The Significance of Housing
The housing sector is just one part of the economy, along with utilities, energy, technology, manufacturing, consumer goods, and everything else. Booms and busts in the business cycle are common, and the US had suffered through a collapse in the information technology sector a few years prior to the housing sector collapse. The technology bubble and collapse left few lingering effects, so why was housing sector collapse so much more damaging?
In general terms, the 2000-2002 stock market crash, although punishing, had a limited effect. Market strategists and economists correctly recognized the proliferation of the internet and associated communication technology as a sea-change that would fundamentally change how business is conducted, but the euphoria would soon exceed common sense. In the speculative dot-com era, the first-mover advantage superseded conventional thinking. Start-up companies reasoned the best way to take advantage of the new frontier was to set up shop quickly. Start-up businesses were funded without common sense provisions, such as a vetted business plan or the expectation of profit within the time granted by their sponsors. Not all of the dot-com businesses failed; the late 1990 saw the emergence of technology companies destined to be long time players like Amazon.com, although the stock still reflects some dot-com era excess given Amazon’s consistently high valuations. (For comparison, the forward price / earnings ratio for Amazon is 105.3, whereas technology stalwarts Microsoft & Apple each have forward price / earnings ratios of less than 10.) For every success like Amazon, there were a dozen companies such as pets.com, startups.com, or govworks.com that suffered an ignominious end.
The speculative bubble and crash reflects a conventional boom-bust cycle that most long term investors have experienced at least a few times. Venture capitalists and irrationally exuberant investors bet, and lost, large sums in dot.com businesses, sometimes without properly vetting them, but many industry professionals had been openly scoffing at a stock-market that had gotten ahead of itself in terms of valuation. The projections of explosive growth and immediate adoption of technology were too optimistic, but the underlying economic activity didn’t stop just because the market crashed (as evidenced by near ubiquity of smartphones, Wi-Fi, high speed internet access, and so on). Plenty of industry professionals had seen the price bubble, made a warning, and simply got out of the way.
The Financial Contraction
Following the September 2011 terrorist attacks, associated pressure to airlines, and the dot com collapse, the Federal Reserve felt sufficiently justified keeping interest rates low and money “cheap”. Some economists have contended that money was too cheap for too long, thus inflating the bubble in the housing sector. Previous articles, notably the Feb 2012 Federal Reserve article, delineate some of the recent efforts the government has taken to prop up the housing market following the 2008 crash including the Fed buying up mortgage backed securities, replacing troubled assets with cash to inject liquidity into the system, mortgage modification programs to reduce bank principal owed and foreclosures, and so on. (For more information about government actions support the housing market, please read our February 2012 article on the Federal Reserve.)
It is important to recognize that capital markets were damaged by the 2001 recession, but the housing market was more stable in the early 2000’s. In other words, the dot com bust did not impact the pillars of personal wealth like the 2008 crisis did.
By comparison, the financial contraction of 2008 affected nearly everyone including both the relatively well-off who had a home or securities (stocks or bonds), but also those borrowers – individuals and businesses – that depended on liquidity of capital markets to make payroll, convert long term sales into short term cash, pay for student loans or credit cards, etc..
For most Americans, their most valuable asset is their house, and that value can be unlocked in a number of ways. Traditionally, a large family house could be sold by a retiree to fund retirement. Enterprising individuals can mortgage the equity on their house or collateralize a loan to start a business, or send their children to college. Also, in less than ideal circumstances, homeowners can simply leverage their equity to support spending they cannot afford.
In the years prior to the 2008 financial collapse, Americans saving rates fell to multi-decade lows, incomes remained roughly stagnant, while household consumption kept climbing. Where did this money to support this spending come from? Housing. As economists drolly noted, American consumers were using their homes like an A.T.M. When the housing market dried up, the last key resource to support consumption fell away.
Consequences to the Housing Collapse
Of course, leveraging home equity to support consumption requires improvement, or at least stability, in home prices. When the housing market tanked in 2008, investors found themselves unable to leverage equity to support consumption. In direct terms, the additional home equity that used to collateralize loans evaporated as prices tumbled. As an indirect factor, the “wealth effect” of owning an asset that is depreciating makes a consumer feel poorer and spend less, even if they had no immediate intention of selling their house, nor any mortgage or lien against it. Indeed, savings rates jumped as nervous investors hoarded their remaining wealth.
