Feldstein’s Mortgage Proposal: No Silver Bullet

Hemera

Martin Feldstein has recently published  a provocative op-ed arguing for a large-scale mortgage write-off program to counteract housing losses. Feldstein is highly influential economist who has served numerous roles in public policy, so his views are worth considering. His latest piece, however, offers a weak defense of an expensive and unfair housing policy.

The core of the plan revolves around a government-backed housing debt-waiver:

If the bank or other mortgage holder agrees, the value of the mortgage would be reduced to 110 percent of the home value, with the government absorbing half of the cost of the reduction and the bank absorbing the other half. For the millions of underwater mortgages that are held by Fannie Mae and Freddie Mac, the government would just be paying itself. And in exchange for this reduction in principal, the borrower would have to accept that the new mortgage had full recourse — in other words, the government could go after the borrower’s other assets if he defaulted on the home. This would all be voluntary.

Before commenting on the plan itself, it’s worth looking through the motivations of an enormously expensive (Feldstein estimates the cost at $350 billion) and difficult to implement plan. What are the problems in the housing market that justify such an extraordinary policy proposal?

Feldstein’s starts with an assumption, common among many economic commentators, that today’s higher savings is partly to blame for our current economic woes:

Since the housing bubble burst in 2006, the wealth of American homeowners has fallen by some $9 trillion, or nearly 40 percent. In the 12 months ending in June, house values fell by more than $1 trillion, or 8 percent. That sharp fall in wealth means less consumer spending, leading to less business production and fewer jobs.

Now, it’s true that the housing collapse has led to large drops in asset values for many households – and in response many households are saving more. The following graph from Calculated Risk shows how personal savings rates have sharply risen in recent years to roughly 5%, up from 2%:

Feldstein’s argument is that a shift from consumption and towards savings is a large contributing factor behind the recession. Yet in typical economic models, a higher savings rate leads to more investment, which is a fundamental driver of long-run growth. Economists have long since moved away from thinking about economic growth as primarily consumption-driven. China’s savings rate exceeds 50% of GDP and its growth rate is nearly 10-times ours, largely because the savings is channeled to productive investment.

If the policy problem is that too much savings is channeled to bank deposits and these banks aren’t lending, the optimal policy responses should focus on adjusting bank incentives rather than consumer decisions. Perhaps the Fed could lower the interest it pays on banks holding deposits at the Fed – which would encourage the circulation of those deposits in the real economy. Such policies may or may not be good ideas. But they ought to be the first point of focus if excess savings is a real issue.

Looking at the historical trajectory of the savings rate also highlights the extraordinary nature of the 2000s housing boom. In this time period, households used ephemeral housing wealth as a substitute for savings. The housing bust demonstrated the weakness of that economic strategy, and has induced many households to begin saving again. Current savings rates are not high on a historical basis – despite high levels of economic insecurity and large looming financial demands from an ageing population. In fact, the current savings rate is around the average for the 1990s, which was a period of robust economic expansion. Given this, it seems hard to argue that an unusually low level of consumption is primarily responsible for our economic woes.

Yet rather than recognizing the disastrous consequences of a housing-based savings strategy, Feldstein argues that we need to re-inflate a housing bubble on the theory that ever lower savings based on artificial wealth is the only way to ensure a working economy. This would simply repeat the disastrous and expensive housing policies that have imposed enormous costs on taxpayers without delivering tangible results to homeowners. Aside from boosting household wealth, Feldstein sees higher house prices as a way to stem the tide of economically destructive foreclosures:

House prices are falling because millions of homeowners are defaulting on their mortgages, and the sale of their foreclosed properties is driving down the prices of all homes. 

Certainly, from a supply point of view, the flow of additional homes on the market from involuntary foreclosures is lowering the price of new homes. Harvard Professor John Campbell and co-authors have written a paper describing this effect. Their team finds that a foreclosure lowers house prices in a .05 mile radius by 1%. There are a number of things to note about this effect.

