Glenn Hubbard calls for the treasury to refinance peoples' mortgages at low rates:

Raising the demand for housing makes sense now. While fundamental factors clearly played a role in driving down house prices that were at excessive levels two years ago, we have argued in a paper (to be published in the Berkeley Electronic Journal of Economic Analysis and Policy) that in most markets house values are today lower than what is consistent with the average level of affordability in the past 20 years.

Nonetheless, without policy action house prices are likely to continue falling, thanks largely to the meltdown in mortgage markets and the weakening employment outlook. Conversely, we see little risk that increasing the demand for housing will touch off another housing bubble. And indexing the mortgage rate to the Treasury yield could avoid this outcome in the future. While the economy is contracting, low interest rates would spur housing activity. When economic activity improves, the U.S. Treasury yield and mortgage rates would rise.

A 4.5% mortgage rate is not too low. The 10-year U.S. Treasury yield closed at 2.3% on Dec. 12, 2008. Hence a 4.5% mortgage rate is 2.2% above the Treasury yield, above the 1.6% spread that would prevail in a normally functioning mortgage market.

Some have argued that lenders should earn more than the average 1.6% spread, to compensate for the fact that housing is a much riskier investment today. We don't think so. Recall that a mortgage can be thought of as a risk-free bond plus two possibilities that increase risk to lenders: default and/or prepayment. Historically, the risk of default adds about 0.25% to the interest rate. The remaining spread of the mortgage rate over the Treasury yield represents the risk of prepayment and underwriting costs. With falling house prices, the risk of default could indeed add 0.75% or more for a newly underwritten and fully documented loan. But 4.5% would be the lowest mortgage rate in more than 30 years -- so the additional risk to lenders of prepayment would be almost nil. And low mortgage rates would substantially reduce the risk of further house price declines...

Brad DeLong seconds the motion.  Arnold Kling vehemently dissents.

I've been thinking a lot about this because I've been following rather closely Elizabeth Warren's attempt to broaden TARP's mandate from protecting the financial system to making sure that people don't suffer from falling house prices.  (See Economics of Contempt for an acerbic critique of that attempt from the center-left).  My recent foray into the housing market has exposed me to the tragedy of overextended landlords, and it is indeed tragic.  We've seen a lot of landlords who are clearly at the end of their financial rope.  Can we help them?

I'm pretty sure we can't, for several reasons.  The first is that a lot of economists (and me) think that the housing market has quite a bit further to fall--but perhaps Glenn Hubbard is right and they are wrong.  But the second problem is that I don't think what we're seeing is simply a matter of excessively high interest rates.  ARM rates (that being what the problem mortgages mostly had) are not high right now.

I think we're seeing a lot of problems that low mortgage rates won't fix:  a supply overhang, as Arnold points out, and people who need to sell in order to move or downsize after a job loss.  But mostly I think the problem is that the housing market, and homeowners, had not merely become dependant on easy credit, but on expanding credit.  House prices two years ago were founded on the implicit assumption that the homeownership percentage would keep rising, not merely stay steady.  And it can't rise any more, or even stay where it is, without putting a lot of people into risky loans.

Risky not because they necessarily have a high interest rate, but because when you own a house, you're very illiquid.  If you need to sell quickly, to move or downsize, you can end up in big trouble.  The way we used to protect against that illiquidity was to require big downpayments--traditionally, 20% of the house.  That way you could be virtually assured that you could, if you really had to, get out without involving the bank.

Some of the problems in mortgage markets are because of resetting interest rates.  But a lot of the problems are because people are hitting financial hardship, or they need to move for some other reason.  In the olden days, people in trouble could take out home equity loans to tide them over, or sell the house.  But with negative equity, they can do neither.  If someone has lost their job, lowering their mortgage payment from $1,000 to $850 is not going to help for long--and indeed, getting into that sort of program will probably take longer than they have.

The only way to really stabilize markets is to somehow build up home equity.  But such a program is both incredibly expensive, and politically ludicrous--are you really going to give people tens of thousands of dollars outright because they took out a mortgage they couldn't afford?

Beyond that is the problem of how the government manages all these loans.  They will, definitionally, be the ones to the borrowers most likely to default on even the newer, cheaper mortgage.  Foreclosure is said to cost banks 25-50% of the price of the house; it will not be cheaper for the government.

Whether or not it should, there are certainly situations where the government can prop up prices artificially.  But the housing market is too big, and too dislocated, for that to work at this point.  The supply curve and the demand curve will find each other--and given the overhang of new construction, I'd guess that in the near future, they'll meet at a point even lower than we're seeing now.


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