The limits on policy options for housing

What should the federal government do to address the inventory of foreclosed properties?

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The views expressed herein are those of the author and do not indicate concurrence by other members of the research staff or the principals of the Federal Reserve Bank of Boston or the Board of Governors of the Federal Reserve System.

Since the subprime crisis appeared five years ago, policy makers have searched for a “game-changer.” Many believed that HopeNow, Hope for Homeowners, HAMP, HARP and large-scale MBS purchases by the Fed had the potential to mitigate the cycle of falling prices and foreclosures. But in the end, the foreclosures have marched on and the crisis has evolved more or less as expected. It was apparent in 2007 that the collapse in house prices over the previous two years had changed the dynamics of the housing market. In normal times, most borrowers have positive equity in their homes and the result of adverse life-events like job loss, illness and divorce is sale but by 2007, falling prices mean that millions of homeowners had negative equity and no longer had an exit strategy. Even in good times, normal transitions in the labor market mean that millions of people lose their jobs every month but after 2007, negative equity mean that those job losses translated, too often, into foreclosures. To eliminate the negative equity problem and restore the market to health, there were basically two options: reduce debt or increase prices. Both have proved exceedingly difficult to achieve.

As we argued here, reducing principal balances is extremely expensive. Many have tried to make the case that principal reduction is free because the lender would lose so much through foreclosure in any case. In other words, so long as the reduction in principal fell short of the loss on the foreclosure, lenders could make money by reducing principal. But this logic assumes that lenders know exactly which borrowers will default and which will not. Otherwise, the lender could lower principal for borrower who planned to repay anyway and the cost of principal reduction could exceed the losses on the loans that defaulted. In the end, most lenders concluded that the costs of principal reduction outweighed the benefits. There have been no large scale principal reduction programs to date.

The alternative was to try and drive prices up. Some argued that policy makers should lower mortgage interest rates which would reduce the cost of owning a home and make household invest more in housing. In the winter of 2008-2009, the Federal Reserve Bank of New York started buying large quantities of Mortgage Backed Securities which did indeed lower mortgage interest rates. But while this led to a wave of refinancing activity, the purchase market remained moribund and although house prices have stabilized compared to 2007, we have not seen a boost.*

Recently, a third view has come into vogue: that we can combine the two policy options, raising prices and lowering balances at the same time. The argument starts with the claim that by increasing the supply of property on the market, foreclosures are actually contributing to the fall in prices. Thus principal reduction, by preventing foreclosures, could actually raise prices. The argument continues that lenders eschew principal reduction because they fail to internalize the benefit of foreclosure prevention on house prices. If we could convince all lenders to reduce principal at the same time, the benefits of higher prices would make it financially attractive.

There is a flaw in this argument. Principal reduction may prevent foreclosures but it won’t prevent property from coming on the market. Recall that under normal circumstances, borrowers who suffer adverse life events could avoid foreclosure by selling their homes. If we reduce principal balances, we may well see a wave of selling as all the borrowers who would have lost their homes to foreclosure now choose to sell them. Many principal reduction proposals try to address that by restricting the ability of the borrower to sell but that rule also severely limits the effectiveness of principal reduction at preventing foreclosures.

More broadly, I would caution against any policy that is based on a supposed effect on prices. As my colleagues and I argued here, the house price formation process is, at best, poorly understood. Economic research gives little guidance on how or why house prices evolve the way they do. To give one example, it is an article of faith right now that foreclosures are depressing prices by adding supply to the market but if that were true, standard theory says we should see an increase in sales volume. In fact, the number of new and existing home sales in 2011 was about half the level at the peak of the bubble.

* For a discussion of the effects of the Large Scale Asset Purchase program, see http://www.bos.frb.org/economic/ppdp/2010/ppdp1004.htm Paul S. Willen is Senior Economist and Policy Advisor for the Federal Reserve Bank of Boston.

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