Do We Still Need The GSEs? – Part I

Between 1996 and 2006, the Federal Reserve's housing price index rose by 90% based on quarterly data, but then it fell by 12% between the first quarter of 2007 and the last quarter of 2010. While many believe that the main cause of the housing boom was easy access to credit in the form of subsidized interest rates, which changed the nature of the marginal home buyer, others focus on different problems.

The two government-sponsored entities (GSEs), Fannie Mae and Freddie Mac, were established with the primary goal of developing a secondary mortgage market to increase homeownership among low-income groups and in underserved areas. However, they became involved in profiteering and mortgage-backed securities, which left them far behind their primary goals.
Mortgages effectively became a tool for speculation and bonus profiteering throughout financial institutions. According to research published by the Center for Community Capital at the University of North Carolina at Chapel Hill, over 2.3 million homeowners faced foreclosure in 2008, an 81% increase from 2007. The re-default rate for single-family loans (the percentage of modified loans that are seriously delinquent or that completed the foreclosure alternative of subprime loans) reached the unprecedented level of 50% in 2008. This figure dropped to 38% in 2009, and then to around 8% in 2010.

The high delinquency rate of subprime mortgages led to substantial losses for the holders of securities. The problems in the subprime mortgage market led the investors to re-assess the credit risk, thoroughly undermining the credibility of financial markets. The link between financial market and real estate market motivated many economists to look for conceptual or empirical reasons to explain how changes in financial market conditions could cause the boom-bust behavior of the housing market.

Thus, we need to ask: What were the effects of the GSE interventions in the housing markets through subsidized interest rates and reduced down payment requirements on median single-family home prices at the national level?

Contrary to the standard asset market approach, down payments may operate through two opposite transmission channels. The first channel affects the affordability of a typical home buyer, while the second affects the supply of mortgage loans and may have positive effects on the demand side.
Let's review the determinants of home prices, as well as the effects of GSE liquidation on housing prices. Many scholars have found that home prices are affected by the real after-tax interest rate; permanent income; mortgage credit; the vacancy rate; the distribution of income; the unemployment rate; the price-to-income ratio; annual growth in home prices; financial deepening; and demographic factors such as percentage of the population age 65 or older and changes in household size.

Regardless of the methodology used, many studies have found a negative correlation between home prices and interest rates. In addition, some have concluded that interest rates cannot explain a large part of home price movements, and a few have found that down payment changes are unlikely to have a major impact on home prices.

A reduced form equation for the real home prices can be obtained from the models of aggregate supply and demand for real estate markets. The liquidation of Fannie Mae and Freddie Mac is expected to affect home prices through two main channels – mortgage interest rate and down payment requirement – because the GSEs have been involved in practices that mainly affect these two variables. Indeed, in 1996, Fannie Mae and Freddie Mac eased the requirements for down payments and started to subsidize mortgage interest rates for purchasing a house.

First, a higher down payment reduces the affordability to the buyer if the buyer is budget constrained and thus reduces the demand for real estate. Therefore, a negative effect on home prices is expected.
Second, a higher down payment provides more resources to financial institutions, which positively affects the amount of available mortgage loans to potential home buyers. Assuming that these resources will be available to new home buyers, it stimulates the demand side and leads to higher home prices.

Thus, there are two different channels operating in opposite directions. The first channel is an income effect, and the second is a substitution effect. The final impact on home prices depends on which channel dominates.

An important stylized fact – a simplified presentation of an empirical finding – in the U.S. housing market is that down payments have been relatively stable over time, but home prices have been volatile, increasing until the third quarter of 2006 and then dropping off sharply. The data suggest that down payments have not played an important role in shaping peaks and troughs in the housing market because they have been relatively stable, varying between 20% to 28% at the national level, whereas the median home price has been relatively volatile over time, underlining that there is no significant relationship between the two.

But if home prices are inelastic to down payments, this implies that GSE interventions in the market to ease the access to loans among home buyers have not significantly affected home prices. Therefore, liquidating the GSEs may affect home prices only marginally or not at all. This corollary has important policy implications because it can pave the way for a housing market without GSEs.

Another stylized fact is that the conventional 30-year mortgage interest rate and effective interest rate have moved together very closely since 2003, suggesting that most loans are dominated by the conventional 30-year mortgage interest rate rather than by market interest rates. Indeed, the intervention of the giant monopolies has been so intense that most loans have a subsidized interest rate.

Finally, changes in home prices and the S&P Index have been moving closely together, although the S&P Index has higher volatility, especially during the sharp drops in 1987 and 2008. People look at real estate as an alternative to investing in the stock market, suggesting a negative correlation between the S&P Index and home prices. The two may be positively correlated because household assets inflate when the stock market index soars. This, in turn, induces demand for real estate and leads to higher home prices.

The coefficient on the dummy variable for measuring GSE intervention in the housing market suggests that the interventions have led to higher prices by increasing demand through easy access to mortgage credit, which may have adversely affected poor- and low-income groups. Therefore, if the federal government plans to improve the housing market in underserved areas, it should consider other policy instruments rather than subsidizing mortgage interest rates or easing down payment requirements, which have failed to achieve its housing market goals.

The federal government's policy of subsidizing mortgage interest rates and lowering down payments to raise homeownership has failed due to inelasticity of home prices to these variables. In essence, the government intervention has led to a large deadweight loss for society rather than helping low-income individuals to secure homeownership through lower prices.

Although lower interest rates through a macroeconomic stimulus package may benefit borrowers who refinance existing mortgages at lower interest rates for a while, market imperfections and asymmetric information may prevent this from having a long-term benefit.

This should have important implications for policymakers. The federal government should avoid offering any subsidy in the form of lower interest rates or lower down payments because it adversely affects both the housing market and the economy over the long term. Although such a policy may boost the demand side in the short term, it risks inflating another housing bubble in the medium or long term.

Therefore, it would seem that the appropriate action is to re-establish market forces by phasing out the GSEs. Although GSE supporters may argue that diluting these two corporations would lead to higher interest rates for borrowers, econometric results indicate that higher interest rates will lead to lower median home prices, which in turn will increase the ability of low-income groups to purchase a house.

Moreover, elimination of the GSEs will enhance competition among financial institutions, leading to lower interest rates in the medium to long term. Curtailing the monopolies in the housing market will certainly contribute to achieving housing market goals and reducing the large amounts of deadweight loss.

(Next week, part two of this series will examine the GSEs' impact on homeownership rates.)

Nahid Anaraki is a visiting fellow for special projects in the Center for Data Analysis at The Heritage Foundation in Washington, D.C. She can be reached at (202) 546-4400. This article is adapted and edited from research published earlier this year by the Heritage Foundation.


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