Our house . . . in the middle of our street . . .

Felix Salmon takes me to task for my two posts on housing.  First, of my post on who is at fault in the mortgage market, he says:

This misses the fact that, like any leveraged borrower, the homeowner has already taken substantial losses. Homeowners are no different from any other leveraged borrower. Is Cerberus on the hook for all of Chrysler's losses? Are bank shareholders liable for unlimited capital calls in the event their company loses lots of money? No. Most secured loans are non-recourse, and banks understand full well the concept of a non-recourse secured loan: if the value of the security falls below the value of the loan, they're liable to lose money.

Now legally, it's true, many US mortgages have recourse to the borrower. But it's equally true that in the real world, the overwhelming majority of mortgages are de facto non-recourse.

I am certainly not arguing that we should make home loans recourse loans.  And neither is anyone else, as far as I know, proposing to take large amounts of extra money from the homeowners and transfer it to the lenders in order to make up for the fact that their collateral isn't worth what it once was; when people did make such a proposal, during the 2005 bankruptcy reform, I was against it.  The only proposal in that direction is that the homeowners should have to keep paying what they agreed to pay, or else lose the house.

On the other hand, there is a proposal on the table to make the homeowners partially whole on their losses by writing down their mortgage interest rates, at the expense of the banks who lent them money.  In the context of that argument, a number of people seem to be making the argument that the homeowners really deserve a large transfer from the banks, because it was the fault of the banks that they lent them money in the first place.

I think both the lenders and the borrowers were acting like idiots.  I don't think that either of them "deserve" to lose money, in the sense that I would actually like to see them do so; I think it would be much nicer if homeowners and bankers were both prosperous.  I think that there need to be substantial costs to both sides to a foreclosure to prevent either side from abusing the system, and I think we've actually got a pretty good balance:  banks lose money obtaining and selling the collateral, and borrowers lose any downpayment and get a big ding on their credit report.

I think that during the asset bubble, these potential penalties lost their sting, and that leaves us in the unhappy situation of today.  That's why I think something like a system where homeowners hand over the deed in exchange for taking no hit on their credit report or their tax bill is a good idea because it doesn't reward borrowers for irresponsibility, or penalize them unduly for buying during a bubble.  But I don't say this because I think either of them deserves it; I simply think we'll all be better off if we let everyone escape with as little damage as possible, but no incentive to be stupid again.

A side quibble:  as far as I can tell, most borrowers who bought with little money down haven't taken any real losses.  They may take losses in the future, if they make all their payments and prices never recover.  But most of the really troubled homeowners haven't paid enough money towards equity to claim they've lost anything except a little time.

Felix also says that the mortgage interest tax deduction doesn't matter to most people:

The standard deduction in 2009 for a married couple filing jointly is $11,400. That means you get to subtract $11,400 from your income even if you don't pay any mortgage interest at all. Now suppose that married couple bought a home for $200,000, put 20% down, and got a 6% mortgage. Then their annual interest payments are 6% of $180,000, or $10,800. They own your own home, but they get no benefit from the tax deduction: they're still better off taking the standard deduction.

Of course, if you own a home in Washington DC or in New York, you're likely to have a mortgage of much more than $180,000. But let's say that our married couple bought a $350,000 house instead, and have annual mortgage interest payments of $16,800. Then their taxable income will be reduced by $5,400 as a result of the mortgage-interest tax deduction, which means that their taxes will be reduced by about $1,900, or about $150 a month -- compared to $1,400 in mortgage interest payments. By contrast, refinancing from a 6% mortgage into a 4.5% mortgage will save them $350 in mortgage interest payments: movements in interest rates are much more important to homeowners than tax laws are.

It's true that the mortgage interest tax deduction doesn't really matter at the low end of the market, but this is as much because buyers there don't pay much in the way of income tax as it is due to the standard deduction.  But towards the middle of the range, things change because of course, the mortgage interest tax deduction is not the only potential deduction against income.  There are also things like state income taxes, childcare expenses and the dependant deduction. 

To flip Felix's formula around, this doesn't matter so much in pricey areas like DC and New York, because so few people can afford more than one or two children.  But add in state taxes and three or four children, especially if one or two are under the age of six, and the mortgage interest tax deduction starts to really matter in the house price again.  Perhaps not as much as changes in interest rates, but I don't think I claimed that the mortgage interest deduction did matter more than interest rates, and indeed, it seems mathematically impossible that it would.  But again, we aren't comparing the mortgage interest rate deduction to government controls on interest rates; we're comparing it to no deduction.