Removing a Portion of the Housing Trap

In Escaping the Housing Trap, Chuck Marohn and Daniel Herriges describe half of the housing trap as the American Economy’s reliance on high housing prices. A significant portion of both household wealth and banks’ balance sheets rely upon financial instruments tied to housing. If we build enough homes to meaningfully bring down housing prices, the wealth and balance sheets that rely upon those housing prices will be undermined. If that happens, our entire banking system will become unstable. This is exactly what happened in 2008 when the housing market crashed.

As the market crashed, and homeowners were unable to refinance their adjustable rate mortgages after their teaser rates ended, banks started foreclosing on large numbers of homes. As this happened, the mortgage backed securities that used these mortgages became worthless. The Big Short includes a great description of how this worked by Margot Robbie, but the entire movie is worth watching to better understand the 2008 crash and resulting financial fallout.

The cause of the 2008 is not as relevant as the fallout of the crash and the government’s response. There is an excerpt from Escaping the Housing Trap where Chuck and Daniel explain how the government responded as the housing market crashed and the market for mortgaged backed securities failed. In essence, the Federal Government created a market for mortgaged backed securities by buying them at face value. This was an incredible bailout to the banks and ensured the banking system remained functional. It also did not do anything to help homeowners who couldn’t pay their mortgages, which caused the insolvency of the banks in the first place. One of the problems with the government’s response to the 2008 housing crisis was that banks were bailed out but homeowners still lost their homes. This had a huge destabilizing effect on neighborhoods, especially since so many homes sat vacant for extended periods of time once they were foreclosed on.

This was not the only possible response to the banking crisis caused by the 2008 housing crisis. There could have been a better way to ensure bank solvency while also helping homeowners stay in the homes.

What happened in 2008 and how the government could have responded better matters for the future. Mortgage backed securities still make up a large portion of the wealth on the books of banks. If cities are able to build enough housing to meaningfully reduce housing costs, the value of those mortgage backed securities and the solvency of banks will be brought into question once again. While the cause of the 2008 market crash is unlikely to repeat itself, the fallout from the crash may be eerily similar.

Since the root of the problem was that homeowners owed more than their homes were worth and were unable to pay their mortgages (due to adjustable rates increasing and an inability to refinance), a revised program to bail out homeowners instead of banks could have solved the problem with having the knock-on effect of stabilizing neighborhoods. When we’re faced with a similar problem in the future due to housing production driving down home prices, a similar future program couple be used to stabilize the banking sector and keep homeowners in their homes.

An example of how this could work would be for the Federal Government to make payments to homeowners that are underwater on their homes to pay down their mortgage so that they hit some predetermined loan to value ratio, something like 80% of the current market price of the house. This would ensure the banks are kept whole, and would allow homeowners to have their monthly payments recalculated and reduced based on their new outstanding principal. These government payments could easily be restricted to first mortgages and include some type of means testing, to ensure that people aren’t using the program to pay down equity they pulled from their home prior to the decline in home prices.

A program like this would be great to have in place before another housing market crash happens. This would be especially true if the program is limited to regions that hit specific housing growth targets. By preemptively instituting such a program, it would ensure that communities are encouraged to build more housing and would eliminate one of the largest causes of opposition to new home construction for many existing homeowners.

While creating such a program before a crisis is not something anyone should reasonably expect from Congress, this is the type of program that could truly help us escape the housing trap we’ve built for ourselves. Unfortunately, this type of Federal policy solution is not the type of things that Strong Towns would suggest or endorse, but it’s an example of the type of policy I said I’d be interested in last week at the end of my review of Escaping the Housing Trap.