The Real Estate Crisis
References: PBS News Hour and Wall Street. (I am not affiliated with PBS nor either PBS program.)
The Real Estate Crisis is yet another area where I am not hearing any real solutions from either political party. Tax cuts and incentives won’t resolve the crisis. Government intervention will not resolve the crisis. Home foreclosures only exacerbate the crisis by lowering house prices. Restructuring Fanny Mae and Freddy Mac may have long term benefits, but in the short term may have no effect on the current crisis.
In order to illustrate what I am talking about, let’s create an imaginary person named Mr X. Mr X is a successful business executive earning millions of dollars per year. He bought his current home for 150 million dollars. He took out a 120 million dollar mortgage at a 5% interest rate. Everything was fine when he bought it. He could easily afford the mortgage payments.
But then, other foreclosures forced the value of his home down to $400,000. The principal of the mortgage was still very close to 120 million dollars because most of his payments during the first several years covered the interest and didn’t significantly reduce the principal.
Mr X has two choices. Refinancing may not be an option because the principle of the mortgage is well above the actual value of the house and the outlook for rising home prices is poor. Mr X could continue dumping his money into mortgage payments. But this option is comparable to flushing money down the toilet. Especially since he could abandon his home, rent an apartment and save lots of money by defaulting on the mortgage. Furthermore, the savings could be used to send his children to college.
So, putting ethics aside, Mr X makes a decision to stop paying his mortgage. The bank ends up taking the loss when they foreclose and try to sell the house. There is no way the bank could win.
Experiences like this make the bank less willing to give out mortgages. Furthermore, people hesitate to buy homes because of the concern that they will end up in the same situation as Mr X. It all amounts to a downward spiral of the real estate market. This concern will not fade for years after the declining home prices turn around. People will be keenly aware that they may end up in a situation comparable to Mr X’s position.
The question is: How do we turn it around?
Restructure Freddie and Fanny Mae?
Provide insurance against mortgage defaults? Who will provide that insurance and how much will it cost?
Provide government subsidized mortgages?
Add tax incentives to encourage people to buy homes?
Provide tax credits for people who end up in Mr X’s position?
Provide a way for banks to lower the interest rate on an existing mortgage rather than having the home owner try to refinance with a new mortgage?
Government grants for housing market?
A combination of any of the above?
The most promising answer is bank insurance against mortgage defaults. But it doesn’t resolve the concerns of the current family thinking about buying a home.