The mortgage finance system is broken. Housing prices continue to decline. In 2010, nearly 26% of all home sales were foreclosed houses. What's more, although the number of foreclosures was down in the first quarter of 2011 compared to the previous quarter, it is expected to increase in the months ahead. So does this foretell the end of the so-called American dream of homeownership?
In my view, the housing finance system is on life support.
Not by a long shot, you might be surprised to know. As Gallup's Chief Economist Dennis Jacobe, Ph.D., explains in the following conversation, the roller coaster housing market of the past decade was an aberration, not the norm. But that doesn't mean the U.S. can't return to the days when homeownership was a public good -- a symbol of the American middle class and a source of stability for communities across the country.
What we need is a change in how houses are financed, Jacobe says. The recent way -- with mortgage bankers throwing money at anyone with a pulse, then having Wall Street bundle the mortgage loans into securities before selling fragments of those securities to investors all over the world -- isn't such a hot idea, it turns out. It may have made a lot of people on Wall Street rich, but it devastated the U.S. banking system and economy and had ripple effects in economies around the world.
The old way, according to Jacobe, is better: Local financial institutions make careful evaluations of local mortgage borrowers -- thereby allowing average people to buy houses they can afford -- while simultaneously allowing local banks to hold the mortgage loans they make in their portfolios. And Jacobe thinks the old way is coming back, welcomed by the pressures of the "new normal" in housing finance, the growth of "virtual companies," and a chastened home buying public. Further, he argues that homeownership in the future is likely to be more enjoyable and more beneficial to American society than it has been at any time in the past.
GMJ: How would you describe today's housing market?
Dennis Jacobe, Ph.D.: Not good. Today's housing market is in the midst of a depression. The reason we don't hear more about this disaster is that it is being masked by the many other major economic challenges facing the country.
GMJ: What do you mean by disaster?
Dr. Jacobe: In my view, the housing finance system is on life support. I started out as a housing economist. I've seen housing have its ups and downs. However, I've never seen anything like the current situation. During the financial crisis, the mortgage finance market basically collapsed. It has been maintained in what might be called a minimum mode by the government's resuscitation of Fannie Mae and Freddie Mac, both of which are still being bailed out by the Treasury, and by FHA/VA, which is totally government backed.
To get a home loan today, you must meet some very high, very standardized criteria: You must have a near-perfect credit record and a substantial down payment, and you must endure an onerous application process. If you don't meet these high financial standards, it makes a mortgage tough to get. And in many markets, the "conforming" loan limit makes it even more difficult to get mortgage financing in high-cost markets like San Francisco or Washington, D.C.
At the same time, so-called "non-conforming" loans are very difficult to get, so you'll have trouble getting a loan if you are self-employed, for instance, or if you haven't been employed for a certain length of time at the same employer. The pendulum has swung from "anything goes" to "very difficult to get a loan."
GMJ: So getting a loan is tough. How does that affect the housing market?
Dr. Jacobe: There are many negative aspects to the current housing market, and some of them are masked by the difficulty of getting a loan. There were more than a million foreclosures last year, and observers think there will be more than that this year. That builds the inventory of houses that are for sale. When banks put those houses on the market, they generally list them at a discounted price, which tends to drive down prices.
So -- depending on the market -- a third to half of the houses could be for sale at greatly depressed prices. If you're selling your home, you may be competing with a pile of foreclosures that are reducing prices. There may be a lack of financing for potential buyers, and then there may also be a lack of financing for you if you need it to buy another house.
Once upon a time, twenty or thirty years ago, the housing finance system was dominated by savings and loans or thrifts. The board of the local thrift would review your loan, and if the board voted to approve it, the thrift would keep the loan in its portfolio. Then came the savings and loan crisis of the 1980s and the booming of the secondary mortgage market.
Wall Street got actively involved and began to package most mortgage loans into mortgage securities through so-called securitization. These mortgage securities were backed by Fannie Mae or Freddie Mac, which in turn were backed by the federal government. Wall Street was then able to sell pieces of these U.S.-government-backed mortgage securities all over the world. That whole system has now collapsed.
GMJ: And the result was global financial devastation.
If more people become unemployed, it could cause more foreclosures and keep driving down housing prices.
Dr. Jacobe: That's right. And something needs to replace the mostly failed U.S. mortgage finance system, whether that's requiring banks to be more involved and accountable or some kind of alternative securitized system. Something needs to replace the current housing finance system to make credit more available not only to average Americans but also to people who don't necessarily fit the strict profile required to get a government loan right now. If you're self-employed, you need someone who can look at your balance sheet and determine if you're a worthy credit risk.
GMJ: Are houses themselves still worthy risks?
Dr. Jacobe: It's a riskier venture for buyers today because house prices are volatile and involve leverage. Leverage worked well for investors during the boom days when prices were rising, but it often works against home buyers today. You can buy a half-million-dollar house with a loan at a good interest rate, for example, but if house prices drop 10% in your market over the next year, you'll lose $50,000 in the value of your investment. The unemployment situation makes this leverage issue especially troubling; if more people become unemployed or if they aren't able to make their house payments for any reason, it could cause more foreclosures and keep driving down housing prices.
GMJ: And if you lose your job, you can't move to a better employment market if you can't sell your house.
Dr. Jacobe: Yes, but I don't know if that's the problem now that it has been in the past. I think the future of housing finance is a lot different than what traditional analysts might think. Traditional analysts would probably say that housing demand is driven by the creation of new households. So when the economy revives, people will need to move to their jobs. They'll want new homes, and they'll sell their existing homes. At the same time, new people are entering the job market; they'll also want new homes. That creates demand. So the thinking is that there's enormous pent-up demand for housing -- there are all these potential buyers out there, and they will all spring on the market at some point in time. And there could even be a housing shortage in a couple of years.
