US Housing Crisis and Public

Policy Response
The global financial crisis sprang from a systemic failure
of the US housing market. Both the Bush and Obama
administrations did too little, too late in suppressing the
housing meltdown. The current high level of delinquency
and foreclosure will delay the return of normalcy in the
housing market. This will continue to be a drag on
consumption and housing construction, thereby
prolonging the current US recession.

KIM Sunwoong

US Housing Crisis and Public Policy Response

KIM Sunwoong

The global financial crisis sprang from a systemic failure of the US

housing market. Both the Bush and Obama administrations did too
little, too late in suppressing the housing meltdown. The current
high level of delinquency and foreclosure will delay the return of
normalcy in the housing market. This will continue to be a drag on
consumption and housing construction, thereby prolonging the
current US recession.

The Greate Recission Continues

As of August 2010, the US economy was still struggling to climb out of the biggest
recession since the Great Depression of the 1930s. Although the quarterly GDP
growth rate returned to positive numbers in the third quarter of 2009 after six
consecutive quarters of near zero or negative growth in 2008 and the first half of
2009, the unemployment rate still has been hovering around 9.5 percent for almost a
year. While most economists expect that the recovery would take the form of long
bottomed "U", some even worry about a possibility of a double-dip recession. The
current spell of recession is deservingly called the Great Recession.

It seems that the momentum of recovery wore out the massive fiscal and monetary
stimulus packages adopted by the Bush and Obama administrations in the
aftermath of the global financial crisis. Recently, a spectacular piece of news that
shows the limitation of the Bush/Obama stimulus plans came out of the housing
market. According to the National Association of Realtors (NAR), the number of
existing- home sales (including single-family homes, townhomes, condominiums
and co-ops) during July of 2010 dropped by 27.2 percent to a seasonally adjusted
annual rate of 3.83 million units, down from 5.26 million in June, and 25.5 percent
below the 5.14 million in July 2009. The figure was the lowest since the NAR started
to compile the data in the mid-1990s. As the substantial homebuyer's tax credit
program was scheduled to expire at the end of June, the lower sales figure was
expected. However, the extent of the drop amid the lowest mortgage rates in 50
years surprised most economists, and pessimism about the speed of the economic
recovery of the US continues.

As is widely known, the current Great Recession started with the US subprime
mortgage crisis in 2007–2008. Although the epicenter of the crisis was asset-backed
securities collateralized with subprime mortgages, the main cause of the crisis can
be attributed to the sudden housing market downturn that started in 2006. The irony
of the crisis is that the US housing finance system was created mostly during the
Great Depression, and that it had been heralded as one of the best in the world in
promoting affordable home ownership. Since the 1930s, the innovation of the 30-
year-fixed-interest-rate-amortized mortgages enabled US homeowners a much more
affordable monthly payment than the five-year balloon loan that was commonly
used before the Great Depression. Also, the successful creation of the secondary
mortgage market by establishing Fannie Mae in 1936 and letting it issue mortgage-
backed securities (MBS) successfully attracted larger amounts of private capital
from institutional investors around the world. Due to its low-risk and stability, total
US mortgage debt has grown to around $14 trillion (comparable to the US GDP of
$14 trillion). Fannie Mae and Freddie Mac, the two Government Sponsored
Enterprises (GSE) that issue MBS, had a combined $5 trillion in mortgage
obligations when they were put into government conservatorship in November
2008.

However, the pre-crisis institutional arrangements of the US housing finance

system and the corresponding incentives of the economic agents were not
equipped to deal with recent developments that happened after 2000. The
combination of several factors (i.e. the large global supply of investment funds
demanding investment grade bonds, deregulation that allowed major investment
banks to take excessive leverage, political pressure to increase home ownership by
low and moderate income households, and the common usage of incorrect pricing
of derivatives) created unsustainable mortgage lending practices that came to a
sudden stop. Recognizing that the crisis represents a systemic failure of the
working of the housing market in general and the housing finance system in
particular, the US government responded with several policies to deal with the
crisis. In addition to short-term solutions such as homebuyer tax credit program
and mortgage modification program, it called for a long-term reform in the housing
finance system. In fact, on April 14, 2010, the US Treasury Department went so far
as to release a list of seven questions and solicited the advice of housing market
professionals and the general public (see Box 1). It is likely that the US housing
system is likely to change fundamentally in one way or another.
Making of the Financial Crisis
A recession after a financial crisis is typical. As the scale of the financial crisis in
2007–08 was unprecedented in 50 years, its impact on the real economy was bound
to be enormous. While many factors contributed to the making of the crisis and
undoubtedly, there will remain significant disagreements among experts that will
continue in regards to the extent of each contributing factors, several main culprits
can be identified.

