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Foreclosing the Crisis

The Household: Informal Order around the Hearth
By Robert C. Ellickson
(Princeton University Press, 272 pp., $24.95)

An economic maelstrom has struck the world. The Dow Jones Industrial Average dropped by 35 percent between last New Year's Eve and the start of this year's somewhat bleaker holiday season, making this the worst year for stocks since 1931. The crisis has already been responsible for massive political change, carrying in not only a new president but also a new appetite for large-scale government action. Who would have thought, a year ago, that America would be seriously considering a semi-nationalization of the automobile industry?

This crisis, which has buffeted every bourse and rocked every government, had humble origins. It began with ordinary homes in Las Vegas and Miami and Cleveland. The arcane magic of mortgagebacked securities meant that few observers realized just how sensitive the entire world had become to fluctuations in the American housing market, but that is exactly what happened. The troubles began, as is well known, in the subprime market, where a bout of extreme optimism led investors to think that the dross of no-down-payment loans to high-risk borrowers could be transformed into the gold of triple-A securities.

As mortgages began to default, the owners of mortgage-backed securities became de facto homeowners, acutely sensitive to the price of housing. Rising defaults, not coincidentally, were accompanied by falling prices. Between January 2000 and July 2006, the Case-Shiller home price index rose by 126 percent, the biggest nationwide boom in the history of housing. Between July 2006 and September 2008, housing prices dropped by 23 percent. Falling prices encouraged more defaults, since many homeowners owed far more than their homes were worth. Lenders' liens became worth less and less.

Waves of policy proposals followed the path of financial disaster. First, there was a hue and cry to reduce the suffering inherent in millions of foreclosures. Then the banking crisis, created by the collapse in the mortgage market, led to billions of dollars of "emergency injections" to shore up the banking system. Now, the next administration is discussing a trillion-dollar fiscal stimulus to limit the damage of a full-fledged recession.

If housing policies are to be wiser in the future than they have been in the past--and they had better be--then they must be based on a better understanding of housing and housing markets. Robert Ellickson's new book is a good place to start. In 1975, Ellickson wrote a seminal analysis of zoning law that described the beginning of a great change in American property rights. In the 1960s, he showed, the ability to build in much of America was relatively unlimited; but over the last forty years, increasingly stringent land-use controls have enabled neighbors to veto more and more projects, which has reduced construction and increased prices in America's most desirable areas. In 1991, he wrote the classic Order without Law, which jump-started a legal literature on extra-legal arrangements that settle disputes and establish rights. Now The Household brings together his long-standing interest in housing with his interest in informal contracts.

Ellickson wrote his book before the current crisis. He pays more attention to Fourier and kibbutzim than he does to mortgage lenders. His core argument is that households are delicately derived institutions that manage to work well with only a modest dependence on formal law. Intimacy and blood ties help households function; or to put it slightly differently, "attorneys who contribute to the legalization of home relations typically not only waste the fees that their clients pay them, but also debase the quality of life around the home." The legal arrangements that matter most, such as homeownership, are finely crafted to "reduce the transaction costs of coordinating domestic life."

Ellickson's book represents a skillful use of the analytical tools of the law-and-economics movement to understand relations within the household--a complicated machine for living that involves a large number of joint decisions. When decisions about a home are made by people who do not particularly care for one another, costly conflict can easily ensue. Anyone who has had an unfortunate flat-mate should understand the coordination problems inherent in joint control over space. Landlords and tenants often fight over maintenance. Co-op board members frequently debate which social qualifications for a residence are most crucial. Mortgage lenders lose out if homeowners treat their houses poorly.

The current foreclosure crisis is an extreme example of an Ellicksonian fight over household space. Delinquent homeowners want to inhabit and to control their homes. Lenders want to get them out and to limit the damage done to the property. During the foreclosure process, home occupants have no reason to invest in their homes. Indeed, spite sometimes pushes them to abuse the property. Ellickson's logic suggests that such periods ensure an abuse of the housing stock, which is one reason why homes often lose close to half of their value when they go through foreclosure.

One current policy response to the housing debacle is to create lengthy foreclosure moratoria. Ellickson's analysis suggests that this is just about the worst of all possible policy responses. By drawing out the foreclosure process, these moratoria increase the time during which homes are no-man's-land. During such periods, homes and neighborhoods depreciate. A better policy would move the home quickly, either back into the hands of the owner with a new, more realistic mortgage, or into the hands of a new owner that can afford the house.

Why can't lenders and borrowers quickly come to arguments that would reduce the costs of foreclosure? Ellickson strongly emphasizes the problems inherent with the diffuse ownership of homes. The same logic applies to diffuse ownership of mortgages. The securitization process spreads property rights across hundreds of investors separated by oceans and continents. Mortgages are being handled by servicers, not by conventional banks, many of whom have little expertise at wisely handling delinquent loans. The servicers are scared of being sued by the security owners that they represent. For this reason, they follow rules of thumb that lead to evictions that could have been avoided.

