US Treasury’s Housing Report Gets it Half Right

Earlier this month, the US Treasury released its much anticipated report to Congress on Reforming America’s Housing Finance Market

At only 31 pages, the report is a refreshingly easy read. It identifies clearly and concisely what went wrong with mortgage financing and lays out three broad options for reform aimed at:

  1. Encouraging greater private sector involvement in the mortgage market by reducing government support for housing finance and winding down Fannie Mae and Freddie Mac.
  2. Restoring trust and integrity in the housing market through: stronger underwriting standards (including larger down payments) and consumer protection laws; increasing transparency, standardisation and accountability in the securitisation chain, including by requiring securitisers and originators to retain 5% of a security’s credit risk when sold to investors; and strengthening regulatory oversight.
  3. Better targeting of government support for affordable housing.

The specific reform options outlined by Treasury are as follows:

  1. Promoting a privatised system of housing finance with the Government’s insurance role limited to credit worthy lower and moderate income borrowers.
  2. Same as (1) but with a government backstop (guarantee) mechanism added to ensure access to credit during a housing crisis or credit crunch. The guarantee would be provided for a fee set at a sufficiently high level that it would only be competitive in the absence of private capital.
  3. Same as (1) but with the Government providing reinsurance of private mortgage insurers. Under this option, the Government would charge a premium for this reinsurance, which would be used to cover future claims and recoup losses to protect taxpayers. Holders of the insured mortgages would only receive payment from the Government after the private mortgage insurers had been wiped out.

The reform options laid out by Treasury are, in my opinion, a significant improvement on the system that existed prior to the US housing crash. Importantly, the Government’s involvement in the housing market and moral hazard would be significantly reduced. And with it, the risks inherent in mortgage lending would be better captured in mortgage credit availability and pricing. 

However, the report is somewhat inconsistent in that it advocates higher down payments on the one hand, but then proposes to give higher down payment assistance to “qualified low- and moderate-income homebuyers.” on the other. 

The proposals, if implemented, could also cause some short-term pain for the housing market, since the reduced access to financing and increased mortgage rates would likely reduce housing demand, thereby driving home prices lower, increasing the number of homeowners with negative equity, and increasing the number of defaults and foreclosures.

The Treasury also specifically targets affordability in the rental market by providing funding to “support the development and preservation of more affordable rental housing for the lowest income families to address serious supply shortages” in order to provide families with “rental options with good schools and good jobs”.

Finally, the report questions the efficacy of the mortgage tax interest deduction, which Treasury identifies as being unique to the US and partly responsible for causing economic distortions and risks.

Where the report goes missing:

Although the Treasury’s report is targeted at mortgage financing, I was disappointed that it did not acknowledge the role played by regulatory barriers to land supply.
As explained in The Truth About the US Housing Market, states that have operated restrictive land-use policies that significantly restrict the expansion of suburban residential development have experienced volatile boom/bust cycles and lower levels of housing affordability compared with states that have adopted liberal market-based approaches (i.e. ‘more responsive land-use regulation’).

On the first point – house price volatility and boom/bust cycles – first consider the below chart, which plots the CPI-adjusted house price performance of the cities included in the 20-city Case Shiller Composite index and deemed by Demographia and/or the Brookings Institution as having “more prescriptive land regulations”.

As you can see, prices have been highly volatile, with all cities experiencing wild boom/bust conditions.

Now consider prices in the cities within the 20-city Case-Shiller Composite Index with “more responsive land regulations”.

As you can see, real house prices have remained relatively stable in the supply responsive cities.

The situation is exactly the same when FHFA house price data is used at the state level (see here and here).

Now consider the “Median Multiples” (median house price divided by gross annual median household income) as calculated by the  Harvard University Joint Center on Housing from 1980 to 2006.

First, the cities with “more prescriptive land regulations”:

Now, compare to the Median Multiples of cities with “more responsive land regulations”:

As you can see, Median Multiples have been both higher and more volatile in the supply restricted states, with the exception of Minneapolis-St Paul.  Even Dallas Texas, which is said to have experienced a ‘large’ housing bubble in the early 1980s, never experienced a Median Multiple above 3.5.

