My Market-Based Solution to the Housing Market Mess
Posted by Frugal on February 28th, 2008
I think few people realize that America/the world is facing the biggest financial storm ever, and how dangerous it is for investing in stocks before a full implosion. The housing-induced credit crisis has gone far beyond anyone can potentially control, probably not even the Fed.
Reading over so many current/future proposals from politicians and bloggers, I have my own thoughts in this. For sure, there simply isn’t a solution without pain. But there can certainly be solutions that are more fair and less pain.
One of the most fair and easiest way to help propping up the housing market is to subsidize all the buying or holding cost for primary residences. Instead of helping on the sell-side directly, the government can help the buy-side. Of course, the subsidy will indirectly go into sellers. But the solution is market-based.
Why is this a fair solution? For sellers, there is simply no direct bailout. For anyone who chooses to buy, the buying decision is done on the open market where everyone else is competing on the same ground with subsidy, and existing real estate investors will also be helped with a more stable housing price. For any renters who choose not to buy and take up the subsidy, their decision is solely of their own based upon their evaluation of the current housing market and personal circumstances.
What kind of subsidy will make sense? The easiest way is certainly done through mortgage interest reduction or tax deduction. The tax deduction cannot be limited by the amount of adjusted gross income, and has to be actually beneficial on top of the existing standard deductions. By reducing the overall housing cost, government will encourage more of it, and prop up the housing market.
Since 65% to 70% of the Americans are home owners, most of this housing aid will effectively become a tax cut for middle class. I suggest that 50% of the total amount of both property tax and mortgage interest from primary residence can be used as a tax credit (rather than tax deduction in the itemized section). Here are some examples of the housing aid scenarios, with loan interest at 6%:
1. $700K home in California with 20% down for someone with tax bracket at 28%:
Because loan amount is $560K, the interest is $42K a year, and the additional tax subsidy amount will be roughly (50% - 28%) * $42K / 12 months = $616 a month. This monthly subsidy will effectively lower the interest rate from 6% ($3357) to 4.25% ($2755). That will be a tremendous stimulus.
2. $500K home with 20% down for someone with tax bracket at 15%:
The additional tax subsidy amount will be roughly (50% - 15%) * $500K * (1-20%) * 6.00% / 12 months = $700 a month. This monthly subsidy will effectively lower the interest rate from 6% ($1852 payment) to 3% ($1686 payment). This is an even better deal for lower income people.
Effectively speaking, this tax cut will target middle-class home owners specifically. Using the assumption of a median home value of $240K, and an average tax bracket of 15%, this tax aid comes to be about $4032 dollar per family household, 110 million US households, with 70% home owners, it will be about $300 billion annually. I’m not going to re-do my numbers here, but probably instead of 50%, one could go for 40% of the interests as tax credit. This will adjust this bill from $300 billion to about $214 billion. I hesitate to go to much lower, simply because in California, where most of the housing problems are, you have to be at 25% to 28% tax bracket to afford the homes. Since one is already getting existing tax benefits at 25% to 28% through itemized deduction, the 40% as tax credit will only give 15% to 12% additional benefit.
Bottomline, this printing of tax money will be truly the best way of distributing the helicopter money, since it goes to the homeowners directly without discrimination, AND it is also tax-progressive. The rich who has a bigger loan do get a lot more, but only because they are paying a lot more for their home. But the middle class will not be left out at all, and will enjoy the biggest piece of the tax reduction. This will effectively encourage home purchase/consumption, and props up housing market. The solution is also market-based without ANY bailouts to those people who abuse the mortgage markets.
In respect to Republican tax position, this is a market-based solution. In respect to Democrat tax position, this is a tax aid for most of their incumbents. In respect to stock markets and US economy from Keynesian economics, this is a huge positive. Tax cuts stimulate economy. On the other hand, money from direct taxpayer bailouts go into the pockets of these fraudulent bankers and homeowners, and continue to encourage moral hazards and speculation.
Frugal at 1stMillionAt33.com
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February 29th, 2008 at 10:59 am
I think there’s already a too much of subsidy on home ownership in the current mortgage interest deduction. I don’t think the government should sacrifice immediate gratification for long term troubles. While it’s probably imprudent to eliminate the current deduction, i certainly don’t think we should be adding to it.
February 29th, 2008 at 1:14 pm
I have a better idea. How about anyone who is renting a house right now from a landlord that foreclosed is allowed to buy that house for the price they rent for. The government pays the rest.
The problem isn’t going to be the spanish family up the street that overpaid, got a crappy rate, and foreclosed. It’s going to be when a failed flipper mails 15 sets of keys to the bank. THAT will devastate a neighborhood. The 40% of demand between 2003 and 2006 that was investors and speculators is what we need to worry about. Obviously these people have greater resources than our poor subprime friends, but like everyone else they will eventually cave. The jig is up.
March 1st, 2008 at 1:36 am
Frugal,
I want to give you credit for taking a stab at a solution. I disagree with you completely, but I respect the effort.
I read your posts every day, because I find them interesting and well thought out. This post is interesting, but it is not well thought out. The only thing on which we agree is the fact that this financial crisis will be the biggest we have seen in a very long time. But that is where it ends.
Your proposal is NOT a market solution. It’s a government-sponsored market manipulation.
I am also confused - you suggest that this is a subsidy to the buyers, but then your math suggests that this applies to anyone who owns a home. Does it apply to existing homeowners as well? Your later math suggests that it does.
How long will this subsidy be available? Do you really think you can get rid of it once you put it into place? Once you get rid of it, what will happen to housing prices? If I don’t have credit or capital, how can I take advantage of the subsidy? Why should renters, who will have to bear the cost of the subsidy with their income taxes, subsidize homeowners?