First, it was the 2006 crash of the housing boom, which had started in the late
1990s. After a prolonged stagnation after the 1990-91 recession housing prices
started to rise in 1997. Between 1997 and 2006, the median housing price increased
by 125 percent before it dropped precipitously between 2007 and 2009 (see Figure
1). At the peak of the boom around 2004-05, it rose about 20 percent per year, and
much more in some areas. At the same time, between 2000 and 2003, the US Federal
Reserve Board lowered the federal fund rate target from 6.5 percent to 1.0 percent.
The lower interest rate increased mortgage borrowing and the US home mortgage
debt relative to GDP increased from an average of 46 percent during the 1990s to 73
percent in 2008. The rising home prices and low interest rates enabled many
homeowners to take out home equity loans or second mortgages to boost their
consumption. Home equity lines of credit increased from $600 billion in 1995 to $1.4
trillion in 2005.
Second, deregulation of the financial system can be blamed. Since 1998 the over-
the-counter derivative market was allowed to self-regulate. The result was a massive
increase in the utilization of credit default swaps (CDS) to more than $600 trillion in
order to hedge against credit risks. Also, investment banks and other non-bank
financial institutions were allowed to increase their level of debt when the US
Securities and Exchange Commission (SEC) relaxed the net capital rule in 2004. In
order to take advantage of the rule changes, some commercial banks shifted a
significant amount of assets and liabilities off the balance sheet to take a highly
leveraged position. Due to these deregulations, large investment banks increased
their leverage ratio from 12 to 1 to 30 to 1.

Third, the incentives for mortgage brokers and mortgage holders were not
compatible. The former receive commission by issuing the mortgage while the latter
receives interest payment from the homeowner. As soon as the mortgage was
underwritten, the broker has no financial interest with the mortgage. Therefore, they
have strong incentives to issue the mortgage by making them attractive to
homeowners without due consideration of their ability to repay for the duration of
the mortgage. As the supply of credit increased and the housing boom continued,
mortgage brokers started to market more risky mortgage products, such as interest
only or negative amortization mortgages. This was particularly true when mortgage
bankers could sell their mortgages to institutions that issued MBS.

Up until the mid 2000s, virtually all US MBS were issued by government sponsored
enterprises (GSE) such as Fannie Mae and Freddie Mac. Such MBS were
collateralized by so-called "prime" mortgages. Prime mortgages are mortgages with
particularly low credit risk because the loan to value ratio (LTV) is low (usually 80
percent and lower), the borrower is very creditworthy, and the housing unit is easily
marketable (not too expensive and in a good neighborhood). Although these two
GSEs are 100% privately owned and operated, they have implicit guarantees by the
US government. As such their MBS commanded almost the same credit ratings as
US government bonds in the international financial market. However, beginning in
the mid 2000s, several large US investment banks issued MBS based on subprime
mortgages because of their high profitability during the housing boom.

The term "subprime mortgage" refers to the mortgage issued to a borrower without
strong creditworthiness so that there is a greater risk of default than prime
borrowers. Subprime mortgages remained below 10 percent of all mortgages until
2004, but began to climb as investment banks dramatically increased their leverage
and aggressively issued mortgage backed securities. There were over 7.5 million
subprime mortgages outstanding with an estimated value of $1.3 trillion as of March
2007. In addition to the subprime mortgages, relaxed lending standards with large
supply produced a substantial amount of Alt-A mortgages given to prime borrowers
with less stringent underwriting criteria. The return on the early vintage of the
subprime mortgages was relatively high and the risks relatively low during the
boom period.

