2010 Mar 7th

Rethinking Federal Subsidies

Robert Shiller, the Yale economist (and as in the Case-Shiller housing price index) wrote an interesting piece for today’s NY Times about FHA and other government housing subsidies.  He talks about the taxpayer subsidizing homeownership not only as an economic stimulus but also as a means to preserve our sense of national identity.  He claims Americans believe owning a home in a healthy community is connected to individual liberties that embody our national identity.  You know – a way to avoid the oppression of the masses imposed by the lord of the land, etc.  After discussing the merits of renting, he says we need to retool or reinvent our financial institutions (think Fanny Mae, Freddie Mac, FHA) to create a different kind of housing while preserving our core values even if the subsidies don’t end.  The subsidies should focus on “enhancing the qualities of life that we really value”.  I wonder how that would play out on Wall Street.

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  1. shortsequalmarket

    Interesting a world reknown economist would consider FHA a government subsidy. Perhaps he should consult Wikipedia before making such claims.

  2. guest

    But FHA is a government subsidy.

  3. Confused

    Perhaps he should read this blog. I’m sure there are a few people here who would like to try and set him straight.

    Shorts, was that sarcasm? I hope so.

  4. Craig

    Sorry, but Shiller has it wrong where FHA is concerned. FHA is not funded with a dime of public taxpayer funds. So how exactly is it a taxpayer-subsidized entity?

  5. Lori Turoff

    Didn’t we have this whole debate already a few posts back? I have to agree with the “yes, it’s a subsidy” side on this one. When the FHA defaults get bad enough, and they will, who do you think is going to foot the bill? A private entity? No, the taxpayers. If I’m paying for it against my will it’s a subsidy.

  6. Craig

    C’mon Lori, you are a lawyer (as am I). You know better than to base your argument on a hypothetical. You guys can’t win this debate on the facts. If your hypothetical happens, then maybe you have an argument. But until it does, the fact remains that you aren’t paying for anything related to FHA against your will. Thus taxpayers do not subsidize FHA and never have.

  7. Confused

    Never have….but I wouldn’t bet against never will.

  8. Laki

    Craig I’ll give you a hypothetical:

    Say US Government decided to start guaranteeing my personal debt and obligations (As they do with FHA right now). Upon receiving this great news I went out there and started borrowing left and right at VERY LOW rates. Say, I borrowed hundreds of millions of dollars to finance my extravagant lifestyle… parties, spending, waste, you name it… I borrowed a lot and I spent a lot… Couple of years later, my debts came due and I was out of money…. so what did I do? I went out there raised DOUBLE the amount i did the first time around and used half to pay off my earlier debts and the other half i used to keep my lifestyle going… and so on. Borrowing cheaply is extremely easy if US government guarantees the debts.

    According to you this would not constitute a subsidy, as the government never gave me a cent directly. But this is clearly not a sound argument. The government is the ultimate enabler of my irrational non-economic behavior… so they are subsidizing me. Without them my life would not be so glamorous.

    You might be a great lawyer and a smart person and everything that comes with it… but I have to say that you clearly don’t know much about finance if your claim is more or less reduced to: The US treasury never transferred any money to FHA – hence it is not subsidy.

    Using this argument you would fail Econ 101 at a community college.

  9. Lori Turoff

    Laki, I agree with you 100% but please, let’s all be nice to each other, no?

  10. Laki

    If I said something offensive I apologize. I didn’t mean to be offensive at all… maybe it came off that way, but I simply wanted to point out how truly trivial and elementary my argument is (hence the community college reference) and that the only way to disagree with something so basic is if you’re arguing with limited and imperfect information at your disposal or if you’re not familiar with the subject matter that you’re debating.

    OK. I’m done arguing about FHA for good.

