Fed pushes Congress for Housing Policy Action

Financial Review

Published January 21, 2012

Anna Bernasek, New York

US Federal Reserve chairman Ben Bernanke this month sent Congress a report on the housing market urging more policy action. Since then, a rising chorus of Fed officials has reinforced Bernanke’s message in speeches around the country.

Despite “green shoots” in some parts of the American economy, the Fed remains concerned about the effects of continued weakness in the housing sector. Just how big a problem is the housing market?

Housing prices have fallen on average about 33 per cent from the peak in 2006. The last time home prices fell anywhere near that much was during the 1930s. And by some measures at least, the current crash in housing prices is even worse than what happened in the Great Depression. According to the S&P/Case-Shiller home price index, a measure of national housing prices, the average price of a home fell 24 per cent from 1929 to 1933.

As a result of the recent decline in prices, $US7 trillion in household wealth simply vanished, drastically reducing consumer spending. Today the value of all housing assets is about $US14 trillion. It was close to $US21 trillion at the peak.

Falling home prices have a big economic effect due to leverage. A significant fall can wipe out a home owner’s equity and eat away the value of the bank’s mortgage. Analysts estimate that a 10 per cent fall is the typical threshold for those pernicious effects. With home prices falling three times as much, the impact has been unprecedented.

Lots of people are desperate. The Fed estimates that 12 million borrowers owe more on their mortgages than their homes are worth. That represents about one in five mortgages in the US.

In Florida, Nevada and Arizona, where prices have fallen more than the national average, as many as half of all mortgage borrowers owe the banks more than their homes could be sold for.

It all adds up to a whopping $US700 billion in aggregate negative equity, according to the Fed. To put that another way, it would take a 5 per cent increase in prices just to absorb that shortfall, without any gains going to home owners.

About 3.4 million borrowers with negative equity, amounting to $US275 billion, are late or have stopped making mortgage payments. While the remaining 8.6 million or so are still paying, they might stop at any time. That’s a continuing risk for US banks.

Negative equity creates a series of headaches for borrowers. For starters, banks won’t approve refinancing for borrowers with negative equity so they can’t take advantage of record low interest rates when they need it most. Worse still, it ties borrowers to homes and locations that might not offer the best job prospects so it creates a vicious cycle of falling prices, more negative equity and reduced economic prospects. And to top it off, the worst price declines tend to occur where the job market is not terribly strong.

Although the decline in home prices mostly occurred between 2007 and 2009, more recently home prices have begun falling again. As of October, the S&P/Case-Shiller index of property values in 20 cities showed a decline of 3.4 per cent from the previous year.

What worries the Fed is that it has already used its main tool, interest rates, to try to stimulate the housing market, with little visible effect. Mortgage rates are at record lows, with a typical 30-year mortgage priced under 4 per cent. Yet that seems to have had little impact on boosting demand, which would help home prices.

It seems that the banks aren’t eager to lend. The Fed believes there may be a permanent shift under way in the availability of mortgage credit as banks introduce tighter lending restrictions. Americans who would like to refinance their mortgages or buy properties are finding they simply can’t get a loan.

Mortgage applications are at their lowest level in 12 years and the Fed forecasts that home-loan borrowing in 2012 will decline to its lowest level in 15 years.

If the Fed is correct, new lending standards will further burden the housing market as demand is held back while supply continues to flood the market.

The Fed acknowledges that it lacks a silver bullet to end the housing crisis but it has urged Congress to take three steps.

Since rental markets are strengthening, the Fed has asked Congress to reduce barriers to converting foreclosed properties to rental units.

Next, the Fed wants Congress to reduce obstacles blocking people from getting credit.

And finally, the Fed wants Congress to encourage banks to make loan modifications rather than pursuing foreclosures, which are costly and put more pressure on home prices.

The Fed’s recommendations should come as a welcome relief. They rely on rule changes rather than spending money.

So far, though, the response has been lukewarm at best. More than a few Republican members of Congress have told the Fed it has no business trying to affect the housing sector.

For the sake of the economy, let’s hope Bernanke doesn’t give up too easily.