It seems to me that if the objective is to support home prices, the emphasis has to be on preventing forced selling. This is why the admittedly irritating proposals have all focused on preventing foreclosure. A solution that just entices buyer to saddle up one more time doesn’t really fix the problem. It just delays the inevitable. The fact is, we have more residences than we need in America, particularly in boom locations. No one wants that condo in FL. That was always the problem.
The best option open to the government for preventing massive forced selling is still monetary devaluation. This can be done as a one-time effect. For those with fixed rate mortgages, the inflation will lead to higher nominal wages and a fall in real housing costs. It will also allow for an increase in rents so that the “investors” can make payments. Of course, it will make mortgages expensive, so selling will still be a drag later, but it will minimize the forced selling en masse now.
Still, this won’t really solve the problem. Prices have to adjust to reflect the intrinsic value of the assets. Trying to prop up the economy with various “stimulus” is what caused the bubble in the first place.
March 1st, 2008 at 5:48 am
Sorry, I had to disagree with someone on their own blog, but with respect I agree with Doug. What we’re seeing now *is* the market solution. The market is reminding everyone that “you can go wrong with housing”, just like a stock market crash reminds people that they can go wrong with stocks, and so on.
I understand your thinking, and agree that there are going to be painful consequences, but in my view their have to be. The sooner the world deflates some of the asset inflation that has bubbled through it in the past few years, the sooner we’ll see consumers doing more useful things with their money than spending it on housing. And, more importantly, we’ll see more efficient use of capital other than putting it into flipping condos etc.
Anyway, just my 2 cents, no offence meant.
March 2nd, 2008 at 5:16 am
Dumb idea. any type of bailout is a stupid idea. The entire market needs to burn to the ground. Then and only then can a long term solution rise from the ashes, like say, eliminating the Fed, no fiat currencies, real capital formation, savings, investment and US based production.
That can only happen if they entire global financial system burns to the ground, and the leaders of it burn up with it.
March 2nd, 2008 at 9:44 am
If anyone thinks that they can still keep their job or operate their business normally in an economic depression, and they have zero savings and investment to be affected, then probably a bailout is not necessary.
Again, my opinion is that we are basically facing an abyss. The collateral economic damage can easily be wide-spread and affect everyone of us in terms of holding my or your own job.
March 3rd, 2008 at 1:04 am
Frugal,
you are right - this crisis is going to be devastating, particularly if you live and/or are invested in CA, NV, FL and other boomlet locations. I suspect that metro NYC will also have some rough times aheaad, given the high leverage of the economy there to the health of the financial svcs industry.
You are also right that a major recession/depression will have consequences much broader than just punishing errant speculators. A bailout of some kind to prevent a collapse of the financial industry is quite possibly necessary in an effort to prevent more serious economic shocks.
I share your desire to prevent sellers (often speculators or outright frauds) from getting a bailout at the expense of everyone else.
Moreover, your position is original.
What you are arguing is that rather than reduce supply (foreclosed homes) it is easier and more practical to incite demand (through a purchase subsidy). Fair enough. Your proposal would indeed change the fundamental value of owned real estate (by reducing carrying costs of the asset) - but it would only do so if the subsidy were permanent. It would likely be so. Even if it were originally proposed as temporary in order to get through the slump, politically, it’s hard to see how anyone could oppose extension - it’s like the home mortgage deduction, people can’t live without it and sellers want the higher prices buyers can offer because of it.
Plus, if it were temporary, it might not be that helpful. Buyers would know that in 5-7 years (when they might want to be selling) the subsidy will no longer be available and they still might be facing negative equity.
Finally, it doesn’t guarantee demand for the current excess stock. It might be that homebuilders use this opportunity to build additional stock.
I grant you that focusing on the sell side, as was done in the 1980s with the formation of the RTC, also has its weaknesses. It’s very expensive and tends to cause problems for years (the RTC spent seven years unloading speculative real estate and depressed prices until 1995). Treasury will be attempting to manipulate the market sufficiently to create a market where home prices will remain stable, and home construction will fall short of household formation, so that it can sell its own stock can be absorbed. This is really tough to do. But, at least it is self-liquidating.
As I said in my earlier comment - I commend you for taking a shot at a solution. Your approach is definately different than the other proposals.
March 3rd, 2008 at 5:29 pm
This is certainly better than other ideas I have read, but I don’t think we should increase the benefits of home ownership. One reason housing is becoming unaffordable is because the government has provided these types of benefits. The reason the housing situation is so bad is because the market is distressed. The only way to fix it is to let the markets correct. Any band aid will only mask the problem.
March 10th, 2008 at 1:00 pm
I don’t approve of any government sponsored bail-out. If so, the government should bail-out everyone, from banks to stock market speculators.(yes, buying a house you cannot afford with a neg-am loan & counting on appreciation to make up the difference is speculation).
Also, people who buy 700k houses should be in a higher tax bracket. If they’re in the 28% bracket, I don’t think they’re making enough money to qualify for the house in the first place. (which is why I guess they need bailing out!)
March 18th, 2008 at 1:46 pm
I agree with you Frugal, there will be a bail out. I don’t think that it is right, but there will be one.
April 6th, 2008 at 3:26 pm
Most middle class mortgage holders don’t get the full advantage of the mortgage interest deduction because of the increases in the standard deduction that have occured over the years.
I suggest that a class of mortgages be introduced where the interest is not deductible by the mortgage holder and the interest income to the investor is tax free.
This would lower the necessary rate to attract capital to about 70% of “market”, similar to the interest rate advantages that tax free municipal bonds enjoy.
John