Ever since Americans became familiar with the term “subprime mortgage,” the housing market has loomed large as both a primary cause and a continuing source of the economy’s struggles. Two of the nation’s leading housing market scholars see a way out, however. In May, the Federal Reserve Bank of Cleveland invited these professors to discuss the state of the national housing market, its role in the economic recovery, and possible policy actions to address the housing sector’s problems.
Reducing household debt
Amir Sufi, a professor of finance at the University of Chicago’s Booth School of Business, argues that housing is in fact the key to understanding how the recession spread across the United States and how addressing its problems now can speed the economy’s growth.
Financial bubbles have come and gone throughout history. According to Sufi, the housing bubble was made particularly onerous thanks in part to three key ingredients:
Right now, households that need the money the most can’t get it, and because of the glut of vacant properties, lower interest rates don’t help builders as much as they usually would.
- First, high levels of debt are associated with housing. (Even the former industry standard of a 20 percent down payment today seems quaint in the wake of zero-down mortgages that presaged the crisis.)
- Second, housing is an illiquid asset. So even home equity isn’t something that homeowners can readily tap. As of 2007, home equity represented the majority of net worth for homeowners, even for those up to the 90th percentile of the income distribution, Sufi noted, citing the Federal Reserve’s Survey of Consumer Finances. This means that even the vast majority of American homeowners, including those typically considered well off, had more than half of their wealth tied up in their homes.
- And finally, households with the largest propensity to consume have higher debt ratios, Sufi argues. When the housing crisis hit, there was a dramatic jump in the ratio of U.S. housing debt to value, and the households with the largest consumption were hit hardest. Of course, they weren’t the only ones who suffered, but the aggregate impact of their troubles sent the wider economy reeling.
Add it up, and it was a recipe for disaster. Before the recession, household debt levels varied greatly. With the recession, household balance sheets took an enormous hit, and consumption by high-debt households sharply declined. And households with little debt still couldn’t pick up the slack, Sufi says.
Consider the plight of the U.S. counties with the highest debt-to-income ratios as of 2006. These counties saw elevated levels of foreclosures; constraints on borrowing; and from 2006 to 2009 the largest declines in house prices, household spending, and employment in local jobs such as dry cleaners and auto dealers. As the recession spread and unemployment spiked, even low-debt counties were affected because the goods they produced no longer had the previous demand. And while interest rates sank to historically low levels, the people who needed to access inexpensive credit couldn’t meet the qualifications.
Right now, households that need the money the most can’t get it, and because of the glut of vacant properties, lower interest rates don’t help builders as much as they usually would. Sufi’s leading policy prescription is to reduce household debt by reducing mortgage principal, not just payments. This approach, he says, would have the most positive impact on the economy.
Restoring normal credit
Chris Mayer, the Paul Milstein Professor of Real Estate and Finance and Economics at Columbia Business School, notes more positive trends: New delinquencies are falling rapidly and household formation is getting to a point where demand for housing is rising. Mayer prefers a different set of government efforts over principal reduction, which, he cautions, could have damaging effects on the financial system.
The key for Mayer is credit, which is not returning to mortgages as it is in other sectors of the economy, such as in auto financing. Since the crisis started, the availability of mortgage credit has rested largely on Fannie Mae and Freddie Mac (government-sponsored enterprises, or GSEs) and the Federal Housing Administration (FHA). But getting these loans is not that simple: Mayer points to numbers that show that even with a great credit history, it’s hard to get a GSE loan, and while qualifying for an FHA loan is easy by historical standards, these loans come with high costs and rising fees.
The middle class is the loser in all this: Either they can’t get loans or they can’t afford the ones they can get. Mayer’s prescription is to focus on restoring credit at normal terms. The credit supply channel has been understated, and Congress needs to act. Reducing principal can be effective, but difficult—so he suggests going for the low-hanging fruit by providing more normal credit. A widespread refinancing program, which the Federal Housing Finance Agency already has the authority to pursue, is a good place to start. Compensate servicers for modifying mortgages and pass legislation that modifies existing securitization contracts. Then reduce mortgage rates to levels seen in a normally functioning housing market. One way to do this, says Mayer, is for the Federal Reserve to swap debt in Fannie Mae or Freddie Mac for an equivalent Treasury security.While Sufi and Mayer might diverge a bit on the best and most effective way to address the housing problem, they agree that it’s continuing to hold back the recovery. A large part of the population is simply “sitting it out” because they have too much debt or too little normal credit to participate in the economic recovery. Unless household debt and credit problems are addressed swiftly and soundly, economic growth will remain tepid at best, they argue.