A Better Way to Fix the US Housing Crisis

A sure sign of a dysfunctional market economy is the persistence of
unemployment. In the United States today, one out of six workers who
would like a full-time job can't find one. It is an economy with huge
unmet needs and yet vast idle resources.

The housing market is
another US anomaly: there are hundreds of thousands of homeless people
(more than 1.5 million Americans spent at least one night in a shelter
in 2009), while hundreds of thousands of houses sit vacant.

Indeed,
the foreclosure rate is increasing. Two million Americans lost their
homes in 2008, and 2.8 million more in 2009, but the numbers are
expected to be even higher in 2010. Financial markets performed dismally
- well-performing, "rational" markets do not lend to people who cannot
or will not repay - and yet those running these markets were rewarded as
if they were financial geniuses.

None of this is news. What is
news is the Obama administration's reluctant and belated recognition
that its efforts to get the housing and mortgage markets working again have largely failed.
Curiously, there is a growing consensus on both the left and the right
that the government will have to continue propping up the housing market
for the foreseeable future. This stance is perplexing and possibly
dangerous.

It is perplexing because in conventional analyses of
which activities should be in the public domain, running the national
mortgage market is never mentioned. Mastering the specific information
related to assessing creditworthiness and monitoring the performance of
loans is precisely the kind of thing at which the private sector is
supposed to excel.

It is, however, an understandable position:
both US political parties supported policies that encouraged excessive
investment in housing and excessive leverage, while free-market ideology
dissuaded regulators from intervening to stop reckless lending. If the
government were to walk away now, real-estate prices would fall even
further, banks would come under even greater financial stress, and the
economy's short-run prospects would become bleaker.

But that is
precisely why a government-managed mortgage market is dangerous.
Distorted interest rates, official guarantees and tax subsidies
encourage continued investment in real estate, when what the economy
needs is investment in, say, technology and clean energy.

Moreover,
continuing investment in real estate makes it all the more difficult to
wean the economy off its real-estate addiction, and the real-estate
market off its addiction to government support. Supporting further
real-estate investment would make the sector's value even more dependent
on government policies, ensuring that future policymakers face greater
political pressure from interest groups like real-estate developers and
bonds holders.

Current US policy is befuddled, to say the least.
The Federal Reserve Board is no longer the lender of last resort, but
the lender of first resort. Credit risk in the mortgage market is being
assumed by the government, and market risk by the Fed. No one should be
surprised at what has now happened: the private market has essentially
disappeared.

The government has announced that these measures,
which work (if they do work) by lowering interest rates, are temporary.
But that means that when intervention comes to an end, interest rates
will rise - and any holder of mortgage-backed bonds would experience a
capital loss - potentially a large one.

No private party would buy
such an asset. By contrast, the Fed doesn't have to recognise the loss;
while free-market advocates might talk about the virtues of market
pricing and "price discovery", the Fed can pretend that nothing has
happened.

With the government assuming credit risk, mortgages
become as safe as government bonds of comparable maturity. Hence, the
Fed's intervention in the housing market is really an intervention in
the government bond market; the purported "switch" from buying mortgages
to buying government bonds is of little significance. The Fed is
engaged in the difficult task of trying to set not just the short-term
interest rate, but longer-term rates as well.

Resuscitating the
housing market is all the more difficult for two reasons. First, the
banks that used to do conventional mortgage lending are in bad financial
shape. Second, the securitisation model is badly broken and not likely
to be replaced anytime soon. Unfortunately, neither the Obama
administration nor the Fed seems willing to face these realities.

Securitisation
- putting large numbers of mortgages together to be sold to pension
funds and investors around the world - worked only because there were
rating agencies that were trusted to ensure that mortgage loans were
given to people who would repay them. Today, no one will or should trust
the rating agencies, or the investment banks that purveyed flawed
products (sometimes designing them to lose money).

In short,
government policies to support the housing market not only have failed
to fix the problem, but are prolonging the deleveraging process and
creating the conditions for Japanese-style malaise. Avoiding this dismal
"new normal" will be difficult, but there are alternative policies with
far better prospects of returning the US and the global economy to
prosperity.

Corporations have learned how to take bad news in
stride, write down losses, and move on, but our governments have not.
For one out of four US mortgages, the debt exceeds the home's value.
Evictions merely create more homeless people and more vacant homes. What
is needed is a quick write-down of the value of the mortgages. Banks
will have to recognise the losses and, if necessary, find the additional
capital to meet reserve requirements.

This, of course, will be
painful for banks, but their pain will be nothing in comparison to the
suffering they have inflicted on people throughout the rest of the
global economy.