The key point is that by focusing only on mortgage financing (the demand-side), the Treasury is only addressing half of the housing equation. If it truly wants to achieve greater financial and economic stability, improved housing affordability, and lower levels of speculation in the housing market, it needs to also look at removing regulatory impediments that make it impossible to bring low-cost housing quickly and efficiently to market. 

It is no surprise that the epicentre of the US housing bubble/bust – California – has nearly 50% share of Jumbo (large non-conforming) mortgages, despite accounting for only 10% of the US housing stock. The reason lies in California’s strict land-use policies that limits home construction, thereby ensuring that extra credit demand feeds into higher prices instead of new construction.

Now compare California’s experience to Atlanta, Georgia, which was subject to intense predatory and sub-prime lending in the lead up to the global recession. Because of its permissive zoning and abundant land, Georgia was able to easily increase its housing stock, which prevented large price increases and a serious bubble (see above charts).

This is not to say that Georgia is an ideal housing market – it’s not. Whilst Georgia had the supply-side down pat, its consumer protection laws and underwriting requirements were inadequate, leading to prolificate lending and a high number of bank failures. Nevertheless, Georgia’s responsive housing supply was able to mitigate these credit excesses, thereby limiting the overall damage to its economy.

A better model can be found in Texas, which has adopted both an open market-oriented approach to land-use regulation (see here for details) as well as stronger consumer protection laws and underwriting standards, which ensured that credit demand was kept in check whilst other states were gorging on easy money.

The Treasury could learn a trick or two from their compatriots down south. 

Cheers Leith

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Leith van Onselen
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  1. Nice summary. Another interesting thing about the report is that in several places it mentions increasing the quality of rental options. ie the overarching goal of US housing policy is no longer simply to increase the home ownership rate.

    Regarding the three options, they are pretty different. You would have to think (1) would be a disaster for house prices, while (3) would keep considerable moral hazard in the system. (2) is probably the best bet in my opinion.

  2. I think the whole point is pretty moot since the smouldering wreckage of the US housing market and economy in general is pretty unlikely to see runaway house price speculation again in the forseeable future. Probably more like Japan, where 20 years later, house prices are still less than half of the peak reached when their bubble imploded.

    • 1)The USA isn’t going backward demographically like Japan.
      2) The US is a set of different housing markets, as Leith’s post shows.
      3)”..and economy in general is pretty unlikely to see runaway house price speculation again in the forseeable future” Never say never……

      • You’re probably right, Crocodile Chuck, about why Japan’s bubble deflated slowly while so many others have burst spectacularly. Japan also has very little “migration”, espcially compared to the USA or any member of the EU.

        Britain is a case study in 5 decades of restrictive town planning. The best author of papers on this subject, is Paul Cheshire of the London School of Economics (and co-authors, of which Stephen Sheppard is the main one). Britain is unlike Japan. They have had a bubble and bust approximately every 15 years since the 1950’s. Each one is more volatile than the previous one. Each one is accompanied by a SMALLER “supply” response from the building industry, while prices reach new record levels each time. The “TREND” has been steadily higher, with the pricing volatility cycling around a rising trend line point.

        Actual “SHORTAGE” of homes has become greater and greater, now numbering in the millions. Floor space per person is the lowest in the OECD, including Japan. Overcrowding, old and dilapidated and unsanitary housing is an epidemic and a disgrace in a first world nation. Even “social housing” has wait lists of years. Yet no politician has dared to buck the Green myths and lies that underly this absurdity.

        I have said a lot before about all this on this site, and won’t repeat myself now. It would be even more ridiculous for Australia and NZ to engineer themselves a similar situation over the decades to come.

        Oh, Britain has a serious problem with its international economic competitiveness because of its inflated land prices and living costs. Apart from the direct impact, unnaturally inflated land costs result in REDUCED efficiencies of urban form. Yes, you read that right. Sydney’s urban form is observably getting less efficient by the year for this reason. Some commentators call it “dense sprawl” or “dysfunctional density”; the main reason for this phenomenon is the inflated land prices and their effect on every “location” decision made by everyone operating in that urban economy.

        Read Paul Cheshire to find out why. Alain Bertaud is the other outstanding author on this subject.