  11. patk14

    Laki, your example captures exactly what the FHA has done. Fundamentally they are using extremely poor lending standards by allowing such a low level of down payment and they ramped up their volume even after there was widespread defaults on mortgages across the country. Why were they allowed to risk taxpayer money to do this? It was government policy to try to prevent housing prices from falling dramatically. The cost of this effort is that it was known that the FHA would suffer huge losses (just like Fannie Mae and Freddie Mac). The portfolio of mortgages that the FHA has insured is underwater and the FHA doesn’t have the funds to cover these losses. Did you really expect that they would highlight this known fact on their website? Fannie Mae and Freddie Mac were in denial right up to the moment that the government essentially seized them to prevent them from going bankrupt which would have crushed the US housing market. Again, the FHA is subsizing people who cannot save enough for their down payment, this subsidy goes directly from the government/taxpayer to the seller of the condo in the form of a higher sales price.

  12. vreporter

    Real estate transactions receive subsidies in many other forms as well. Our mortgage interest deduction is just another such variety. I don’t know of any other country in the world that follows such heavy-handed ways to put real estate into weak hands. Such policies are a major reason we are paying the piper for the foreseeable future. Rising property taxes will just soak it all up while prices continue to drop and financing rates are kept (relatively) low to cushion the blow.

  13. Tiger

    vreporter, true, other countries do not allow you to deduct mortgage interest from your income taxes, but those same countries do not charge you that much tax to begin with.

    And those of them who do (such as the UK), they have other ways of pushing real estate. A friend of mine bought a condo near London; they basically have a system were you tie your bank savings to your mortgage, which means after a few short years your condo will literally pay for itself; and in his case, put additional money in his pocket.

  14. bill

    Tiger – how does that work?

  15. Craig

    I find it curious that many on this blog have such disdain for agencies such as FHA, yet they don’t have similar disdain for the mortgage interest deduction – which is unquestionably the biggest federal subsidy of home ownership of them all. It’s kind of hypocritical if you ask me.

  16. Tiger

    bill – I don’t know the details, but I am seeing my friend soon so I will check because I myself am curious.

    He is actually a colleague of mine, a UK employee who transfered to the US last summer. His condo (or as he calls it, me flat) came up in a conversation and I remember him mentioning setting up a ‘cycle’ where interest earned from savings would feed into mortgage and more than offsetting it. He did buy back in 2002 though so I don’t know how it is now.

    Craig, so it is a subsidy then? A smaller subsidy than mortgage deduction but it is a subsidy? It is ok dude, that says nothing about your income or finances. Heck, it seems the richer people get the more the get freebies. Have you seen the ‘gift baskets’ given to celebrities for participating in award shows? They are worth 3 times my car!

  17. Lori

    Craig – Maybe that is because programs like FHA allow buyers with little to no savings, who otherwise wouldn’t qualify for a mortgage under standard credit risk anaysis, to buy anyway thereby increasing the risk of default. The mortgage interest deduction doesn’t. Sure, it provides a tax deduction and is in that sense a subsidy but it doesn’t enable buyers with little or no savings to buy. In fact, the higher your income the more value the mortgage deduction has since you’re in a higher tax bracket.

  18. Craig

    Lori – you make a valid point, and I agree in some cases FHA assumes an unacceptable risk. But you can’t paint all FHA loans with such a broad brush. I may not have had 20% down, but my front-end monthly debt to income ratio is well under the 28% required under standard credit risk analysis. So how am I any more likely to default than someone with a similar monthly front-end D/I ratio but who had more savings than I did?

    Who’s less of a risk: the buyer like myself who put down less than 20% and yet held back several months of living expenses still in the bank in case of emergency; or the buyer who put down 20%, but exhausted all savings in doing so? Not everyone who uses FHA is broke and can’t afford a home. I have quite a few friends with 6 figure household incomes who used FHA because they didn’t want to exhaust all their savings. That’s how I got turned on to it. 40% of all new mortgages are through FHA now. That isn’t all poor people who can’t afford to buy homes. That’s not to say I don’t see flaws in FHA’s methods. I do think that FHA should adopt the conventional 28/35 front and rear end debt to income ratio to ensure borrowers don’t over-extend themselves.

