Monday, September 12, 2016

Housing: Part 178 - The Front Loading of American Housing Expenses

In the book, I may play around with an idea regarding mortgage amortization that would lead to mortgage payments that are somewhat variable in nominal terms but less variable in real terms over the life of the mortgage.  Partly what led me to think about this is considering the number of ways we impose financial insecurity on American households.

Owning a home has many natural and arbitrary advantages.  The main natural advantage is control.  This is paired with the disadvantage of non-diversified large asset that correlates to other personal financial risks.  But, it appears to me that the control premium is worth more than the non-diversification cost for most households.

The main arbitrary advantages are the tax advantages of tax-free imputed rent, the mortgage tax deduction, and deferred or exempted capital gains.

All of these arbitrary advantages front-load the costs of ownership, because they raise the value and price of a home, but that value is due to cash flows that come slowly or in the future.

This is exacerbated by the treatment of mortgages as nominal securities.  So, as the home gains in value each year, the real value of the mortgage payments declines over time.  This is true whether it is a floating rate or a fixed rate loan.  The real value of the mortgage payment in year one will be higher than the real value of the mortgage payment on the same mortgage in year 15.

Some of the cash-out refinancing that is common in mortgage markets is necessary to simply slow down the decay of the real value of the mortgage payment.

So, the advantages of home ownership, made more acute by tax policy, induce households into becoming homeowners earlier.  This means they will rationally try to become homeowners when they are younger, their incomes are slightly lower, and they have saved up for a smaller down payment.  Frictions in the housing market induce them to buy a larger home that will reflect their future consumption preferences - again when they will expect to have higher incomes, etc.  All of this leads to a natural and predictable tendency to purchase a house that is somewhat financially destabilizing at the point in time when the household is purchasing it.

On top of this, there is the nominal mortgage, so that the mortgage payment for that home is higher in the early years than it will be in the later years.  So, households are induced, rationally, to utilize forms of debt or other methods for funding the mortgage in the early years.

Most people, who are under the odd illusion that access to credit causes households to irrationally bid up home prices to values unmoored from their present cash values, might see this as an advantage.  Front loading costs would prevent the lemmings they think populate the American home buying market from buying even larger homes, because it forces them to be credit constrained.

Considering that many neighborhoods aren't particularly credit constrained, and yet prices in those neighborhoods don't rise uncontrollably until the marginal household there becomes credit constrained, this notion that we have to constrain credit seems to me to be bizarre.  This bizarre belief is the core ideal of our current credit policy.  Don't let the rubes get their hands on any borrowed funds.  They can't handle it.  For once there are plenty of one-handed economic policymakers in Washington, because their second hands are all employed patting each other on the back for shutting down that dangerous mortgage market that somehow funded homes for 40 years before inevitably collapsing.  In the midst of a "bubble", only a masochist would suggest that prudent lending would be more lenient lending.  Then, when unnecessarily tight lending led to a bust, it became even more reputationally risky to suggest more lenient lending.

There is probably an axiom here.  Most unspeakable policy proposals are self-evidently bad.  But, especially in a crisis, the policy that is most needed is inevitably also an unspeakable policy.  That is why it is a crisis.  The problem is picking the right unspeakable policy - pulling the yoke from the scramble (tm).

This is one of many areas in housing policy that are theory by attribution error.  We presume that households are prone to excess, so we impose financial instability on them as the cure.  And, when this produces a bunch of young, highly leveraged, over-committed new homeowners - it proves that we were right about them all along.

I wish we could take this another direction.  Obviously, get rid of all the tax benefits.  But, also, if mortgages amortized in a way that was more like a real (inflation adjusted) security, then the cash outflows of homeowners would be less front-loaded.  I reject theory by attribution error, and I believe that these adjustments would lead households to be much less financially strained when they first buy their homes.

We take for granted that households deleverage after a financial crisis.  That's what they would do if they, in the aggregate, were generally risk-averse.  Reasonable households match empirical evidence, unlike the lemming households of our fever dreams.  It seems like the "bubble" was empirical evidence of lemming households, but much of my current project has been a process of discovering that this belief comes largely from errant premises determining a false conclusion.

California - the epicenter of the housing bubble - makes these front-loaded factors even worse.  Rent control even causes these to apply to renters.  If your rent inflation will be limited, you will pay more for the initial rent, because that buys you access to future economic rents - the political ability to pay future below-market housing rents.

Proposition 13 - the infamous property tax policy that is in place there, also makes housing costs more front-loaded, because embedded in the purchase of a home is the right to below-market property taxes in the future.  And, as rent inflation increases the price of homes, there is a positive feedback effect that makes the future property tax benefits even larger.

In housing, it appears that homo economicus is alive and well.  Everyone seems to agree that tax benefits lead to higher housing consumption.  Clearly California's back-loaded tax benefits lead to higher prices.  Oddly, it is widely acceptable to imply this ultra-rational condition when complaining about how tax benefits cause homo economicus to overinvest in over-priced housing.  Or, to blame deleveraging for a timid recovery.  But, to imply the same condition to defend market efficiency is free market fundamentalism.  Who wants to be one of those na├»ve people?

So, we keep front-loading costs, creating large incongruities in life-cycle cash flows, and blaming bankers, speculators, and middle class households for the truly inevitable instability that our policies create.

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