Fourth, the pricing of complex derivatives did not correctly reflect the systemic
risks associated with them. Only a few credit rating agencies have a global
monopoly so many institutional investors insist on using them only. For a variety of
reasons, including technical complexity, market participants did not accurately
measure the risk inherent with financial innovations such as MBS and collateralized
debt obligations (CDOs), or understand their impact on the overall stability of the
financial system. Also, professional investment managers are generally
compensated based on the volume of client assets under management, creating an
incentive for asset managers to expand their assets under management. As the glut
in global investment capital caused the yields on credit assets to decline, asset
managers tended to invest client funds in over-priced (under-yielding) investments
in order to maintain their assets under management.

Fifth, there has been substantial political pressure to increase the supply of
mortgages to low and moderate income households. The Community Reinvestment
Act (CRA) of 1977 requires urban banks to increase their lending to the residents of
inner cities. During the Clinton and Bush Administrations, Fannie Mae and Freddie
Mac, totally privatized GSEs, received substantial political pressure to increase
mortgage supplies to low and moderate income households. The higher rate of
homeownership has always been a popular political theme in the US. The so-called
"American Dream" typically involves a single family home in the suburbs with dogs
and children. Since the introduction of the federal personal income tax in 1912, the
deduction of mortgage interest has been a sacred cow that few politicians advocate
abolishing, even though it is an expensive benefit that favors high income
households.
As late as in July 2007, when several mortgage banks that specialized in subprime
mortgages started to experience liquidity problem, most economists including the
Fed thought the problem would be limited to the subprime segment of the housing
market. Former Fed chairman Alan Greenspan said. "It doesn't appear likely that a
national housing bubble, which could pop and send prices tumbling, will develop."
Also, Ben Bernanke in his first speech as the chairman of the White House's
Council of Economic Advisers in 2005 said, "While speculative behavior appears to
be surfacing in some local markets, strong economic fundamentals are contributing
importantly to the housing boom."(Associate Press, July 12, 2007) The Fed sought
to use the monetary policy to guide a soft landing in the housing market by
gradually
increasing the federal fund rate to 1.25 percent in August 2004 and to 5.25 percent
on June 29, 2006.

Emergency Plicies by the Bush Administration

However, the collapse of the housing boom drastically altered the prospect of a soft
landing. The housing market started to decelerate at a fast rate. When the Fed
gradually increased the federal fund rate, housing expenditure to many households
that hold adjustable rate mortgages (ARMs) started to increase substantially, and
the delinquency rates started to increase accordingly. At the same time,
construction activities started to plummet. Housing starts decreased from 1.47
million in 2006, to 1.05 million in 2007, to 0.62 million to 2008, and to 0.45 million in
2009. At the same time, housing price increases slowed down significantly in 2007
and started to decrease precipitously in 2008 and 2009, particularly in the boom
states of Nevada, Florida, and California. The decline in home prices stopped in
2010, and returned to the level of 2003. (see Figure 2)

High delinquency rates and increasing foreclosures generated serious liquidity

problems not only to mortgage banks but to several major financial firms that
heavily invested in MBS and other collateralized debt obligations (CDO), as the top
US investment banks (Lehman Brothers, Bear Stearns, Merrill Lynch, Goldman
Sachs, and Morgan Stanley) had over $4.1 trillion in 2007 (about 30 percent of US
GDP) in subprime mortgage related products.
When the housing market indicators (delinquency, foreclosure, construction, and
price) started to show an imminent danger of meltdown and the stock market
started to descend rapidly (the Dow Jones Industrial Average lost 16 percent from
October 2007 to January 2008), the Bush Administration hurriedly passed the fiscal
stimulus package with bipartisan support. President George W. Bush signed a $150
billion fiscal stimulus package into a law on February 13, 2008. It provided $300 tax
rebates to low and middle income individuals ($600 to married couples) in 2008.
Also, it provided $300 per dependent child under 17 ($600 limit for a single person
and $1,200 for married couple). Some 117 million families would receive rebate
checks, including 35 million with earnings too low to have qualified under an earlier
Bush proposal that limited checks to income tax payers. Rebates were limited,
however, to single taxpayers with adjusted gross income up to $75,000 (up to
$150,000 for couples). Above that, the benefit was phased out until hitting zero for
individuals with adjusted income of about $87,000 ($174,000 for couples). In
addition to the tax rebate program, businesses were offered a one-time incentive to
invest in new equipment and a temporary increase was approved for "jumbo"
mortgages that could be bought by Fannie Mae and Freddie Mac, from $417,000 to
as much as $729,750 in expensive housing markets. At the same time, the Fed cut
the federal fund rate by 0.5 percent from 5.25 percent in September 2007. Later, the
Fed gradually lowered it further all the way down to 2 percent in March 30, 2008.

