Saturday, October 17, 2009

Poll: What will be the effect of the Making Home Affordable Program?

Jeffrey Miron has been posting frequently on his blog about the U.S. Government response to the housing bubble. Here's Miron in a recent post.
No one should object if a lender, without subsidy and without pressure, negotiates a mortgage loan. That can make sense for both lender and borrower because the foreclosure process is costly.

But Treasury's attempt to subsidize and coerce loan modifications is fundamentally misguided. It means many homeowners will stay in homes, for now, that they cannot really afford, merely postponing the day of reckoning.

Treasury's policy is also misguided because it presumes that everyone who owned a house before the meltdown should remain a homeowner. Likewise, Treasury's view assumes that all the housing construction over the past decade made good economic sense.

Both presumptions are wrong. U.S. policy exerted enormous pressure for increased mortgage lending in the years leading up to the crisis, thereby generating too much housing construction, too much homeownership and inflated housing prices.

The right policy for the U.S. economy is to stop preventing foreclosures, to stop subsidizing mortgages, and to let the housing market adjust on its own. Otherwise, we will soon see a repeat of the fall of 2008.
So, how do prices look when they're inflated? Here's a graph of the price-to-rent ratio that I borrowed from Calculated Risk.

That brings me to my poll question of the week.

What do you think will be the effect of additional home subsidies and programs like the Making Home Affordable Program?

(a) Another bubble
(b) Stimulate the economy
(c) Save hard-working Americans' homes
(d) No effect

As with all polls, this one will be open for a week. So, in the Chicago tradition, vote early and often. Tell your friends and homeowners to vote. I look forward to seeing what you have to say.


  1. Hi Tony

    Miron's observation that the government policy is bad policy is quite correct, but it is nowhere the whole story. The housing market could easily have dealt with that and not caused a bubble and crash.

    In all lack of humility I'm not giving away my analysis here. I'm waiting to see if any economists come up with what happened. Parts of the whole like Miron's may be very accurate, but as in this case by itself could not have caused much of a problem. It could certainly not have caused a world wide crash. I doubt it would have even caused any reaction in the financial markets with the exception Fanny and Freddie who were set up to take the hit.


  2. Fletch,

    Point well taken. I think Miron would agree that it isn't as simple. He's probably abstracting a bit to make a clear, simple point.

    I thought I would take some time to share some of my thoughts on the issue. Keep in mind that I'm no finance guru (I like microeconomics better).

    In my reading, the worldwide crash came from has been a confluence of several factors.

    First, there was an active attempt to get people into houses. From Econ101, we know that subsidies (and other governmental nudges) raise the equilibrium price (though one would expect the final price to be lower for those receiving the subsidies).

    In this setup, it's not surprising that rational individuals would expect the prices to stay high, especially given a continued and concerted effort by the government to promote homeownership.

    Second, these loans were converted into securities by the financial community. The original idea was to spread the idiosyncratic risk of default on any given mortgage. Viewed in this light, mortgage-backed securities would be a good thing.

    But the mortgage-backed securities came with a downside: They were susceptible to systemic shocks (just like the bursting of the housing bubble would create). Because we looked at these securities as idiosyncratic-risk smoothers, we forgot that they could be systemic-risk propagators.

    Third, and importantly, things turned south for a bunch of ordinary Americans. Accordingly, the default rate on these mortgages increased to the point that the mortgage-backed securities started doing really poorly.

    Because these securities were rated AAA (other issues there), lots of places held these assets. They were considered safe, idiosyncratic-risk smoothers. They played a fundamental role in lots of portfolios. Therefore, most places started doing horribly, and because our financial system is so interconnected, this horribleness spread.

    The trouble is that the financial instruments did what they were supposed to do: they spread risk. We like to spread risk when the losses (in aggregate) are small, or on average, cancel each other out. But that's not what happened here. The risk was to the system, and hence, it didn't cancel out.

    So, it comes down to the fact that our society encouraged a bunch of people to take unwise risks in the housing market. That is, point one is a real problem. The push toward more homeownership created systematic risk in the housing market, which by itself, isn't a disaster.

    What is a disaster is how it so easily spread.


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