Beyond the damage to consumer balance sheets, institutions suffered. Poorly conceived loans - permitted by faults of lenders, borrowers, and regulators - shocked financial institutions into tightening their credit standards, reducing the amount of capital in the system and restraining economic activity. Further, the surviving banks and other lenders were compelled to hoard their remaining cash in an effort to stay solvent. If the financial institution crashes, then economic activity actually stops. Debt driven companies that depend on free-flowing credit to expand or conduct business faced a harrowing liquidity crunch. The restraint to economic activity, protracted panic all weighed heavily on stock market investors.
Bond market investors were not immune to the damage. Treasuries, seen as a safe haven, rallied during much of the market panic, but other fixed income instruments, like mortgage backed paper, were hit hard. Mortgage backed paper works by pooling the projected repayments from a mortgage loans as security, a bond. The problem is that a continued housing price bubble supported poor loan management (sub-prime loans) and standards. Worse, the credit analysis of the securities made with these loans was also flawed. Many supposedly safe mortgage backed securities, some with AAA credit ratings, became “toxic assets” that were ultimately worthless since borrowers defaulted when the housing market collapsed. All of these factors were a part of the sub-prime housing crisis, financial crisis, and the Great Recession.
A Tenuous Recovery in Housing?
Only after a truly unprecedented amount of support, the housing market finally looks more stable and is, possibly, prone to growth. Most key markets, measured in the Case Shiller index, have higher prices year over year, distressed sales (which drive down prices) are fewer, demand is healthy, inventories are manageable, and affordability is the best it has been in decades.
That is good news, but how stable is that growth given the potential reversal of programs that prop up the market? Specifically, there are active proposals to limit tax deductions, specifically the mortgage interest deduction, for homeowners. A direct effect of limiting the mortgage deduction includes increase of tax revenues by about $1.4 trillion over 10 years. Most Republicans and Democrats acknowledge the need for more revenue during the ongoing Fiscal Cliff negotiations, but losing the deduction will remove a key support to the all important housing market.
This tax benefit was intended to spur broad home-ownership, by making home-ownership cheaper after taxes, but it also had the unintended effects. For example, unlike most tax policy, the mortgage interest deduction is essentially regressive. In other words, the mortgage interest deduction offers the highest benefits to wealthy households which purchase the more expensive houses. Also, a taxpayer can limit the taxes on mortgages worth up the $1 million on first or second homes. The mortgage deduction was established to promote home-ownership, but perhaps that does not justify the provision allowing for second homes – often rental properties or investment houses for speculators. Furthermore, the program specifically incentivizes borrowing to pay for a house, because the deduction only applies to mortgage interest. If a consumer was sufficiently indifferent between purchasing a home outright or borrowing money for financing, the mortgage interest deduction increased their incentive to borrow, thus adding unnecessary debt to the financial system. Finally, imagine a consumer is going to require a loan. The existence of the mortgage interest deduction specifically incentivizes borrowing against home equity because other loans (e.g. credit card debt) are not deductible (since 1986); ironically, the law now exhibits an unintended consequence of lowering the amount of home equity owned by consumers.
The National Association of Realtors strongly opposes eliminating the mortgage interest deduction, claiming, "Housing is the engine that drives the economy, and to even mention reducing the tax benefits of homeownership could endanger property values. Home prices, particularly in high cost areas, could decline 15 percent if recommendations to convert the mortgage interest deduction to a tax credit are implemented." These reasons previously outlined provide justification for removing the mortgage interest deduction, but ending the program will undoubtedly be a shock to builders, resellers and buyers, that have had a tax deduction since 1894.
The market is addicted to the subsidies and incentives, like the mortgage interest deduction, and the fragile progress we’ve seen could be easily snuffed by removing all the supports at once. One possible solution is to phase out the mortgage deduction over time, but even that “would send the wrong signal” to housing prices, according to the National Association of Realtors. As the Fiscal Cliff negotiations continue, we’ll be watching to see which proposals ultimately get enacted and we’ll be sensitive to the direct and indirect effects of those changes.