In an ideal world, the foreclosure crisis would be resolved by local banks that would buy up bad mortgages, and then use their skills to get the most value out of delinquent mortgages. Certainly, many mortgage-backed securities are now so cheap that it is hard to believe that there aren't such profit opportunities. But this process has not happened, and it is hard to imagine how it could. Like Humpty Dumpty, the mortgages are in too many pieces to be put back together again.

The best that can be done, I think, is to create an as-if situation that gets servicers to act like local banks. Ideally, a set of sensible rules could lead to renegotiating the mortgages of people who can pay for their homes and speedy evictions of people who bought more than they can afford. If the government sets a series of rules that give servicers safe harbor from lawsuits, then the whole process can be made more efficient. For example, the rules might specify a simple test that determines whether the current occupant can plausibly support the home. If thirty percent or less of the current owner's income can pay for reasonable mortgage payments, marked down to the level implied by current housing prices and interest rates, then the owner can afford the house. If the owner can afford the house under those terms, then the loan should be renegotiated, since that is pretty much all that the house could generate in the best of circumstances. If the owner cannot afford the house, even at today's lower prices and interest rates, then the owner should be quickly moved out.

Such an arrangement would be fair all around. If lenders agreed to cut interest rates to current levels, and reduce principal in proportion to the level of housing price declines, then they should be rewarded with a share of the upside. Fully one-half of any future price appreciation, for example, could be shared between the lender and the owner. Ellickson would presumably warn us that this arrangement would reduce owners' incentives to care for their home. To address this problem, the lenders' share of appreciation could be based on the average price increase in the zip code, rather than the actual price of the home.

To reduce the human suffering of speedy evictions, the government could give people who lose their homes a lump sum payment, perhaps $5,000, a relatively modest sum that would help at least to offset the costs of moving and finding a rental unit. For current foreclosures this sum would be paid for by taxpayers; it would be small beans relative to most proposed housing programs. In the future, this payment could be funded with an appropriate tax, tied to the riskiness of new mortgages. If the payment was contingent on the house being left in good order, this would reduce the incentives to abuse the housing stock.

Simple rules, rather than judicial discretion, have the best chance of improving the foreclosure process. Some have suggested that bankruptcy courts should be able to re-write, or cram down, mortgage terms for primary homes. Ellickson's warnings about legal fees and transaction costs should scare us away from that idea. If individual judges adjust every mortgage on an ad hoc basis, the system will become more costly, less predictable, and less fair.

Ellickson's clear thinking can improve both the foreclosure process and the long-standing housing policies that helped us to get into this mess. During the giddy years that came before the Great Depression, government policy was guided by Calvin Coolidge's maxim that "the business of America is business." During the giddy years that preceded the great housing bust of 2008, government policy followed George W. Bush's view that "the more ownership there is in America, the more vitality there is in America." Housing policies, most of which long preceded the election of 2000, ardently promoted the homeownership rate, which peaked at 69.2 percent at the end of 2004.

Since the New Deal, the government has promoted housing and homeownership by means of subsidizing borrowing. The Home Mortgage Interest Deduction makes it cheaper for wealthy itemizers to borrow to buy more expensive homes. Fannie Mae and Freddie Mac provide mortgage insurance at subsidized rates. The Community Reinvestment Act pushed banks to lend to lower income homebuyers. Subsidizing borrowing is so attractive to politicians because its looks like a free lunch. Borrowing at Treasury rates and then lending at slightly higher rates seems to allow the government to do well by doing good. Of course, this free lunch is an illusion. The government can only offer below-market rates by taking on the risks of defaults. Taxpayers are currently paying for the costs created by Fannie and Freddie.

The popularity of subsidizing borrowing has led some to advocate a new round of federally subsidized lending, perhaps at an interest rate of 4.5 percent, aimed at pushing housing prices back up. But nothing is going to bring back the boom days of 2006. On average, housing prices go up between 3 percent and 5 percent when interest rates fall by 1 percent. A big loan program that pushes lending rates down to 4.5 percent would probably lead to a price boom of less than five percent. Such a modest impact would be barely noticeable in markets that have lost more than one-fifth of their value in the last year. It certainly would do little stem the tide of foreclosures. Housing in America is a $20 trillion market. It is no more plausible that the government will be able to bring housing prices back to bubble-like prices than it was for Herbert Hoover, or Franklin Roosevelt, to bring stock prices back to their 1929 levels.

I doubt that the government should try to make housing more unaffordable to ordinary Americans, even if it could manage that trick. Higher prices would just mean more overbuilding in places such as Las Vegas, which already have a glut of homes. In almost all cities, prices are still far above 2000 levels. Why is unaffordable housing now a national desideratum? The most recent housing boom made some of America's most economically dynamic and beautiful places unaffordable to ordinary Americans. Higher housing prices made it difficult for young and middle-income families to get by in America's costly coastal regions. There is much to like about housing's return to reality, not least its increased affordability, and much to dislike about artificially trying to make homes expensive.