However, both monetary and fiscal policy actions were too little too late. Clearly the
housing market was in trouble and it was worsening, and the federal government
wanted to stabilize the housing market as quickly as possible. On July 30, 2008,
President Bush signed a major housing market emergency legislation, the Housing
and Economic Recovery Act (HERA) of 2008.

HERA took several approaches to stabilizing and revitalizing the housing market.
First, it tried to reduce foreclosures by increasing mortgage insurance by the
Federal Housing Authority (FHA) which primarily insures mortgages with low (or no)
down payments for low and moderate income households. As mortgage is a non-
recourse debt (the lender cannot go after anything more than the housing
collateral), households with a low down payment in area with low housing prices
have strong incentives to default. With HERA, FHA is authorized to increase their
amount of insurance by $300 billion if the mortgage lender is willing to reduce the
principal mortgage balance under 90 percent of the market value. The objective was
to help 400,000 such households not to default. Also, HERA increased the maximum
size of mortgages that Fannie Mae and Freddie Mac could buy and FHA could insure
to $625,000.

Second, HERA established the Federal Housing Finance Agency (FHFA) by merging
the Federal Housing Finance Board (FHLB), which formerly regulated twelve
regional Federal Home Loan Banks and the Office of the Federal Housing Enterprise
Oversight (OFHEO), and the US Department of Housing and Urban Development
(HUD), which oversees Fannie Mae and Freddie Mac. HERA empowered FHFA to put
any GSE into a receivership or a conservatorship. With this authority, on September
7, 2008, FHFA fired the CEOs and assumed the function of the Board of Trustees of
Fannie Mae and Freddie Mac, putting them into a federal government
conservatorship.Third, HERA established a tax credit of $7,500 (or 10 percent of the
purchase value, whichever is smaller) for those who purchase a primary residence
for the first time during the period of April 9, 2008 and July 1, 2009. The program
was limited to individuals with an annual income of $75,000 ($150,000 for married
couples). The tax credit is to be returned to the government within 15 years. In
essence, the credit is as an interest-free loan with the same amount from the
government. Six months later, the Obama administration drastically expanded the
program (see below).

The initiative to pass HERA by the Bush administration clearly indicated that the
Administration was keenly aware of the fact that the housing market was in deep
trouble. However, such attempts were again, too little too late, as the situation in the
housing market continued to deteriorate. The ever increasing delinquency and
foreclosure endangered not only the mortgage banks that underwrote risky loans,
but several large investment banks that issued private MBS with the mortgage
collateral.

The jittery stock market collapsed in the aftermath of the bankruptcy filing of
Lehman Brothers on September 15, 2008 and subsequent failures of numerous
financial institutions in the US and Europe. In the first week of October 2008, the
DJIA lost more than 15 percent. The problems of the US housing market now were
passed onto the global financial market. As many financial institutions tried to be
afloat by recalling existing loans and being extremely conservative to give out new
loans, a full-fledged worldwide credit crunch spread like wildfire.

In order to deal with the major panic in the global financial market, the Bush
Administration passed the Emergency Economic Stabilization Act of 2008 on
October 3, 2008, creating what is commonly called the Troubled Asset Relief
Program (TARP). It was a $700 billion government bailout plan (although at least
one half of the initial government outlay is expected to be recovered later). The
TARP package included the $40 billion bailout of American Insurance Group (AIG), a
$245 billion equity investment to US banks, a $25 billion loan to General Motors and
Chrysler, and targeted guarantees and equity investment in Bank of America and
Citigroup.The massive bailout plans by the US government and other governments
around the world along with the actions by the major central banks including the
International Monetary Fund (IMF), spared the financial market from further chaos.

