How to Stabilize the Housing Market

Note: This op-ed also appeared in the Financial Times.

The central irony of a financial crisis is that while it is caused by too much confidence, borrowing and lending, and spending, it can be resolved only with more confidence, borrowing and lending, and spending. This is true, above all, of housing policies. Fannie Mae and Freddie Mac, government-sponsored enterprises (GSEs) whose purpose is to mitigate cyclicality in housing and that today dominate the mortgage market, have become a textbook case of disastrous and pro-cyclical policy.

Construction of new single-family homes has plummeted from about 1.7 million annually in the middle of the last decade to the range of 450,000. With annual housing starts averaging well over a million during the 1990s, the shortfall in housing construction now dwarfs the excess of construction during the bubble period; it is the largest single component of the shortfall in gross domestic product.

Losses on owner-occupied housing have reduced consumers’ wealth by more than $7 trillion over the past five years, and uncertainty about homes’ future value as well as the inability to refinance at reasonable rates deters household outlays on durable goods. The continuing weakness of the housing sector is an important source of risk for major U.S. financial institutions, significantly raising the costs of the loans they offer.

Unfortunately, for several years policy has been preoccupied with backward-looking attempts to address the consequences of past errors. While the focus has been on helping individual homeowners, decisions that are ultimately more important regarding the GSEs have been left to their conservator, the Federal Housing Finance Agency, which has taken a narrow view of the public interest. The FHFA has neglected its conservatorship mandate to ensure that the GSEs help stabilize the nation’s housing market. It has taken no account of the reality that the the GSEs’ health depends on a national housing recovery. Instead, the FHFA’s focus has been on reversing previous policies, heedless of changes in the environment and treating mortgage finance as a morality play. A better approach would involve a number of substantive changes.

First, and perhaps most fundamentally, credit standards for those seeking to buy homes are too high and too rigorous. The characteristics of the average successful applicant in 2004 would make that applicant among the most risky today. The pattern should be the opposite, given that the odds of a further 35 percent decline in house prices are much lower than they were at past bubble valuations.

Second, as President Obama stressed in rolling out his jobs plan, there is no reason that those who are current on their GSE-guaranteed mortgages should not be able to take advantage of lower rates. From the perspective of the guarantor, as distinct from the mortgage holder, lower rates are all to the good since they reduce the risk of default. The GSEs, however, have made refinancings very difficult by insisting on significant fees and by requiring that any new refinancier take on all the liability for errors in underwriting the original mortgage at a cost to American households of tens of billions a year.

Third, stabilizing the housing market will require doing something about the large and growing inventory of foreclosed properties. Aggressive efforts by the GSEs to finance mass sales of foreclosed properties to those prepared to rent them could benefit both potential renters and the housing market.

Fourth, there is the issue of preventing foreclosures, the initial focus of housing policy efforts. The right way forward is far from clear. While the Obama administration’s loan modification effort has been criticized for overly restrictive eligibility criteria, a significant fraction of those receiving assistance have ultimately been unable to meet even their reduced obligations, which suggests the difficulty of targeted foreclosure reduction. Surely there is a strong case for experimentation, with principal-reduction strategies at the local level. The GSEs should be required to drop their opposition to experimentation and move to a more constructive posture.

Fifth, there were clearly substantial abuses by financial institutions and most everyone in the mortgage industry during the bubble. Just compensation to the victims is a legitimate objective. But allowing negotiation over past actions to be the dominant thrust of policy creates overhangs of uncertainty that impose huge costs on the financial system and inhibit lending. A rapid resolution of disputes is equally in the interests of bank shareholders and the housing market. The FHFA should be striving to rapidly conclude this period of uncertainty.

Other players in housing policy could also help. Bank regulators could facilitate inevitable restructuring of underwater mortgages by requiring banks to treat second mortgages and home equity loans in realistic ways. The Federal Reserve could support demand and the housing market by again expanding purchases of mortgage-backed securities.

With constructive approaches by independent regulators, far better policies could be in place in six months and the tone of the market could improve immediately. There is nothing else on the feasible political horizon that can make as large a difference in driving America’s economic recovery.

The writer, a professor and past president at Harvard University, was Treasury secretary in the Clinton administration and economic adviser to President Obama from 2009 through 2010.