Does Government Exacerbate Housing Bubble?

Is the U.S. government responsible for exacerbating the housing bubble that we now see gripping much of the nation? Dan Amoss, a financial advisor and columnist, suggests as much in his recent effort for The Daily Reckoning.

Maybe you’ve noticed, especially in areas like the Florida housing market, how much real estate has become a national pastime in the United States. It is now vital to the continued growth of consumer spending, even the growth of the economy. According to the U.S. Census, there are approximately 74 million owner-occupied housing units in the nation as of 2004.

Combining this fact with the number of existing and new home sales over the past few years, this tells us that about 9-10 percent of the housing market turns over every year.

Compare this low turnover with volume in the stock market. The typical S&P 500 stock has about 150 percent turnover per year, so you can be reasonably sure that the stock sitting in your portfolio is worth within a fraction of a percent of the last tick. The low housing transaction volume makes aggregate national housing value statistics misleading.

• The near-term value of real estate, therefore, is completely, 100 percent dependent on what current shoppers are willing and able to pay for your house.
• The “willing” part is of the equation is psychological, and psychology has morphed from “my house will appreciate 15-20 percent per year” to “my house will appreciate 8 percent per year.”
• The “able” part is dependent on global liquidity and Florida home mortgage financing aggressiveness.

When studying the bubble’s formation, it’s crucial to take a good look at the federal government’s historical promotion of homeownership.

The first influence that comes to mind is the effect that Fannie Mae and Freddie Mac have had on Florida mortgage banking. By replenishing mortgage originators, allowing them to rake in fees for each approval, the agencies provide due diligence and then some.

As per the New Deal, the Federal Housing Administration (FHA) was created to stoke the housing market. It accomplished this by providing default insurance for lenders leery of buyers without the ability to afford the high down payments required for mortgages.

As with all government programs, politicians never respect the costs beyond the next election cycle. In hindsight, those consequences are clear.

The artificial influence of government-subsidized housing is resulting, and ultimately will result, in a misallocation of resources, and usually asset bubbles. There is an interesting parallel between the Federal Reserve and the FHA, in that they both interfere in the free market, which has charged the business (and now housing) cycle.

Just as the Fed thinks it knows better than the free market what optimal short-term interest rates should be, the FHA has developed into a conduit through which the government subsidizes the entire housing market, granting first-time buyers an artificial boost in home purchasing power.

Decades of housing market inflation attracted several private companies to enter the mortgage insurance business. They viewed it as a no-brainer investment to take on the risk of default in return for modest monthly premiums. It’s important to respect the government’s aggressive response to the private sector’s market share gains.

This excerpt from President Bush’s 2007 budget proposal includes initiatives to respond to increased competition from both “piggyback loan” financing and private mortgage insurance:

“The Federal Housing Administration (FHA) is currently undergoing a rapid transformation to enable it to expand homeownership opportunities for low- and moderate-income families. Traditionally, FHA has assisted homebuyers underserved by the conventional mortgage market to obtain mortgage credit at a reasonable cost.

Since the 1930s, FHA has been a primary mortgage source for first-time and minority buyers. However, in the last three years, FHA loan volume has fallen precipitously. This is good news, in part. Lower interest rates have made unassisted mortgages affordable for more families, and the private sector has increased its use of automated underwriting, allowing it to offer loans on favorable terms to more homebuyers.

This is a positive development, when the private sector is offering favorable terms to borrowers who previously would have turned to FHA. However, a small portion of borrowers may still be ill served by incurring higher costs or unfair terms as compared to a comparable FHA loan product.

Premiums for FHA mortgage insurance currently do not vary according to a borrower’s credit risk or the expected cost from default, causing better borrowers to subsidize weaker borrowers. This has driven safer borrowers to seek alternatives offered in the conventional market and pay higher prices than they would have if offered FHA risk-based pricing. The budget proposes tiered risk-based pricing to address this issue, which will decrease homebuyers’ costs, and thereby increase access to homeownership.

This type of pricing will enable borrowers to know why they are paying certain costs and how to lower them…

To remove two large barriers to homeownership — lack of savings for a down payment and impaired credit — the administration proposes two new FHA mortgage products. The Zero Down Payment mortgage will allow first-time buyers with a strong credit record to finance 100 percent of the home purchase price and closing costs.

For borrowers with limited or weak credit histories, a second program, Payment Incentives, will initially charge a higher insurance premium and reduce premiums after a period of on-time payments. In conjunction with risk-based pricing, these products will expand homeownership opportunity on an actuarially sound basis.”

The private mortgage insurance industry was invented in 1957 by Max Karl, the founder of Mortgage Guaranty Insurance Corp., after he observed a disconnect between those who could not afford a 20 percent down payment on a Florida home loan and lenders who, for good reason, avoided extending mortgages with greater than 80 percent loan-to-value ratios.

The word “private” describes this industry because up until Mr. Karl’s entrepreneurial venture, the FHA had a monopoly in the mortgage insurance business. Memories of the Great Depression were still fresh in the minds of bankers in those days.

By shouldering the risk of default in exchange for monthly payments from people with less than 20 percent equity in their homes, this was another big step in the evolution of insurance, and has undoubtedly contributed to the nonstop buying pressure on housing over the past 50 years.

Right now, it sounds like a cash machine-type of business, provided that premiums are priced at a highly profitable level, housing prices do not decouple from income growth (they have), and the willingness of lenders to extend Florida mortgage financing does not fall short of required demand (a distinct near-term possibility).

Two widely respected economists assert that in order for the U.S. housing market to sustain current price levels, either household debt must continue growing exponentially or real wage growth must rise up from the doldrums.