The Second Stimulus Package and Housing Policy Initiatives my the Obama
Administration

When the Obama administration took office in February 2009, the US economy was
definitely heading into a deep recession. A large decline in consumption and
investment, and massive layoffs resulted in negative GDP growth and record
breaking unemployment. The annualized quarterly GDP growth rate dropped to -4.0
percent in the third quarter of 2009 and -6.8 percent in the last quarter. It was the
worst performance of the US economy since the Great Depression. Unemployment
rate started to increase very rapidly, from 5.4 percent in May 2008 to 8.2 percent in
February 2009. With worsening output and growing unemployment, the new
Administration pushed for the second stimulus package, as many felt that the size
of the previous Bush stimulus package was too small to have an adequate effect on
such a large-scale recession.Despite strong opposition from the minority
Republican Party, the Obama administration and the newly installed Democrats-
controlled House and the Senate, passed the American Recovery and Reinvestment
Act (ARRA) in February 2009. This $825 billion Obama stimulus plan was intended
to create jobs and promote investment and consumer spending. As the Fed already
lowered the fed fund rate to close to zero making the monetary policy ineffective,
fiscal stimulus was a natural government option amid the recession. While the
Bush's stimulus package was mainly a tax cut, ARRA was an assortment of
government spending programs. It included federal tax cuts, but most of the
provisions were long-time Democratic favorites: the expansion of unemployment
benefits, increased spending in education (school upgrade and increased funding
to the National Science Foundation), health care (electronic health care database
system and preventive care), energy (government building upgrades and green
technology), and infrastructure (electricity transmission lines and high speed rail).
The sharp ideological debate on several issues such as contraception and tax
rebates for low income households made the vote on this legislation very much
follow partisan lines.

However, in ARRA there was an important tax credit program for home buyers. In
fact, the program greatly expanded the Bush's tax credit. It included not only first-
time home buyers but repeat buyers, and the requirement of repayment of the credit
was eliminated, providing a much bigger benefit to taxpayers. For those who
purchased a principle residence for the first time, the tax credit was increased to
$8,000 and the income limitation was extended to less than $125,000 ($250,000 for
married couple). For repeat buyers the tax credit was $6,500. The deadline for the
signed sales contract was also extended to November 30, 2009 with the closing date
no later than December 31, 2009. Later, the deadline for sales contract was extended
to April 30, 2010 with a closing deadline of June 30, 2010. The closing deadline was
extended one more time to September 30, 2010.

Clearly, the Obama administration also recognized the problems in the housing
market as the key element of the Great Recession. Indeed, the housing market was
in a vicious cycle. As the economy worsened and many workers lost their jobs,
many homeowners (particularly ones with high LTVs) were more likely to default.
The increased supply of foreclosed home in the market further reduced home
prices, which made homeowners unable to refinance their mortgage even when the
interest rate fell to record-lows.

In an attempt to get control of the housing market in the tailspin, the Obama
administration devised a comprehensive strategy called, the Homeowner
Affordability and Stability Plan. In addition to the massive tax credit program for
home buyers, the Plan sought more affordable mortgage payments through a
mortgage modification program called the Home Affordability Modification Program
(HAMP). Also, the administration wanted to keep mortgage rates low by pumping
more funds to Fannie Mae and Freddie Mac.

For HAMP, the government committed $75 billion. Its main purpose is to reduce the
chance of foreclosure of qualified at-risk homeowners. When the homeowner's
monthly mortgage payment exceeds 43 percent of income due to economic
hardship, the government subsidizes its payment so that the mortgage payment
does not exceed 31 percent as long as the mortgage banker modifies the loan
(through lower interest rate and/or longer maturity) so that the monthly payment
stays below 38 percent. In order to increase participation by banks, the government
pays $1,000 for three years, and to increase homeowners staying current in their
payment, HAMP pays the homeowner $1,000 for five years. However, the
implementation of the program is time-consuming and requires substantial
administrative resources.

Another major element of the Obama plan is to keep the mortgage interest rate low.
In addition to the low interest rate policy adopted by the Fed, the Treasury
Department increased its preferred stock purchase of Fannie Mae and Freddie Mac
from $1 trillion to $2 trillion. Thanks to the low interest rate policy, mortgage rates
have been kept very low since 2009. For example, the 30-year fixed mortgage rate
decreased from 5.42 percent in June 2009 to 4.74 percent in June 2010. However,
the severe drop in housing prices prevents many homebuyers from being able to
refinance their mortgages. To ease the situation, the government allowed Fannie
Mae and Freddie Mac to buy the refinanced mortgages with LTV higher than 80%
when the original mortgage was obtained within regulation LTV.

