The “Housing Market” - The Greatest Fraud of All

As the financial crisis has unfolded over the past few weeks, many high profile leaders have had their faith in a market driven economy shaken. Even Alan Greenspan had to admit in testimony before Congress that the assumptions behind his economic policies were wrong. He now says he made a mistake in believing that banks “operating in their own self-interest, would do what was necessary to protect their shareholders and institutions.”

Actually, I think markets work well when the conditions for them are allowed to exist. But we are seeing the unmasking of one of the greatest economic deceptions of all time—the claim that in the United States a market determined home prices. The “invisible hand” that Adam Smith envisioned setting prices in a marketplace is suppose to be just that—invisible. Smith’s economic model rested on the assumption that many buyers and sellers acting in their own self-interest and without government interference would negotiate fair prices for scare commodities.

But lets count the ways the so-called “housing market” has failed to meet these conditions.

Government subsidies for homeowners – For decades the federal government has taxed homeowners at a lower rate than renters. It accomplishes this by allowing payments for home mortgage interest to be deducted from income. Homeowners can borrow up to the entire equity in their house and spend the money on whatever they want—cars, vacations, college tuitions—and the interest paid on the loan is tax deductible. Renters are not allowed to deduct interest paid on loans. The effect of this policy is that homeowners are taxed less as long as they remain in debt. That makes owning a home intrinsically more valuable than just having a place to live.

Government-backed loans eliminate lenders’ risks-The point of Freddie Mac and Fannie Mae was to encourage banks to loan private money to purchase homes by promising public money if the loan went bad. This policy effectively privatized gains and socialized losses. The result is a moral hazard that subverts the functioning of the market. Banks can loan money under the most outlandish of circumstances because they have everything to gain and nothing to lose.

A single person sets interest rates – The Federal Reserve Chief dictates interest rates. It’s no accident that Alan Greenspan had the nickname “Maestro” when he ran the Federal Reserve. Rather than allow market processes to determine interest rates he orchestrated market movements by dictating the rates himself. Allowing the judgment of one person to determine something as fundamental as the cost of money on such a grand scale is the antithesis of a free market.

Of course the government had good reasons for these policies. Congress decided that communities benefited from widespread home ownership. In other words a social good resulted if more people owned homes rather than rented. But government manipulation of markets to achieve a social goal is the definition of socialism.

That is where the great fraud arises—the creation of a socialist system for home ownership but labeling it a “free market.” The claim that no regulation is needed for mortgages because the market will operate is absurd. Socialist systems need regulation; otherwise the moral hazards are too great. The government appears to have no plans for ending the mortgage interest deduction, ending bailouts of failed lenders, or ending Federal Reserve control of interest rates. If it continues to use these policies to manipulate home prices its needs to be intellectually honest. The government should admit that fact that the housing market has been socialist for decades and adopt appropriate regulations to protect the public.

Tips on Mortgage Math

I have been writing this month on what has gone wrong in the mortgage industry and mistakes lenders and homebuyers have made. Here are some tips about mortgage numbers that consumers should know to protect themselves.

Home Prices: Speculation abounds in the media on when the mortgage market will bottom. My research suggests that the magic number for a fair sustainable housing market is 3. That number is the ratio of the median home price to the median household income in the United States. An examination of census data shows that from 1987 to 2002 that ratio remained unchanged at 3, even though home prices and income rose steadily during that time period. In 2002 home prices began increasing much faster than household income causing the ratio to shoot up to nearly 5 at the peak of the housing market in 2006.

The fact is home prices cannot rise substantially faster than household income or soon everyone will be priced out of the housing market and there will be no more buyers. At the beginning of 2008, the U. S. median home price—$195,900—divided by the median household income—$50,233—was equal to 3.9. That means more time is needed for income to rise and/or home prices to fall for that ratio to go back to its historical average of 3.

Monthly Payments: The number 3 is important in another way. Total monthly payments for principal and interest should not exceed 1/3 of after-tax household income. Many people think that at higher income levels a greater fraction of income can be allocated toward the mortgage. My last post profiled people who were willing to allocate more than half of their take-home pay to monthly mortgage payments. I imagine they thought that their income was so large that all additional living expenses could be funded with 30% - 40% of take-home pay.

But, ownership costs scale with the price of the home. The more square footage bought, the more it costs to heat, cool, maintain, insure, furnish and pay property taxes. All of those additional costs rise with inflation. If you take out a 30-year fixed-rate mortgage and live in the house a long time, there will come a day when the monthly cost of owning the home will exceed the monthly mortgage payment. That will be true for just about any size home.

Mortgage Options: Creative financing has risks. Recent years have seen an explosion of exotic mortgages. You can choose ARMs, interest-only mortgages, 40-year mortgages, mortgages with balloon payments and many other combinations and payment structures. But, the common element in all of these financing schemes is to make the initial monthly payments as small as possible by postponing actual debt reduction. That’s not a problem in a rising market, but it can be a disaster in a falling market. When prices fall it’s easy to find yourself “upside down” meaning that you owe more than the house is worth, while payments adjust upward to level that you can’t afford. If you are considering a mortgage without a fixed rate, figure out what the monthly payment will be in a few years after the interest rate adjusts. If you can’t afford to make that higher payment now, chances are you won’t be able to afford to make it in the future.

Plan for maintenance: Set aside money equal to about 1% – 1.5 % of the value of the home each year for maintenance, repairs and improvements. It’s easy to be optimistic, but the fact is things will break on a regular basis. When you think of all the things in a house with finite lifetimes that are essential—furnace, water heater, air conditioner, refrigerator, roof, plumbing—you realize that repair and replacement will be an on going expense. It is better to budget ahead of time those expenses with money set aside in a separate bank account. Repairs should not be a financial emergency requiring borrowed money every time they happen.


Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy