neighborhoods. Those with uncertain incomes may be better off building nest eggs through other forms of savings than that created as a byproduct of monthly mortgage payments.
Whose Housing Policy?
Our policy debate should not be about the desire of realtors or homebuilders or lenders to maximize the number of profitable transactions. Nor should it be about how to maximize the homeownership rate, regardless of the consequences. It should be about building a sturdier structure all around, with a policy and legal framework that strengthens family finances and enhances the capacity of capital markets to lend willingly to creditworthy borrowers.
It's pretty clear that we've been sidetracked into policies that make the mortgage market bigger and more volatile. It's equally clear that we've strayed far from the broader public interest – and that the route back lies in building equity, not debt.