America's housing market implosion was the epicenter of the Great Recession. It's hardly surprising that the federal government directed enormous resources at the market. Besides bailing out vulnerable banks, the federal government nationalized mortgage behemoths Fannie Mae and Freddie Mac, opened the lending spigot at the Federal Housing Administration (FHA), passed a first-time home buyers' tax credit, and established a mortgage modification program for troubled homeowners. The Federal Reserve embarked on a $1.25 trillion purchase of mortgage-backed securities in an effort to engineer lower mortgage rates.
The Herculean efforts may be understandable. But they were a mistake in the early months of the downturn—and now stand as a public policy blunder in the early months of a recovery. That's a harsh judgment, but it's way past the time for ending taxpayer support of the housing market.
These policies are geared toward propping up home prices, the definition of a perverse public policy. Artificially holding prices at above-market levels harms new potential buyers, from young adults starting their own households to immigrants putting down stakes in the American Dream. The subsidies wrongly delay the inevitable home market price adjustment to excess supply in many markets across the country.
"I don't see anything being gained by holding housing prices higher than the market rate," says Dean Baker, economist and co-director of the liberal Center for Economic & Policy Research in Washington. "It is difficult to see why the government would want to pursue policies that would encourage people to pay too much for homes."
Dump the Tax Credit Entirely
At a minimum, the government should allow the first-time home buyer tax credit to expire on its target date of Apr. 30 , 2010 (with the purchase completed before July 1). The tax credit has already been expanded and extended past its original expiration date of Nov. 30, 2009. The Obama Administration may be under pressure from some members of Congress and advocates for beleaguered homeowners to beef up its troubled Homeowner Affordability & Stability Plan mortgage relief program, but it would be far better to scrap it altogether. The FHA should continue its recent move toward boosting its lending standards. The Fed should adhere to its plan to stop buying mortgage-backed bonds by the end of the first quarter.
Longer-term, the Administration and Congress should start the process of culling the U.S. tax code of the myriad special provisions that favor housing. In a modern economy, it makes no sense for homes to get preferable tax treatment over stocks and other investments. What's more, Canada doesn't allow mortgage interest deductions, yet its homeownership rate is comparable to that of the U.S.
To be sure, the U.S. housing market remains weak and is going through another rough patch. For instance, sales of existing homes plunged 7.2% in January. That's on top of a revised 16.2% drop in December. New home sales plunged in the first month of the New Year to the lowest level in five decades. Mortgage applications are weak. Foreclosure projections are running in the 3 million-plus range for 2010. With a near double-digit unemployment rate, plenty of potential home buyers are wary of betting on housing at the moment.
Still, the market may not have much farther to fall. For example, by one important measure, the housing market is nearing bottom. Many factors affect the value of homes, from the health of the job market to the animal spirits of speculators. But prices in the rental market are critical. After all, rent and home ownership compete for household dollars. If rental prices are going up, owning a home becomes more attractive, and vice versa.
That's why it's worth paying attention to a metric called the rent-to-price ratio. It measures the gap between the price of a house and the amount of rent tenants would pay to live in it. For instance, if a house priced at $283,000 would rent for $10,000 a year ($833 a month), the rent/price ratio is some 3.5%. Economists Morris Davis, Andreas Lehnert, and Robert Martin calculated that the rent/price ratio averaged 5.29% from 1960 to 1995. But from 1995 to 2006 a home buying frenzy drove the ratio down to a historically low rate of 3.5%. Davis, an economist at the University of Wisconsin, Madison, says the ratio has climbed back to a recent peak of 5% in the first quarter of 2009, and in the fourth quarter of last year it was at 4.85%. Rents may trend lower, with a national rental vacancy rate of nearly 11%, close to a record high. Nevertheless, "the ratio is at its historic average," says Davis. "Looking at that ratio, you would say that housing prices have stabilized."
In the forecasting business, everyone eventually comes back, ruefully, to Samuel Goldwyn's famous remark, "Never make predictions, especially about the future." The future direction of the housing market is uncertain. What is certain—and it's the genius of a capitalist economy—is that the market adjustment will be much quicker and fairer if the government stops its efforts to prop up prices. Let the market work.