As the Senate turns to crafting its own version of the stimulus package, many are calling for amendments that directly target the plummeting housing market. To be sure, house prices have been inflated in recent years, so a measured decline in house prices is warranted. The problem is that house prices have already fallen to their pre-bubble levels, and economic forecasters and financial futures markets suggest that, without action, house prices will continue falling into 2010.
These declines have a real impact on the economic climate. About two thirds of Americans own houses, and for most of them their houses constitute a substantial portion of their net wealth. As house prices decline, homeowners reduce consumption and save more to compensate. Stabilizing house prices is therefore a critical component of an economic recovery plan. Several Columbia University professors have recently released a policy proposal to address the collapsing housing market. The plan has two components, one or both of which are likely to be included in some form in proposed amendments to the Senate fiscal stimulus.
Lowering mortgage rates
The first piece, published by Glenn Hubbard (dean of Columbia Business School) and Christopher Mayer (Senior Vice Dean) calls for an immediate reduction in mortgage interest rates. Mortgage rates have historically hovered about 1.6 percent above the ten-year Treasury bond rate, but that spread has recently increased. So although the government and banks can borrow at historically low rates, those rates haven't been passed along to borrowers seeking to buy homes. Reducing rate spreads to their normal levels would bring mortgage rates down as low as 4 percent. Not only would these low rates allow many Americans to refinance their mortgages, translating to an average monthly payment reduction of over $400 per month, it would also bring many new homebuyers into the market, thereby mitigating the current excess housing supply.
Dean Baker says this implicitly means that new buyers will lose money on their homes in the future, since these low rates would inflate house prices above natural levels. But this criticism misses the point of the empirical analysis that precedes the 4 percent proposal, which looks at where house prices should be. If they've already fallen below their efficient level, and they're still falling simply because of ill-functioning credit markets, Baker's fear that we're going to create a new bubble is unfounded.
Some would argue that, in this market of high default rates and economic uncertainty, mortgage spreads should be more than their historical levels. But this ignores a crucial component of the cost of mortgage lending. In mortgage lending, investors face two risks. The first is that borrowers will default, leaving the lender with a foreclosed property. In the present market, this risk is indeed higher than it has been historically, both because default rates are up, and because the property the investor is left with may have fallen in value. But mortgage lenders also face an additional risk -- that borrowers will refinance and pay off their existing mortgages if rates fall in the future, leaving the investor with a bunch of cash (instead of a profitable investment) just when he least desires it - when interest rates are low. This prepayment risk would be far lower for newly refinanced mortgages than it has been historically, since there is virtually no risk that future mortgage rates will fall below 4% and lead borrowers to refinance these mortgages.
To reduce the transaction costs of this plan, the government could automatically refinance the 30 million Fannie Mae and Freddie Mac mortgages already on its books -- it already owns the risk on these mortgages, and such automatic refinancing would leave banks available to deal with an influx of non-GSE applications.