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How to Fix Housing

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As America's economy risks lapsing back into recession, debate continues over who should act and what should be done to avoid another dangerous economic slowdown.

Some urge the Federal Reserve to launch a third round of quantitative easing. Democrats want another stimulus bill. Republicans want more deficit reduction. The Obama Administration offers fixes like extending the current payroll tax holiday, modest infrastructure investments, rebuilding our schools, and incentives for companies to hire.

Given the extreme partisanship in Congress, the full Obama agenda is unlikely to pass this autumn. At the same time, everyone is waiting for the Congressional Joint Select Committee to offer its magic bullet on deficit reduction before Thanksgiving.

The problems facing the American economy cannot be solved without addressing directly the structural issues that created the Great Recession in the first place. Those structural issues find their source in the overheated housing market that led to the massive housing bubble that burst in 2007-2008. As IMF Chief Christine Lagarde said last month at Jackson Hole, "House price declines continued to weaken household balance sheets. With falling house prices still holding down consumption and creating economic uncertainty, there is simply no room for half-measures or delay."

Many Americans - - including many of our elected officials, policymakers, bankers, and most consumers - - are naively hoping that a series of quick fixes will somehow reboot aggregate consumer demand (and restore the go-go days of 2007-2008). These quick fixes may provide some temporary relief, but ultimately they will not succeed because they merely tinker at the edges. We need to confront reality and deal directly with the structure of the American housing market.

When the Japanese economy experienced a bubble associated with its commercial real estate sector in the late 1980s and 1990s, we lectured the Japanese that they must act promptly to move as many nonperforming loans off their banks' balance sheets. The Japanese dragged their feet, and the result has been nearly two decades of lost economic growth.

The United States now faces a similar problem with its own housing market yet refuses to follow the advice we offered the Japanese. Our housing market, as a direct result of the subprime lending practices of so many banks and loan originators, now has an "over supply" of unsold homes, foreclosed-upon homes, or homes whose value is "underwater," meaning that a house's current value is worth less than the outstanding value of the mortgage. Many of these homeowners face possible foreclosure if they are unable--or unwilling--to meet their monthly mortgage payments.

In Las Vegas, for example, some 85 percent of homes with mortgages are reportedly "underwater." Nationally, 10.9 million borrowers have homes worth less than their mortgages, and in July there were some 212,000 foreclosures in the U.S. As long as our housing market remains depressed, our economy will continue to sputter and may even stall. For most Americans, their home is their most valuable asset. Its value strongly influences not only their actual wealth but also their sense of financial security, which in turn affects their savings and spending behavior.

Today's home ownership rate is at 59.7 percent, the lowest since 1965. The bubble (exacerbated by government policy to expand home ownership, lax regulations, and cheap money) clearly boosted home ownership to an artificially high and unsustainable level. Putting a "floor" under current home values is a necessary first step to restoring consumer confidence.

Almost three years ago, the American taxpayer and the Federal government rescued the U.S. financial sector, including several major banks, from near oblivion. While the banking sector has not fully rebounded, its executives have fared exceedingly well as both compensation and bonuses have returned to pre-recession levels. So it is certainly fair to ask the banks to "give back" in a manner that will contribute to stimulating the U.S. economy by stabilizing the housing market.

Here are some ideas:

  • The banks and other financial institutions still holding nonperforming loans or subprime mortgage paper need to get those loans off their balance sheets ASAP. This is what we told the Japanese to do. Merely holding the loans and hoping that prices rebound soon is wishful thinking. Dispose of these assets now. The first step is to write down the value of those loans to their current mark-to-market level. A home that sold for $350,000 that is now valued at $250,000 should appear on the bank's balance sheet at the lower amount.
  • Next, for homeowners who are in "underwater" houses, the principal or loan value of each home should also be reduced to reflect the current market value of the home. As we did with Third World debt in the 1960s and 1970s, the loan agreements should be rewritten to allow longer payment schedules, with lower principal and interest payments, and no foreclosure as long as a homeowner remains not more than three months in arrears. These more favorable terms to homeowners would not be available to any "homeowner" who was in fact a speculator who bought homes intending to "flip" them for a short-term profit.
  • Homeowners who benefit from this favorable reworking of their loan obligations must commit that any future sale of their property for a net gain over the "marked down" value of the property must be shared with the bank or financial institution holding the mortgages on a pro rata basis depending on the time the homeowner stays in the home. For example, if the homeowner sells the house for a net gain within five years, the mortgage holder shares the gain with the homeowner 2/3 to 1/3. Thereafter, the holder and the homeowner split any gain 50/50.

One immediate objection is that this approach could force the bankruptcy of several major American banks. Well, if marking down the value of their subprime loans to today's actual market value results in further undercapitalization, then these banks may be insolvent right now because their balance sheets already show homes that are overvalued. Prolonging the banks' fictitious accounting will only prolong the nation's overall sluggish recovery.

At Jackson Hole, Ms. Lagarde stressed the importance of "halting the downward spiral of foreclosures, falling house prices and deteriorating household spending." She added that solutions might entail "more aggressive principal reduction programs for homeowners, stronger intervention by the government housing finance agencies, or steps to help homeowners take advantage of the low interest rate environment." She's right.

Undoubtedly, others will offer ideas for addressing the problems of our housing market. President Obama should consider convening a high-level meeting with the Treasury and HUD Secretaries, the Comptroller of the Currency, the Office of Thrift Supervision, and the heads of Fannie Mae and Freddie Mac to explore other policy, regulatory, and legislative options. The appropriate Congressional Committee chairs can be included, along with the CEOs of the major financial institutions that would be affected.

As economists Kenneth Rogoff and Carmen Reinhart have written, banking-crisis recessions usually are deeper and entail a longer recovery time than traditional business-cycle recessions. Stimulus spending and tax relief will help in the short-term, but unless we tackle the structural problems of our housing market, we're only applying bandaids to broken bones.

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Charles Kolb is president of the nonpartisan, business-led Committee for Economic Development in Washington, D.C. He served in the George H.W. Bush White House as Deputy Assistant to the President for Domestic Policy. The above views are solely the author's.