Thursday, August 18, 2011

Incentives Matter .... Housing and Government

White Picket Fence? Not So Fast argues for cutting back the various incentives offered by government to individuals to encourage home ownership. The cost in tax revenues foregone is estimated to be $100 billion annually, and government needs the money, so the reasoning goes.

Things such as mortgage interest deductions, property tax deductions, gains on sales and government subsidies for loans make up the $100 billion.

Here's an entirely different take on the matter. As a government, are we helping or hurting people by incentivizing them to borrow money to buy on speculation things that they perhaps can't afford?

While it's true, as the article notes, that government incentives do in fact encourage home buying, the question is, in my opinion, are these "perverse incentives" or do they represent good policy? Perverse incentives are the inadvertent incentives which can be created when we set out to do something completely different. These inadvertent results are also known as the "law of unintended consequences".

My view is that government subsidies to encourage home ownership have been by far the biggest contributor to our current economic mess. Non-government debt is at all time highs because of real estate related loans which were made widely available by lenders due to government incentives. In fact, we added insult to injury when we offered home buyer rebates during the recession to get more people to buy. All that did was make things worse.

In part, here's what the article says, "Until recently, support for home ownership was untouchable because the programs were popular with voters and because of unrelenting lobbying efforts. The political right sold them as part of its "ownership society," whereas the left used them to fight rising income inequality. But the policies have turned into a major disappointment for both sides."

Later it hits the nail on the head again, ".... a comparison of home ownership among economically advanced countries shows that the United States is in the middle of the pack, which suggests that subsidizing housing with tax breaks is neither a necessary nor a sufficient condition for a flourishing housing market. Rather, these subsidies enabled people to borrow more than they could afford so they could buy houses bigger than they needed, leading to a house price bubble. The policies encouraged homeowners to make highly leveraged bets on real estate that turned sour and wiped out nearly $8 trillion in household net worth."

Losing $8 trillion is both a whole lot of money and an unintended consequence, for sure. But since voters liked the incentives, real estate special interests lobbied for them and both political parties thought they were great ideas as well, what more could we ask for $8 trillion?

Well, in the future we could ask of our fellow citizens some Emersonian Self Reliance and a basic knowledge of personal finance.

Homes are places to live. They are also speculative as investments and not one way bets to a sure thing, no matter what anybody says.

As with all speculation, when prices are going up and we've used leverage or borrowed lots of money to fund the speculative purchase, we will make money when we sell. But that's only if we sell before the fever breaks.

Asset inflation induced by an abundance of readily available cheap credit pushes up demand and therefore prices. Until it doesn't. These non-government debt induced asset inflation cycles always end badly, just as happened this time.

Let's look a little closer at what can happen when we're buying houses with lots of borrowed money. We'll assume that we make the home purchase "investment" for $150,000 by borrowing all or most of that sum. We borrow the money at 5% or interest charges of $7,500 annually. If prices go up, we win. But what happens when prices go down?

Normally home prices don't exceed three times a person's annual income (Linkage in Income, Home Prices Shifts). Thus, we are deemed to be able to "afford" a home costing $150,000 if we make $50,000 annually. And during the recent period, we could buy a house that cost five times income. Hence, we could have bought the $150,000 home above with an income somewhere between $30,000 and $50,000. Now we owe $150,000 and must pay $7,500 in interest charges annually as well, not considering the other costs of home ownership such as insurance, property taxes and such.

Home prices have declined by one third the past few years, and brokerage commissions will cost another ~6% or so. Our totally leveraged $150,000 buy-at-the-top "investment" is illiquid, meaning we can't decide to sell it today and receive the money therefor anytime soon.

To sell we first have to find a willing buyer, and it's now very much a buyer's market. Lots of supply but not much demand. We have an asset worth perhaps $94,000 net, but we owe $150,000. And the economy stinks.

Here's the point. Had we not bought the home with $150,000 of borrowed money, we wouldn't owe the $150,000 and also have on our hands an illiquid investment worth perhaps less than $94,000. And we wouldn't have to pay $7,500 in interest annually. For those counting, that 5% rate of interest is now more like ~8% based on the current net asset value of the home.

If in addition we are earning $40,000 annually and setting aside 10% of that for rainy day needs, retirement funding and such, that's the equivalent of our next 14 years in savings going just to make up for the loss of the value of the home we bought. In other words, we unwittingly bet the farm with borrowed money for a very illiquid purchase. And that asset isn't worth much, having declined in market value.

Forgetting about any added dollars in home equity loans that we may also have added to our financial burden, we own something that is worth nowhere near what we paid for it. And we borrowed the money to buy it.

Here are the two questions du jour: (1) Did the government do us any favors? (2) Did we do ourselves any favors?

Will we acknowledge, as Pogo would argue, that we did this to ourselves by following the herd? Or will we search for someone else to blame, such as the evil bankers, who were also encouraged by the government to make the loan in the first place? Or will we blame the politicians for creating these popular but financially lethal "perverse incentives" to enable us to become happy homeowners, even though now we're not happy at all?

Thanks. Bob.

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