November 15, 2010

Helping the Housing Market

The better approach to obtaining a stable and growing housing market would be the opposite of what is being attempted with low interest rates, mortgage interest tax deduction and Govt guarantees on mortgages:
The bust in prices of homes has caused a strange predicament. Many owners owe more loan on their house than it’s worth in the market. This is giving them tummy aches – because they never thought that this was a possibility. They had begun to believe, blinded by more recent history and the canon in the media and financial advisors’ representations, that prices of homes always keep going UP, except small ‘corrections’ of 5% or so. The last time such a thing happened was to Dotcom prices. Folks are not willing to believe that a home can lose significant value: depreciate like a car, or plunge like a stock.

And the reason is not far to seek. In case of a car, they always knew it will depreciate 10% the moment they drive it off from the dealer’s lot. In case of homes they thought otherwise. But they had similarly thought their Dotcom stocks are safe, and ate their losses and ego-bust from their misjudgement when the Dotcoms crashed. So, why not the same in case of housing crash? Why expect the Government actions to “turn it around”. Especially Underwater homeowners are hanging on the hope that the Govt will do everything in its power to manipulate the prices back up to “prove” that its “ economic policies are 'sound' ”. Further, most mortgage loans are “non-recourse loans”, so the borrowers can simply walk out of them, though with a greatly tarnished credit history, and having to pay later for making this choice.

The myth needs to be called that home prices and stock prices reflect the strength of an economy. The number of people that are able to earn their bread and butter without dependence on anyone else is the parameter by which a country’s economic success can be assessed. Excitement around a stockmarket rally et al is really irrelevant. That ONE reason to keep the housing market alive is that abandoned neighborhoods look really bad (just like slums in the developing World) and transmit the feeling of doom and gloom, and abandoned houses do not generate repair and remodeling business, on which many depend for their livelihood. Not to speak of lost property tax collections that provide for a town’s many amenities.

Yet helping the housing market from dying is not the same thing as keeping a speculative bull market on home prices alive. The latter is too expensive and wasteful for the Govt to bring about. It is also doubtful that the prices can be again manipulated so far up that we will begin to get home equity consumption. And ‘wealth effect spending’ too is a mere 4c to the Dollar. The same money is better utilized towards creation of socially useful jobs in Education and Infrastructure. The idea should rather be to get people off the idea that buying a home is a guarantee of Capital Gain, and that taking a loan is a Great thing that the Govt. will reward you for in the form of tax breaks. The home prices are still out of whack from the incomes that people have, so banks are naturally wary to lend without hefty downpayments where the borrower has insufficient skin in the house. Providing Govt. guarantees against default further destabilizes the price discovery process on the home inventory, and makes the Govt. agencies vulnerable to very heavy losses and popular angst just a few years down the road.

The better approach to obtaining a stable and growing housing market would be the opposite of what is being attempted with low interest rates, mortgage interest tax deduction and Govt guarantees on mortgages:

Incentivize higher down payments instead of Loan

Reduce the pressure to flood the financial system with cheap money to fund property loans further backed by Govt agencies. For all homes hereafter bought, take away the mortgage interest tax deduction, and replace it with depreciation. That is, the home buyer can reduce his downpayment towards the house from his taxable income over say, the first 5 or 6 years. Thereafter, he can reduce the repayments made towards the home loan upto a maximum of say, 3% per year. What he could not deduct in a given year can be carried forward.

A limit can be placed on the maximum depreciation that can be claimed on the house over the years, say at 60% of the purchase price.

This approach would have many advantages:

1. Drive home the point that a house is a possibly depreciating asset.
2. Incentivize downpayment and repayments over taking more loan. When the buyer starts with a higher equity in his home, the bank is more willing to lend, and at more attractive rate of interest at that.

Take Away the Concept of Non Recourse Loan

Once it is clarified that a home is not necessarily an always-appreciating asset, the idea of a non recourse loan should also go away. As a buyer you are responsible for paying the loan back, irrespective whether the home increases or decreases in its market price. Buying a home on loan is no different from buying say, Google shares or a car with borrowed money. The only protection from not having to pay back would be willing rework with the lender or Bankruptcy protection.

Introduce the Concept of Eviction Compensation

When the homebuyer is evicted due to delinquency, the bank should be mandated to pay say, 15% of all repayments & downpayment the buyer has done to date. This would be a relief to the home buyer in the event of a tragedy such as a medical calamity or a persistent job loss leading to losing the home. It gives the potential home buyer more confidence to bite on a home he would like to buy on loan. It would also be a driver to make banks try and rework the payments when the home buyer is facing a temporary (in the assessment of the lienholder) downturn.

Allow USE (NOT Self-Loan) of 401K Money towards Paying for Home

Allow the buyer to fund the purchase out of his 401K savings, upto at least 50% of the 401K balance, and without the obligation to repay himself. One can hold part of one’s Roth IRA portfolio as Real Estate, why not extend this to 401K money.

The combination of approaches above is fiscally sound, for one pays much less towards Principal over 30 years as compared to Interest, so it greatly reduces the amount of subsidy that the Govt will pay towards housing. It encourages the use of the money already out there, rather than having the Federal Reserve create even more, adding to risk of having sub-optimal levels of currency floating in the Economy. It encourages the idea of a house as a home that one lives in for a long time, or a stable rental income producing asset that can depreciate over time.
Any value appreciation is purely incidental and a bonus, but cannot be counted upon.
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