In a recent speech in Phoenix, President Obama said his new plan to get the housing market back on track would sound “confusing” to those who have called him a socialist.
The line got a laugh.
The president’s plan is for private capital to take on the leading role in the market, while Fannie Mae and Freddie Mac, which have been propped up by the government for nearly five years, are sidelined.
“I believe that our housing system should operate where there’s a limited government role, and private lending should be the backbone of the housing market,” Obama said.
The comments were seen as an endorsement for a bipartisan Senate bill that would do away with the two government-sponsored mortgage giants and replace them with other government programs.
Overall, I agree with the president’s idea that private capital should support private consumption of housing, just as it does for automobiles and other goods. As I have written here before, I think the only way for the housing market to regain long-term health is to allow market forces to run their course.
Unfortunately, what’s good for us in the long run is often unpleasant in the short run. Obama is not yet ready to accept that. He wants the housing market to benefit from policy spinach, but he also wants housing’s new diet to taste like ice cream.
Specifically, the president promises homebuyers that they can continue to have access to 30-year fixed-rate mortgages. “That’s something families should be able to rely on when they’re making the most important purchase of their lives,” he said.
The problem with 30-year mortgages, particularly fixed-rate ones, is that 30 years is a long time.
From a lender’s perspective, making any sort of loan, including a mortgage, essentially involves renting out money. Just as a landlord is likely to want more for renting out an apartment for two years than for one, banks and other lenders expect to get more if they let borrowers pay back their money over 30 years rather than 10 or 15.
Fixed-rate mortgages are particularly troublesome for lenders because, if interest rates go up, lenders lose the opportunity to benefit from that increase. They remain locked into the lower rates. If, on the other hand, interest rates go down, homeowners can generally refinance without penalty. That’s a lose-lose proposition for lenders.
Lenders who make 30-year loans also must deal with 30 years of risks, ranging from default to inflation. Theoretically, the default risk to mortgage lenders is low, since they have the right to foreclose on the property in lieu of missed payments. In reality, however, foreclosure is generally a long and drawn-out process, and there’s no guarantee that the property will even still be worth the outstanding amount of the loan – though as you get into the later years of a long-term loan, the risk of a housing value decline is small. Small, however, is not zero; sometimes an entire community’s housing values can erode over a long period, as has happened in Detroit and other Rust Belt cities.
Given all this, the real costs of 30-year fixed-rate mortgages in most circumstances are simply higher than homebuyers are willing, or able, to pay. Obama says he wants private capital to take on most of the risk with only a limited government backstop, yet he wants to retain the availability of cheap, fixed-rate, 30-year loans. Very few private investors, other than perhaps the Tooth Fairy, would find anything attractive in the president’s scheme.
To get private capital interested in mortgage lending again, we are going to have to make mortgages more attractive from an investment perspective. That will likely mean higher interest rates, reasonably tough credit standards and, in some cases, shorter mortgage terms. It will mean that many people will have to buy smaller homes, or save a bigger down payment in order to buy a first house. It will also mean that people who depend on home construction and home sales for their livelihoods will make less money.
On the other hand, homeowners can benefit in various ways from taking mortgages with shorter terms. Paying down mortgage balances faster makes it less likely that an owner will find herself “underwater,” owing more than the house is worth, at a point when she wants to sell – perhaps to move to another city with better job opportunities. Also, home equity is a form of savings, and Americans generally need to save more; building equity faster is a way to save more for retirement and other purposes. And faster loan amortization will save the typical homeowner tens of thousands of dollars in interest costs over the life of a loan. This is not always an advantage – money that is going to pay off a mortgage might otherwise be invested aggressively for higher rates of return – but the average homeowner will probably benefit from paying off a mortgage sooner.
In his recent speech, Obama also acknowledged that homeownership is not necessarily right for every American. “In the run-up to the crisis, banks and the government too often made everyone feel like they had to own a home, even if they weren’t ready and didn’t have the payment,” he said. “That’s a mistake we shouldn’t repeat.” This is an interesting observation coming from the president who offered the poorly-conceived first-time homebuyer credit. But his point is well-taken. Some people are simply better off renting, often just in the short term but sometimes indefinitely. There is no reason to stigmatize renters.
Obama’s insistence on keeping 30-year fixed-rate mortgages in place, however, reveals that, while he may not be a socialist, the president is also not fully prepared to accept the realities of the market. Being realistic requires more than recognizing that spinach is good for you. You also have to accept that spinach is not going to taste like ice cream.