Congress is currently debating the Dodd-Frank bill, which would provide relief for struggling homeowners. But does the bill offer the most efficient solution to the housing crisis?

Dean Baker and Robert Kuttner |
June 27, 2008 The American Prospect

Congress, looking to protect debt-threatened homeowners and shore up the economy in the wake of the sub-prime mortgage crisis, has spent the spring wrangling over relief legislation now expected to pass after the Fourth of July recess. The bill, sponsored by Senator Chris Dodd (D-CT) in the Senate and Representative Barney Frank (D-MA) in the House, is designed to ease the threat of mass foreclosures by protecting some existing loans, and prevent future crises by imposing stronger regulations on major mortgage financers Fannie Mae and Freddie Mac. But does the bill go far enough in protecting homeowners, and does it offer the most efficient solution to the problem? Prospect Founding Editor Robert Kuttner and TAP Online columnist Dean Baker debate the bill and the future of the home loan regulation.

Dean Baker:

The housing bubble was an entirely preventable disaster. If the economists and other policy professionals who design economic and housing policy had not been asleep for the last decade, it could have been prevented. Their incompetence will have serious impact on the living standards of a generation.

Unfortunately, these sleepwonkers are still designing policy. Their current bailout proposal, the Dodd-Frank bill, would help many of the banks whose bad lending practices fueled the bubble. It will do little to help the homeowners and communities most affected.

As far as recognizing the bubble, it should not have been hard. Nationwide house prices had on average just kept even from 1895 to 1995. Suddenly in the mid-90s house prices begun to hugely outpace inflation. There were no obvious factors on either the supply or demand side that could explain this extraordinary run-up in house prices.

By 2002, house prices had already risen by more than 30 percent after adjusting for inflation. This was a good time to start asking whether we were seeing a housing bubble sparked by our stock bubble, as had happened in Japan in the 80s.

While the bubble by itself would have created enormous problems, matters were made worse by the explosion of irresponsible lending in the bubble’s late phase. In particular, subprime lending expanded from less than 10 percent of all mortgages in 2002 to more than 20 percent in 2006.

Subprime mortgages targeted the most vulnerable segments of the population, with Latino and African American homeowners being far more likely to receive subprime loans. While the disaster facing these communities was totally predictable, many politicians and policy makers celebrated the increases in homeownership among these groups.

As inevitably happens, bubbles burst and the housing bubble has been deflating since the summer of 2006. In the most recent data, real house prices in the Case-Shiller 20-city index were falling at 26 percent annual rate. In the most inflated markets, like Phoenix and San Francisco, they were falling at close to a 40 percent annual rate.

This plunge is incredibly painful. Tens of millions of homeowners are seeing the bulk of their life’s savings disappear before their eyes as house prices drop as much as 4 percent a month in some cities. A whole cohort of workers is now facing retirement with almost no wealth.

Unfortunately, there is little that can be done to prevent this disaster. It would be the height of foolishness to create a house price support program to try to sustain the bubble. The basic issue is that there is a huge excess supply at current prices. Unless we impose laws restricting construction to constrain supply, prices will continue to drop. At best, we may delay the decline and allow some current homeowners to sell at partially inflated prices so that the new buyers can enjoy the rest of the crash. That is not good policy.

We can protect people facing foreclosure. A no-cost, no bureaucracy method would simply change the rules on foreclosure to allow moderate income families facing foreclosure the right to remain in their home as long-term tenants paying the fair market rent. This would give homeowners security in their home. It would also give lenders a real incentive to negotiate terms that allow homeowners to stay in their homes as owners, since banks do not want to become landlords.

By contrast, the Dodd-Frank bill would have the government guarantee new mortgages, often at bubble-inflated prices. This will most benefit banks with bad loans. Even though they will have to take substantial write-downs against the loan’s initial value, the banks (not the homeowners) get to decide which mortgages are brought into the program.

This will not help homeowners, since many will find that they are paying far more in housing costs than they would to rent a comparable unit, leaving less money for items like food, health care and child care. And since house prices are falling, they are unlikely to accumulate any equity. Of course, when the house price falls, the government is likely to have to make good on the guarantee.

In short, the Dodd-Frank bill will make a really awful situation even worse. We will be using taxpayer dollars to help predatory lenders mitigate their losses. At the same time, we will be persuading moderate income families to pay too much for housing in order to once again end up with negative equity. That’s not good policy.

Robert Kuttner:

Ordinarily, I see eye to eye with my friend Dean Baker. But I think his view of the housing bust is off in several respects. But first, let’s see where we agree.

Certainly, there is a housing bubble, and it is partly the result of bad policy — notably the takeover of a good deal of mortgage lending by predators, and the abdication of financial supervision by the government. Had normal lending standards been enforced, the speculative bidding-up of housing prices would not have been so extreme. We can attribute much of the rest of the bubble to very low interest rates and easy mortgage credit even before the subprime scandal, followed by money pouring into real estate after the stock market crash of 2000-01.

However, it is a mistake to think that the best policy is one of benign neglect, for there is nothing benign about a situation in which American homeowners stand to lose two trillion dollars of their net worth, and foreclosures proceed at the rate of 25,000 a week. Most Americans losing their equity, and sometimes their homes, are innocent bystanders; they did not take out sub-prime loans and they were not speculators. Some of the hardest hit victims are hard working blue collar Americans whose only sin is to be homeowners in neighborhoods with large numbers of foreclosures.

The situation is analogous to the first years of the Great Depression, in which financial conservatives like Andrew Mellon, Herbert Hoover’s Treasury Secretary, cheered on a deflationary spiral, as “purging the rottenness out of the system.” We later learned, from Keynes among others, that an economy can settle down in an equilibrium of high unemployment and depressed purchasing power that is far worse than other possible equilibrium states. We also learned from another great economist of that era, Irving Fisher, that a depression is marked by a “debt-deflation,” which occurs when the price of assets fall below that of their collateral. This situation is befalling millions of American families whose homes are now worth less than the mortgages on them.