While the housing market started to stabilize in the second quarter of 2010,
foreclosures and delinquent payments are still three times higher than before the
crisis. Although the rapid decline in housing prices stopped, not many expect that it
will rise again soon until the supply of foreclosed housing stock is removed from
the market. NAR reported that about one-third of the sales in 2009 involved
foreclosure or short sale. Given that the unemployment rate is still above 9 percent
and the growth is weak, the prospects of the return to the normalcy any time soon
seem unlikely.

It is reported that about 340,000 households permanently modified their mortgages

through HAMP. The performance was far lower than its objective of 3 million to 5
million households. The number of beneficiaries of HAMP frustrated lawmakers.
However, the administration of the program requires substantial program design
and verification of qualification of the applicants. In fact two-thirds of the applicants
who were deemed qualified temporarily lost their qualifications in later stage.
Considering the fact that about 100,000 homes are being foreclosed a month, the
effectiveness of the HAMP program is questionable.

It is too early to tell how many households benefited by the tax credit program, as
the household that took advantage of the program during 2010 will report their tax
return by April 15, 2011. The discontinuation of the program created a spike in the
last month of the program and a sudden drop in the first month after the
discontinuation. As the yearly home purchases range from 5 million to 6 million the
change of the monthly drop suggests that the number of households benefited by
the program would range from around 2 million to 3 million. If that were the case,
the cost of the tax credit would be around $20 billion to $30 billion.

Another limitation of the Obama housing plan was that it excludes housing
investors. Although the recent housing boom involves a great number of small
landlords, "house flippers" and second home owners in the boom states of Nevada
and Florida, the government policy has been exclusively on principle residences of
owner-occupied housing. While such policy may appeal to the populist ideal, (e.g.
"as the hard working Jones family is losing their home because of the bad
economy, the government needs to help them"), limiting the beneficiaries will leave
the large inventory of troubled housing untouched.

Conculusion
The prolonged recession of 2009-2010 started with the subprime mortgage crisis of
2007-08 to US. The impact of the failure of many large US financial institutions with
large exposure to subprime mortgages was profoundly felt by the global financial
market. While it is easy to blame the greed of the Wall Street investment bankers for
the crisis, the crisis represents a systemic failure. Although there are several
important factors that contributed to the crisis, the underlying cause is the sudden
stop of the US housing market boom around 2006. While the Bush and Obama
administrations recognized that the housing market was an important element for
the financial crisis and the prolonged recession, their policy responses were too
late too little.
In retrospect, the housing boom should have been controlled earlier. Greenspan's
view of the "new economy" and extended boom with growing household and
government debt turned out to be unsustainable. If more stringent financial
regulations were in place, over exposure to risky investment in subprime mortgages
by large investment banks might have been prevented. At the same time, the
populist political zeal of providing affordable homeownership to low and moderate
income households had its own limitations. The policy objective should have
focused on "better living environment" rather than "affordable homeownership."

It is easy to be a Monday morning quarterback. However, the more important

question is how to get out of this mess, because it is not easy to be overly
optimistic in the current housing market. The current high level of delinquency and
foreclosure will delay the return of normalcy in the housing market. Therefore, it is
imperative to prevent further foreclosures. It means the housing sector needs to
attract additional capital not only from owner-occupied households but from
investors. The depressed housing market will reduce consumption and housing
construction, thereby prolonging the current recession.

The housing sector used to be a powerful engine out of an economic recession

because lower interest rates typically promote housing construction and it is a
major component of GDP growth in the recovery process. Also, durable goods
purchases are typically important in the recovery, as lower interest rates attract
consumption. However, lower home prices severely constrain household
disposable income and durable goods purchases. An optimistic psyche is important
here. Therefore, the role of business investment and exports may have become
more important in this recovery. In this regard, foreign market becomes more
important to the US than ever before. As long as the US economy remains in
recession, it is unlikely that the housing market can restore its vitality, and vice
versa.

Keywords
subprime mortgage crisis, US housing policy, foreclosure, the Great Recession,
financial crisis, home affordability mortgage program (HAMP), homebuyers tax
credit