  3. Your article on housing, Texas and land use was most interesting and I have been mulling over it for a few days. Do those states that have fewer prescriptive land regulations which you think results in less house price volatility, restrict the use of land for commercial purposes? eg can you build a factory, brothel, a freezing works anywhere too? I wouldn’t like a system where I could wake up one day and find a freezing works being built next door. What about Germany where apparently they did not have price volatility either? Do they also have fewer restrictive land regulations or is house price volatility an anglo saxon disease? Spain’s house prices were volatile too but it was the English who went mad and bought up in Spain. To me, and I admit I haven’t read as much as you have on the matter, it is just too simple to say because there was fewer prescriptive land regulations there was less house price volatility. Apart from the people in the South very few people in the North want to live in Oklahoma or Texas anyway. (My sister lives in OK.) Although that argument doesn’t hold because in Tasmania everybody went mad and traded house among themselves at ever increasing prices. Just like the tulip bulb mania in 1637. I think house price volatility was just a madness that swept some parts of the world and it was an unregulated banking system that let it happen.

    • Hi Patricia. Thanks for your comment. The reason why I like the US comparison so much is that: 1) there is lots of freely available data and literature; and 2) there are wildly different land-use policies in effect across the states, which enables easy comparison of their impacts (since demand-side factors are mostly uniform across the nation).

      I have to disagree with you on your comment that: “Apart from the people in the South very few people in the North want to live in Oklahoma or Texas anyway”. Whilst Oklahoma’s population has been relatively flat, Texas added a whopping 4.3 million people between 2000 and 2010 (21% change). Similarly, Atlanta Georgia added 1.5m people over the same period (18% change). So both are experiencing rapid population growth mostly from inward migration from the north. Other things equal, such strong demand should have resulted in escalating house prices in those two states. However, due to their liberal land-use policies, house prices remained relatively stable and affordable.

      • Thanks Leith for your reply. I can only observe from a wedding I went to in OK and the comments from the people who attended who were from the North – it is pretty dead. Christchurch is very much better – but is the commercial activity in these areas in these countries restricted – I don’t know where to look but you obviously do. And what about Germany?

        • Hi Patricia. I think Texas has open planning for both commercial and residential. But I’m not sure if this means that they can build petrol stations, factories, etc anywhere they like. Here’s a comparative paper comparing the German, Swiss, Irish and Australian planning systems. I am yet to read it, but it looks very good (click link). Australia gets a poor rating.

          Cheers Leith

          • Leith & Patricia

            Houston has a mix of zoning and no zoning with much of the latter deed restricted.

            It is nothing like the “free for al” many percieve it to be in this part of the world.

            Indeed the environmental and building codes are strict – and the quality of the built stock is far superior to our own,

            The most important thingg about Texas and much of the rest of North America is that they do not restrict land supply on the fringes (the Unincorporated Areas as they refer to them).

            Hugh Pavletich

        • I think its something about the anglo-saxon mentality that we want to stick our noses into other people’s business/
          We want to do whatever we want with our piece of land but mysteriously our neighbour can’t. I’ve seen and heard it many times where Joe Bloggs wants to cut down a tree on his own property, or build a new house, but lo and behold if the neighbour was to consider doing that!!!
          It’s very bizarre.
          We should have basic planning controls around heihg and access to daylight, but beyond that there should be minimal controls like they have in Japan and Germany.

  4. Leith – congratulations on a superb article, where you set out clearly and convincingly that scarcity or percieved scarcity is the housing bubble trigger and finance (equity, bubble equity, mortgage debt) is simply the fuel.

    One of the remarkable things is just how long it is taking the “market experts” economists to get this.

    In sorting out the housing bubble messes of Australia and New Zealand, Texas is where our learning focus should be. It does three major things right – open land markets, bond financing Municipal Utility District for infrastructure and sensible Mortgage Consumer Protection laws.

    Put simply – as I wrote in The Age and SMH 31 January “Report: Housing prices out of sync with incomes”, the Demographia Housing Surveys clearly illustrate that housing should not exceed 3 times household incomes and new housing stock should be going in on the fringes at 2.5 times the median household income of specific markets with Development Ratios of 20 / 80 seviced lot / house construction.

    Real basic stuff.

