The housing market continues to suffer from a painful and prolonged hangover commensurate with its worst binge in U.S. history and many politicians and Fed officials are anxious for a housing rebound to pull the rest of the economy along.
This hangover has thus far been nursed with more of the same cheap money and lavish subsidies on which the housing market previously binged. During his State of the Union address President Obama promised additional subsidies to about 3 million refinancing homeowners of an average of about $3,000 annually — to be paid for with a "small tax" on the too-big-too-fail commercial banks — estimated at $5 billion to $10 billion per bank.
Several weeks earlier, a Fed white paper also proposed a variety of other new housing subsidies recently supported in congressional testimony by Chairman Bernanke before the House Financial Services Subcommittee on Capital Markets and Government-Sponsored Enterprises chaired by Congressman Scott Garrett.
The HUD budget shows an average outlay of about $30 billion annually for housing subsidies during the last decade, but this is only the tip of the iceberg as most housing subsidies are provided with a combination of tax and regulatory favoritism that total about several hundred billion dollars annually.
The federal mortgage interest tax deduction is the largest of these, averaging about $60 billion. In addition, the federal government provides a variety of tax credits for low income housing, historic preservation, etc., and the biggest tax subsidy for rental housing is the ability to shield income by accelerating non-cash "passive" losses due to depreciation on rental housing and paying the lower capital gains rate on deferred recognition of income. These tax benefits cost about the same in total as the homeowner mortgage deduction. State and local housing subsidies provided by tax credits, tax exempt financing, and low-income set-asides for redevelopment agencies also contribute opaquely
Low capital requirements for mortgage lenders are the single biggest and least transparent source of home ownership subsidies, providing about $50 billion annually during the last decade to Fannie Mae and Freddie Mac, and an additional $30 billion annually to commercial banks. Equity capital is more expensive than debt both because interest — but not dividends — are deductable and because equity requires a higher yield to compensate for the additional risk. About half of this subsidy reflected the tax savings and half the implicit backing of debt provided by agency status and deposit insurance that made debt cheap, as Fannie, Freddie, the large banks and investment banks were all considered too big to fail. Capital subsidies have likely grown to more than $100 billion annually as the government role has expanded to cover about 95% of the home mortgage market.
All housing subsidies drive up prices, but it was the increase in capital subsidies that caused the recent bubble in house prices, predominantly in the areas with restrictive growth covenants. Bursting this bubble was the immediate cause of the U.S. financial crisis, which spread systemically and precipitated the global economic recession.
The new proposed subsidies are small in comparison to existing subsidies of approximately $250 billion annually, but house prices still haven't reached their pre-bubble trend line and are propped up by massive ongoing capital subsidies as well as the myriad forbearance and legal roadblocks to foreclosure and the Fed's ongoing zero interest rate policy. The U.S. housing market remains addicted to subsidies and the withdrawal pains will undoubtedly be severe. Mortgage borrowing costs will likely rise by several percent to cover the higher cost of capital, and house prices will continue to fall, possibly well below their long term trend line for several years. This will increase the pain of negative equity for existing borrowers, further reducing bank profits. Keynes quipped that "in the long run we are all dead," and more Keynesian stimulus may well dull the short run election year pain, but we may already be approaching the long run when additional subsidies prevent detoxification and recovery.
Many analysts agree with former Kansas City Fed President Thomas Hoenig that the Dodd-Frank Act did nothing to make the financial system safer and another crisis is looming. Phasing out capital subsidies should be the immediate priority to reduce systemic risk. This requires the imposition of appropriate bank risk-based capital requirements with no opportunity for regulatory arbitrage as well as the gradual but certain wind-down and elimination of Fannie and Freddie and the recapitalization of FHA to an actuarially sound condition with strict house price limits imposed on future activity.
Congressman Garrett has introduced sobering legislation to replace these capital subsidies with well capitalized mortgage financing instruments. He recently re-introduced a bill first submitted three years ago to authorize commercial banks to issue private covered bonds, and last fall he introduced the Private Mortgage Market Investment Act to help re-start a private label securities market that presumably wouldn't rely as much on banks.
The bonds would remain on bank balance sheets as collateralized debt, and the FDIC has opposed them for fear of giving up too much collateral in the event of bankruptcy, which is essentially a matter of establishing the appropriate capital requirement. Private mortgage securities with very little retained interest were considered a "sale of assets," but the private market of truly "at risk" investors in securities is mostly imaginary, so it was the too-big-to-fail banks that funded the subprime debacle off-balance sheet. Dodd-Frank proposed a 5% risk retention rule that would eliminate "asset sale" accounting treatment for securities if it refers to first loss — and is otherwise meaningless - making securities a financing as well. Too-big-to-fail universal banks would likely be the primary originators of bonds as they were of securities. Dodd-Frank attempted to eliminate systemic risk not by breaking up too-big-to-fail banks but by sanctioning them with higher — and presumably enforceable — book capital requirements.
Setting high private covered bond issuer capital requirements is one thing, raising capital is quite another. The financial crisis continues to claim many victims, primarily taxpayers, savers and bank shareholders. Picking the purportedly deep pockets of banks with "special taxes" and multibillion dollar legal "settlements" has sent their stock prices to a historically low multiple of earnings, making additional capital even more expensive. The PIIGs (Portugal, Ireland, Italy and Greece) are discovering what the centrally planned economies learned the hard way and is becoming more evident with the ongoing bailout efforts in the U.S.: when political "help" and "protection" socializes all risk, society goes bust.
Kevin Villani was senior vice president and chief economist at Freddie Mac from 1982 to 1985.