    Lastly, anyone want to compare how much FHA costs taxpayers annually vs. how much the mortgage interest deduction costs?

  19. Long&Strong

    Craig – Who cares if FHA is a subsidy, i would argue that getting a FNM/FRE loan is a subsidy. The GSE have a social agenda which is why they fund loans at below market rates. In most other countries people buy a house with cash..not leverage and definately not below mkt priced leverage. Craig – I dont know why you feel you need to justify yourself, leverage is not a bad thing as long as u can afford it and understand the implications. Leverage does amplify returns.

  20. laki

    Mortgage Interest deductions, GSEs, FHA, Tax Credits, Negative real interest rates… they’re all housing subsidies and I hate them all. I simply haven’t been talking about the other ones as nobody kept pushing back saying they’re not as was the case with FHA… so I’m not hating just on FHA.

    The first order cumulative effect of all these policies is to artificially inflate home valuations. If all of these policies were to be abandoned – home values would drop drastically as so many fewer people would actually be able to afford a home at current prices… so the prices would have to go lower in order to reach a new equilibrium level where demand meets supply.

    Now the irony in all these subsidies is that the government wants to make homes affordable but this actually doesn’t work in the long run. The more you subsidize something the more you increase the demand for it. The higher the demand the higher the pricing power for the seller. Hence most of the monetary “benefits” a buyer gets from a subsidy are taken away as he/she ends up overpaying for the house.

    The same paradigm can be applied to education. Because the government subsidizes higher education via extremely cheap loans, more people can now afford to go to college, so the demand is up, but now universities can charge more and they do. So the tuition costs at universities have been going up for decades now at much faster pace than inflation. This is clearly not sustainable.

    No matter how noble and idealistic the goals of the policy makers are LONG TERM subsidies never work. Subsidizing things initially creates an illusion that the policy is “working” and that people are getting education, people are owning their own homes, etc, etc. But at the same time these things are happening, pricing bubbles form as all the subsidized items keep getting more and more expensive. Eventually these bubbles burst and the society ends up paying for everything in one way or another and the cost usually ends up being much higher than it would’ve been had there not been for subsidies in the first place. There is no free lunch out there. Just the question is who is eating the lunch, and who’s paying for it and when?

  21. laki

    Craig to answer your specific question:

    “Who’s less of a risk: the buyer like myself who put down less than 20% and yet held back several months of living expenses still in the bank in case of emergency; or the buyer who put down 20%, but exhausted all savings in doing so?”

    On average, the buyer with 20% down is less of a risk. I’ve been running statistical analysis on tens of millions of loans and the negative equity in the house trumps every other factor when measuring the marginal change in behavior (i.e. who ends up defaulting) now vs pre-bubble era.

    The person who has positive equity in the house – if he gets in trouble – chances are he wont default on the loan. He will sell the house and extract his equity in cash which he could use to deal with his financial problems. So him getting in trouble because he has no money in the bank typically is a non-item for a taxpayer.

    But a person who has money in the bank and sizable negative equity – such person frequently chooses to do a strategic default because it is in his own economic interest to stop paying for an asset that is underwater – and nowadays the taxpayer picks up the tab.

  22. laki

    Based on my calculations:

    Mortgage Interest Subsidy is in the neighborhood of $175 Billion Per year.

    FHA (at current level of activity) Subsidy is in the neighborhood of $30 B Per year.

    So you’re right the interest deduction subsidy is several times larger than FHA despite the fact that FHA is on steroids right now.

    That said, every dollar of FHA subsidies distorts the market a bit more than every dollar of Interest deduction subsidies. Pull out FHA subsidy and you lost majority of buyers. Pull out the interest deduction subsidy and you lost some buyers.

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