Moreover, credit subsidies can be quite regressive. The Home Mortgage Interest Deduction is poorly targeted toward lower-income Americans who are on the margin between renting and owning; its benefits go mainly to the rich. In markets where housing supply is more or less fixed, subsidizing borrowing just pushes up prices, which means capital gains for existing homeowners, not increased housing affordability. In more flexible markets, the deduction encourages over-building and over-borrowing.

In the midst of today's housing crash, certainly, subsidizing borrowing looks particularly foolish. The government essentially encouraged Americans to leverage themselves to the hilt and bet on housing markets. Now a lot of those erstwhile owners have lost everything. Why exactly does it make sense to subsidize gambling on home prices?

Ellickson's book pushes us to think more clearly about the benefits and the costs of homeownership. His book makes sense of one of the most striking facts in the homeownership literature: the extremely tight relationship between structure type and ownership. Roughly 87 percent of all single-family detached homes are owner-occupied. Roughly 87 percent of all homes in buildings with five or more units are rented. Multi-family dwellings have common spaces, such as lobbies, and common infrastructure; sharing joint control over these things can often be quite difficult. Landlord control over large buildings irons out the difficulties of dealing with the cacophony of collective control.

The connection between homeownership and structure type implies that when the federal government gets into the business of supporting homeownership, it also gets into the business of supporting single-family detached homes--and this means supporting lower-density living. New Yorkers have converted plenty of rental units into co-ops, but still 77 percent of the households in Manhattan rent. The government's big post-war push into homeownership was inevitably also a push to suburbanize. You do not need to be an enemy of the suburbs to wonder why the government is implicitly urging Americans to drive longer distances and flee denser living.

By pointing out all of the benefits that come from avoiding the difficulties of landlord-tenant relationships, Ellickson led me to wonder whether we really needed to subsidize homeownership at all. After all, homeownership is common in many societies that lack homeownership subsidies. Moreover, the current system works in ways that can actually increase incentive problems in the home. When homeowners invest little of their own equity, then the benign incentives created by homeownership disappear, because it is the lender, not the owner, who faces the risks of a price collapse. Yet subsidizing lending pushes leverage up, and brings owners closer to the default margin, where they start having incentives to take on more risk.

This problem gets even worse when housing prices are set to decline. Ellickson notes that many lenders require that home-buyers pay for one-fifth of their home with their own cash. That cushion is thought to be enough to ward off the dangers of default, but that is not the case when we are at the top of a housing bubble. On average, for every dollar that prices rise over five years, relative to local and national trends, they go down by thirty-two cents over the next five years. In markets that have more than doubled over a five-year interval, lenders should expect declines that will wipe out any 20 percent margin. Federal policy should protect taxpayers against having to pay for over-extended banks, instead of subsidizing ever more leverage.

What, then, should be done to make housing more affordable? Again, I think that the Ellicksonian focus on property rights points the way. Over the past forty years, as Ellickson presciently noted in 1975, land-use controls have steadily eroded landowners' rights to build on their property. As new construction in expensive areas declined, prices rose. The collision of robust demand and restricted supply caused prices to skyrocket in America's most attractive areas, such as coastal California and Manhattan.

In some cases, these controls were motivated by local environmental concerns. The problem is that local environmentalism is rarely good environmentalism. When local land-use controls stop development in coastal California, this does not slow the pace of new development. It merely moves new development elsewhere, to places where landowners can still freely build. Unfortunately, places with less restrictive controls, such as Houston, have browner sources of energy and less temperate climates. A new home in Texas uses a lot more energy than a new home in California. But when California environmentalists shut down new construction around the San Francisco Bay, they push development to the suburbs of Houston. The net result is that California's land-use restrictions make housing unnecessarily expensive and increase carbon emissions.

Rather than credit subsidies to increase borrowing, it would make more sense to re-think land-use controls. There are certainly legitimate reasons to regulate building, but it seems to me that many jurisdictions have gone too far, putting their own parochial interests first. Perhaps housing policy would do better to create real affordability by eliminating the barriers to building, rather than just inducing lower-income Americans to leverage themselves and bet more on housing.

Houses are most Americans' most important asset. They are the stages on which we live our lives. And so housing policy is worthy of intense attention--but until the current crisis housing policy existed in the netherworld of the more unglamorous public pursuits. Perhaps our present-day troubles will create the opportunity to produce better housing policies, or so I hope. Robert Ellickson's ideas can certainly help.

Edward Glaeser is the Glimp Professor of Economics at Harvard. He directs the Taubman Center for State and Local Government and the Rappaport Institute for Greater Boston.

By Edward Glaeser