That's been the thinking, but I don't know if that's still true. My theory -- and it's part of my view of the new normal -- is that we've had a shock to the housing finance system, and I don't think the system works the way it used to anymore. I don't think people necessarily move out and form new households the way they did when the housing finance market was different. In part, that's because of the current economic climate, but it's also partly sociological.
People are delaying marriage; they're starting to save for a while before they get a house. If you have to save 20% for a down payment on a house, you'll have to work for a while, and you'll either live in an apartment or you'll live with family. Most importantly, I don't think companies move people like they used to. That's in part because of the shock of the economic downturn, but it's also because people are starting to work for "virtual companies."
GMJ: Virtual companies?
Dr. Jacobe: Suppose you are a nationwide company and your headquarters is in Chicago. Once upon a time, you might have moved workers to your Chicago headquarters, paid their moving expenses, maybe bought the old house from them and then sold it, or done a bunch of different expensive things for those workers. Today, you might have an office near the new hire and instead of moving the person, you'll have him or her work from that office.
At one time, I thought the collapse of the housing finance system would create major economic mobility problems because if people can't sell their houses, they can't move. That would create a lack of workforce mobility and inhibit good employees from going to good companies. I don't think that's the situation now.
I think companies, basically to cut costs, have learned how to work in a virtual mode with the technologies available. They don't need to have everybody in the same office, and they're getting more comfortable with people working from a local office or from home. So the idea that when you get a new job you immediately sell your home and get a new one has become a bit anachronistic.
GMJ: What does that suggest for the future of home buying?
Dr. Jacobe: In the short term, I think it means a lot fewer people will be moving when they change jobs or when they need more room in the house. Housing sales activity likely won't be anywhere near what it has been in the past -- home improvement will increase as people stay in their homes -- there will be a new normal in housing.
I don't think the U.S. economy will fully recover until the housing market is stable and growing.
In the medium and longer term, I think we may see a revolutionary change in the way people look at buying a home. If you work for a virtual company, you may be able to simply choose where you want to live regardless of where your company is located. In turn, this suggests that future home buyers may be looking for different things than they used to.
People may decide they want to buy a home in a community where there are lots of outdoor activities available, that has a suitable climate, or that is close to friends and family. Things like the quality of schools, local transportation, and safety will still matter, but I think what a community offers a potential home buyer will be much more important.
GMJ: People who do that will be buying with a much longer ownership time frame in mind, right?
Dr. Jacobe: Right. They'll see a home as someplace they plan to live for a long time, even into retirement. They may no longer see it as a financial investment or as a short-term place to live before they move to another city or simply move up.
Companies might also change the way they locate their offices. Diseconomies of scale and virtual companies could change the strategy companies use to decide where they locate their headquarters, their other offices, and the relative size of each.
Homeownership is likely to be an even better American dream. You not only get all the traditional benefits of being a homeowner -- owning your own piece of America -- but you also get a lot more freedom in choosing where you live and how you live.
GMJ: So what does this mean for mortgage finance?
Dr. Jacobe: We need something of a revolution in mortgage finance. Right now, the housing market is place specific -- and I think changes in home buying patterns are likely to increase these local market differences -- yet the housing finance system is the same all over the country. Lenders in every market are more cautious, whether or not that's entirely warranted. So whatever we do to reform the housing finance system, we need something that provides local finance.
Selling loans around the world created problems because nobody knew or cared about what the local market conditions were. One of the reasons that small businesses have major problems getting loans today is because of the decline in housing prices. Many small-business owners use their homes as collateral for business loans, so some of the economic numbers relating housing to the GDP greatly underestimated the impact of housing activity directly and indirectly on the U.S. economy. The economy is getting better now -- manufacturing and exports have been recovering -- but we really need the housing sector nationwide to improve to get the economy going.
Housing affects the economy indirectly in ways that people don't think about. For that reason, we must focus on what it will take to get financial institutions to invest locally in mortgage finance. Instead of removing the mortgage interest deduction -- a so-called tax expenditure -- which I think is a terrible idea, we need new incentives for lenders to make, underwrite, and keep home loans locally. Lenders generally do have a strong interest in their local communities; no matter how big a financial institution is, their interest is in the well-being of their local communities.
The sooner we get back to financing homes locally and doing so on a solid but individualized basis, the better. An additional advantage of local mortgage finance is that it allows lenders to work with homeowners if they run into financial trouble -- something that has proven very difficult when investors around the world own local mortgage loans packaged into securities.
GMJ: Dr. Jacobe, for you this is wildly optimistic.
Dr. Jacobe: Yes, but I think changing the home financing system will be a challenge. Still, I just can't believe people are ready to abandon homeownership. I think too many people have forgotten how homeownership benefits individual freedom, local communities, and the U.S. economy as a whole. Most importantly, I don't think the U.S. economy will fully recover until the housing market is stable and growing once again.
The reality is that something must be done with Fannie Mae, Freddie Mac, and Ginnie Mae. These companies dominate housing finance in the U.S. and continue to need taxpayer support. I believe the restructuring of these trillion-dollar portfolio companies will put homeownership and housing finance in the spotlight in the months ahead.
I'm hoping there will be overwhelming support for turning over mortgage finance to the private sector in local communities -- a situation that served Americans well in the past. I'm optimistic that everyone will see the benefits associated with aggressively promoting homeownership. Think about it: There's a reason the movie It's a Wonderful Life still resonates.
-- Interviewed by Jennifer Robison