    Maintaining normal affordable housing markets is just so basic and indeed formulaic, the only real question is why professionals are so slow at understanding it. I covered some of these reasons within an article “Housing Bubbles & Market Sense”. It is clear to me that much of the training within the economics, valuation and planning professions is rubbish. So bad in fact, they are taught how NOT to understand markets.

    Another useful check measure is that housing should not exceed 1.5 times Gross Domestic / State / Metropolitan Product.

    One of the remarkable things about Texas is that when the S&L fiasco was at its peak in the mid 1980’s 111.000 residential consents were issued in one year in Dallas, with a population then of 3 million – a consent rate of a straospheric 37 / 1000 population – and it didnt bubble. If Australia was consenting at this rate, 832,000 would be issued! Ireland reached a peak of 20 / 1000 and Spain 15 / 1000 in prescriptive markets.

    The clear message here is that construction markets do have the capacity to kick in with “market stock” when required. And there is a world of difference between market stock and bubble stock, a topic I covered 31 January within an interest co nz aerticle “Respecting the housing median multiple”.

    So there is about $A2 trillion to wipe out of the Australian housing market – a whisker undert $NZ300 billion in New Zealand.

    Last point – whatever happened to the Urban Competitiveness Report COAG instructed the Productivity Commission to get on to early last year – due for completion late last year? Is this hugely important issue still on or off the COAG agenda. If the latter – why?

    Hugh Pavletich FDIA
    Co author – Annual Demographia International Housing Affordability Survey
    New Zealand

  5. Leith Van Onselen is one of a minority in the economics profession, who can actually see real world evidence clearly. Hugh Pavletich, lifetime property developer, who claims to have had very little education, puts almost an entire profession to shame in his analyses.

    I now have no idea what use getting a degree in economics is. The notorious business man Sir Robert Jones said years ago that he only hired Arts Degree holders, because he could make a lot more use of them.

    Simple internet research now provides anyone with any brains at all, with knowledge that econ degree holders seem to be incapable of getting. I can see Sir Robert Jones’s point about the Arts degree guys – at least their minds will still be curious about the real world and how it ticks.

  6. Interesting, but there is not enough data to support the conclusion that land-use policies accounted for the bulk of volatility, and there are some glaring contradictions in the theory. Florida, Arizona and Nevada never met a parcel of land that couldn’t be developed. All of these states have plenty of build-able land and still experienced the brunt of the boom-bust. The causes are multi-variate in nature and can not be traced to a single land-use policy. Variables with higher R values include cities with rapidly expanding economies (yes, even the housing boom itself fed back and reinforced this variable), desirable living conditions (the sand states), economic decline in emigrating states (mostly in the north), high density metropolitan areas (again, mostly in the north), and old fashioned speculation are collectively better indicators of housing volatility.

    • Toby. You might want to check out the Brookings Institution report on land-use planning. You will find that Arizona, Florida and Nevada did in fact have restrictive land-use policies in effect that prevented low cost housing from being built quickly and efficiently on the urban fringe, thereby preventing a supply response that would have mitigated price rises.

      Also check out this article on Las Vegas and this article on Phoenix for more info on their restrictive land-use policies.

  7. It is interesting just how many different interferences to free markets, produce this land rationing effect. Governments that own surrounding land are an obvious one; I understand that is a lot of the problem in Aussie cities.

    In some cities in the USA, there is no “Urban Growth Boundary” as such, but there ARE boundaries between municipalities, and a city which may well have “liberal” land use laws may have grown to butt up against these boundaries – and the adjacent municipality does NOT allow development. Green advocates of restrictive planning, I have found by experience, will try every semantic trick in the book to obfuscate your argument.

    The crucial give-away, that should be foremost in all analyses, is what Paul Cheshire and his colleagues at the LSE, call “Serious Price Discontinuities” (per hectare, in the price of raw land) across boundaries. In the case of Las Vegas and Phoenix, these serious price discontinuities are very definitely there. No genuine free market in land, will have raw land price discontinuities.

    Robert Shiller, in “Unlearned Lessons From the Housing bubble”, points out that farmland everywhere in the world, is a similar low price per hectare, and there is hundreds of times as much of it as there is developed urban land. Therefore, typical farmland prices SHOULD roughly determine the price of raw fringe land.