The most pressing need is stopping the deflationary spiral. Dean is just wrong when he argues that there is no viable way to put a floor under housing prices. For instance, many renters are paying much more than they can afford. An imaginative housing policy could convey foreclosed-upon houses to local housing agencies, where they could be turned into affordable rentals. We could also subsidize first-time home purchases, matching aspiring buyers with an excess housing stock. Both strategies would help put a floor under housing prices, and by helping people seeking affordable housing.

This brings me to the much maligned Dodd-Frank bill. The central provision would help brake the wave of foreclosures by permitting government-insured refinancing. When Dean calls this a bailout of banks, he has it exactly backward. The bill encourages servicers of mortgages to ease the terms for borrowers and to extract the cost from the financial institutions that purchased the mortgage backed securities. This substantial “haircut” would come at the expense of financiers, and would ease the plight of borrowers.

Let’s not forget that most of the people who took out these mortgages were deceived by the lenders and were manipulated into taking out loans with Mafia-like terms. Government failed to do its job protecting consumers. Now government needs to make amends. The main function of the Dodd-Frank approach is to moderate the terms of these loans to normal rates. To the extent that someone eats the cost of the eased terms, it is mostly the investor in the mortgage-backed security, not the taxpayer.

Mortgage foreclosures are projected at about three million in the coming two years. The sponsors of the bill project that refinancings under Dodd-Frank could prevent a third to a half of these. There is no way that three million foreclosures is a case of salutary purging of the rot in the housing market. For the most part, these are people with the most tenuous hold in the lower middle class, who stand to be financially wiped out.

To the extent that some homeowners realized windfall gains from the housing bubble, there is no way to prevent grossly inflated housing prices from settling back down to something normal. But there is a huge difference between a gradual decline and an abrupt deflation. If we learned anything from the Great Depression, we learned that bouts of deflation can be catastrophic and long-lived.

Going forward, we need both a better bank-regulatory policy and a better housing policy. The Dodd-Frank strategy is not perfect, but it is a good start.

Dean Baker:

Bob and I agree on one other important point, the housing crash is really horrible. Innocent people are losing their homes and their life saving because of the malfeasance of people with names like Greenspan, Mozilla, and Bush. The difference is that I consider it no more reasonable or desirable to try to sustain a housing bubble than to sustain a 5000 Nasdaq.

We have a 100 year-long trend in which house prices just tracked inflation. In the years from 1995 to 2006, real house prices rose by more than 70 percent. This run-up led to an unprecedented construction boom, which led to a massive oversupply of housing, which is causing house prices to return to their trend level. I don’t know how to keep prices from declining in this context and I don’t know anyone who does.

The Dodd-Frank bills will not keep prices from falling, as simple arithmetic shows. It will provide $300 billion in guarantees (the equivalent of perhaps $12 to $15 billion in new investment) in a $20 trillion market. That will not prop up a market that is more 1,000 times larger.

This might be enough to keep some badly depressed markets (e.g. Detroit and Cleveland) from falling into a downward spiral, but the bills’ proponents explicitly rejected efforts to restrict the money to these markets. Also, the bill gives the lender — not the homeowner — the decision as to whether a loan gets into the system. Needless to say, the Countrywides will be sure to stick the government with their worst loans.

Finally, it is worth going over the arithmetic on homeownership in bubble-inflated markets. In these markets, the ratio of house prices to annual rent of comparable units is often more than 25 to 1, which means that rent is less than 4 percent of the sale price. If a homeowner gets a 6.5 percent mortgage, pays 1 percent for maintenance and insurance and 1 percent for taxes, then they are paying 8.5 percent of the sale price, not even counting any principle payment. If the house sells for $200,000, then this family will be spending an extra $9,000 a year to “own” a house that is falling in price. I wouldn’t recommend this to a moderate income family earning $40,000 a year.

For those who want to help homeowners rather than bankers, I recommend Representative Raul Grijalva’s alternative.

Robert Kuttner:

Dean is off the mark in several respects. As a good economist, he knows that what matters is change at the margin. It is sales and purchases and foreclosures of houses, not the whole housing market that needs to be stabilized. So his arithmetic is hugely inflated. Dean also ignores the larger risks of a mass deflation led by a housing crash. I urge Dean and readers to review any of several good books on the early 1930s to appreciate what a serious deflation can do — Jonathan Alter’s The Defining Moment, on FDR’s first hundred days, is a good primer.

Yes, some “undeserving” bankers and even speculators were saved, but the alternative was economic collapse. What kind of Calvinist, Hooverite, pre-Keynesian would want to teach such an expensive lesson? It’s not enough to bask in the satisfaction of being able to say, “I told you so” — we are playing with the risk of a depression.

It’s also a gross exaggeration to say that housing prices just tracked inflation for a century. They rose in the 1920s, fell in the 1930s, and have risen in other boom periods. There is no intuitively right ratio of housing prices to incomes. Housing prices do need to settle down, but it’s not constructive to just cheer on a crash. Homes are not the NASDAQ; they are where people live, and they represent the lion’s share of net worth for the working and middle class.

The Dodd-Frank legislation will in fact help to put a floor under collapsing housing values — by preventing about a million foreclosures and helping others to refinance at less punishing rates. It will put more disposable income back in the hands of consumers, by lowering their mortgage costs. That itself will brake the slide in housing prices. Other provisions of the bill will subsidize access to empty homes for buyers and renter. It could be stronger, but it’s what’s on the table.

Dean Baker is the co-director of the Center for Economic and Policy Research.