Thursday, October 02, 2008

Housing: Bad Policy Proposal

by Calculated Risk on 10/02/2008 09:40:00 AM

It would be more than a full time job - and one I don't want - to comment on all the good and bad housing policies being proposed these days. But this piece in the WSJ by R. Glenn Hubbard and Chris Mayer demands attention: First, Let's Stabilize Home Prices .

Chris Mayer recently published a study showing that -- assuming normally functioning mortgage markets -- the cost of buying a house is now 10% to 15% below the cost of renting across most of the country.
Well, it is true that Dr. Mayer recently published a study, but I believe the conclusions were incorrect. Please note that Dr. Mayer in 2005 (with Charles Himmelberg and Todd Sinai) used a similar approach and concluded there was "little evidence of housing bubbles in almost any of the markets we have studied". I disagreed with Dr. Mayer in 2005 (many people sent me his paper), and I felt that there was no question there was a bubble. I disagree with Dr. Mayer today.

But this is even worse:
We are in a vicious cycle: falling housing values cause losses on securities, which reduce bank capital, thereby tightening lending and causing house prices to fall further.
First, house prices are falling because prices are too high when compared with fundamentals like incomes and rents.

Second - and this is important to understand - the value of the securities is based on projections of future house prices, not on current house prices. If we knew the trajectory of future house prices (and the relationship to defaults), we could accurately price the various mortgage backed securties (MBS).

Since analysts are finally getting realistic on their house price projections, further house price declines (that are in line with those projections) will not impact the value of MBS! So the Hubbard and Mayer vicious cycle analysis is flawed. The apparent "vicious cycle" was caused by incorrect forecasts by analyst and economists of future house prices.

This flawed analysis led the authors to a terrible proposal: to try to stabilize house prices by using artificially low interest rates:
We propose that the Bush administration and Congress allow all residential mortgages on primary residences to be refinanced into 30-year fixed-rate mortgages at 5.25% (matching the lowest mortgage rate in the past 30 years), and place those mortgages with Fannie Mae and Freddie Mac.
First, it is important for a healthy housing market to allow prices to return to more fundamental levels (and that means further price declines and/or increases in household incomes).

Second, this shows a misunderstanding of the role of interest rates with regards to house prices. This gets complicated, but if the interest rate is artificially low today, the buyer can expect rates to rise - and therefore that the home price will not be as high in the future (all else being equal). The buyer should discount this lower house price back to the present, and we discover that interest rate changes only play small role in house prices.

This is just a terrible proposal.