First, it seems clear that the price effects of foreclosure are relatively small and local in nature. Is there any reason to think that foreclosures in general are the prime driving force behind housing price declines? Housing prices are determined by a number of factors both on the supply and demand side – such as changes in housing finance, the presence of tax credits, etc. While foreclosures are certainly one of the many (and perhaps most important) elements behind low and flagging home prices, this is an insufficient justification for taxpayers spending hundreds of billions of dollars Moreover, it is not easy to determine when a fall in house prices causes foreclosure or when a foreclosure leads to a decline in house prices

Second, the nature of the “foreclosure price” effect argues against a concerted federal response. Even if prices fall somewhat due to fewer buyers in nearby areas, much of that effect is likely driven by buyers simply choosing to buy or look for a home in another area. In other words: even if foreclosures lower prices in a specific locality, it’s not clear how much they are affecting prices nation-wide.

Even on a local basis, the evidence in the Campbell paper is suggestive that the price effects of foreclosure happen at least in part because of poor maintenance of foreclosed properties. Is it a worthwhile goal of federal housing policy to aim to improve the aesthetics of local neighborhoods? More cynically – would it be worthwhile to spend $350 billion to beautify the nation’s front lawns? One imagines that such a plan would find few takers. Yet Feldstein uses similar logic as a key piece of support for his own proposal.

Finally, it’s worth wondering how much debt relief would actually change default behavior. One study by researchers at the Board of Governors of the Federal Reserve have suggested that equity shortfalls are only a significant contributing factor behind housing default once equity falls to -62 percent of the home value. That estimate would suggest that only the largest transfers to the most underwater borrowers (in particular, the borrowers who levered up the most at the peak bubble periods) would succeed in preventing foreclosures.

Another key point of support for Feldstein is how housing debt negatively impacts moving behavior:

The overhang of mortgage debt prevents homeowners from moving to areas where there are better job prospects and from using home equity to finance small business start-ups and expansions. 

Feldstein here actually makes the exact opposite point as before. When arguing in favor of debt relief on the grounds that foreclosures were “bad”, Feldstein argued that fewer foreclosures would lower the supply of homes on the residential market and thus raise housing prices generally. Here, he argues for debt relief on the grounds that it allows for people to move and put their homes on the market. But, lowering debt may encourage people to stay in their own, or current, homes – at the cost of them not moving to places with better jobs. “Strategic” default behavior involves moving because of debt overhang. 

Both situations can’t be true. Debt relief may allow more people to stay in their homes – potentially at the cost of keeping them stuck in places which offer poor employment prospects. Alternatively, debt relief might encourage people to move elsewhere – in which case it will be a poor mechanism for raising housing prices.

While Feldstein offers a relatively weak sequence of justifications in favor his proposal, the actual mechanisms of his plan leave much to be desired.

In particular, his mortgage relief plan would constitute an enormously inequitable transfer of resources. Americans who took out the largest mortgages in peak bubble periods would receive enormous amounts of taxpayer dollars. Homeowners who did not purchase subprime products, and instead steadily paid down mortgage balances – or those who did not take out additional mortgage liens – would be out of luck. In short, we would see an enormous transfer of wealth away from renters and long-term owners towards housing speculators and homeowners who levered up the most.

The path of implementation will also likely prove to be difficult. The federal government has launched a seemingly interminable number of modification plans over the past few years, the vast majority of which have failed to achieve the desired results. Given that dismal track record, is there really a need for another larger, effort to write down mortgage principal – and what assurances do we have that this effort will be any different?

Feldstein deserves credit for tackling an important issue and offering a serious proposal. Ultimately, however, the justifications in favor of his policy are in conflict. In this era of multi trillion dollar budgets, constant “crises,” and seemingly interminable economic struggles, we’ve grown to expect that the government should “do something” to address every perceived price mismatch in every market. In housing, we’ve seen hundreds of billions of dollars in support for homeownership grow into a Leviathan project of debt relief, and a mortgage finance sector that has been for years entirely dominated by the federal government. Yet the balance of government efforts to induce higher housing prices and greater consumption have left Americans more insecure economically and certainly not richer. It’s time to wean the American economy off of a government-bloated housing sector, rather than doubling down on the reason we’re in a mess in the first place.