Low-Interest Mortgages Are the Answer
Stop the decline in home prices, stop the crisis.
By
R. GLENN HUBBARD and
CHRISTOPHER J. MAYERRecent news articles suggest that the Treasury Department is considering a plan to offer a 4.5% mortgage for home buyers for a period of time. Let's hope it does. It would help arrest the decline in house prices that is at the base of the ongoing financial crisis and recession.
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.
Moreover, a 4.5% mortgage rate will raise housing demand significantly. A simple forecast can be obtained by applying the 2003-2004 homeownership rates to 2007 households. We use the 2003-2004 home ownership rates because those were the years of the lowest previous mortgage rates (the average mortgage rate was 5.8%).
An increase in the homeownership rate from 67.9 (third quarter, 2008) to 68.6 (the average rate from 2003-2004) would increase homeownership by about 800,000 new homeowners. If we also take into account the changing relative age distribution of the population, there would be a total of 1.6 million new homeowners. A simple statistical analysis examining the impact of lower mortgage rates and higher unemployment rates yields an even higher, and firmer, estimate of 2.4 million additional owner occupied homes in 2009.
The increased demand for housing arising from lower mortgage rates would provide a floor on further house price declines. Estimates in our recent paper suggest that real house prices increase by about 75% of the decline in after-tax mortgage payments. So a decline in mortgage payments of 16% would result in approximately a 12% floor on the decline in house prices.
Current futures markets suggest that house prices will decline by 12%-18% in the next 18 months. So a 4.5% interest rate might well lead to flat or even slightly higher house prices in 2009.
Stabilizing house prices will likely improve consumer confidence substantially. Increases in house prices relative to where they would have gone with higher mortgage rates would also provide a housing wealth effect -- that is, higher annual increases in spending as consumers feel richer -- on consumption of as much as $76 billion to $113 billion each year.
The 4.5% mortgage rate that the Treasury is considering also should be available for present homeowners who want to refinance, because of the benefits for the economy as a whole. We calculate that up to 34 million households would be able to do so, at an average monthly savings of $428 -- or a total reduction in mortgage payments of $174 billion. This is a permanent reduction in payments and is thus likely to spur appreciable increases in consumption.
Moreover, trillions of dollars of refinancings would retire a large number of the existing mortgage-backed securities. This would reduce uncertainty about the value of existing mortgage-backed securities. It would flood the market with additional liquidity that the private sector could deploy to other uses such as auto loans, credit cards, commercial mortgages and general business lending.
A reduction of mortgage interest rates to 4.5% (or, given yesterday's Fed action, to a lower level) is superior to other proposals that focus only on stopping foreclosures, or on reforming the bankruptcy code to keep people in their homes. Stopping foreclosures, however meritorious, may not limit the dangerous decline in house prices as much as proponents claim. It could work the other way. Stripping down mortgage balances in bankruptcy would likely raise future mortgage interest rates and lower the availability of mortgages, reducing house prices.
Finally, a decrease in the mortgage rate, even though it is intended be a temporary intervention in the present exigency, plants a seed for future thought. Given the chaos of the recent past, wouldn't a return to simple, 30-year fixed-rate mortgages with a low rate be the right foundation for the long-term future?
Mr. Hubbard was chairman of the Council of Economic Advisers under President George W. Bush and is dean of the Columbia University Business School, where Mr. Mayer is senior vice dean and a professor of finance and economics.
So AM New York says prices have dropped 20%. Really? It even says, "Behind the scenes, brokers are whispering even scarier numbers, like 30 or 40 percent." Oh come on! Sure, prices have dropped, and sure, landlords are more flexible on rental apartments, but the idea that a $1 million apartment will go for $800,000 is simply ludicrous.
I just have to take a minute to say how awesome today's technology is. Just a few years ago, if I were headed out of town, I would have had to alert the right people in my office and my clients that I would be unavailable, I would have had to change my outgoing voice message, and I would have had to put up an automatic response in Outlook. I still have the option to take these actions, but I don't need to because I'm always available on my Blackberry.
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