Download The Impact of US Housing Lending Policies on

The Impact of U.S Housing Lending Policies on Economic Growth
Nataliia Biriukova
ABSTRACT
The U.S. has experienced and recovered from many recessions throughout its
history; the real estate market has traditionally been a powerful force in the
nation’s economic recovery. Although the U.S. government expended tremendous
effort and funds to minimize the impact of the crisis of 2007 and promote
homeownership by subsidizing borrowing, the policies of lending institutions are
slowing the nation’s progress out of the present recession. This research study
investigated the impact of credit restriction policies on the wealth of potential
buyers who faced foreclosure. The background of the mortgage crisis, its impact
on the U.S. housing market, current lending policies and key credit restrictions are
addressed in the literature review. This research used the qualitative research
method of case study with a fictional sample representing a section of the
homeowner market in Northern Virginia. The research found that housing lending
policies impact the wealth of households and, by extension, the economy of the
U.S.
INTRODUCTION
During the last few decades, the policies of U.S. government have promoted
homeownership. This policy is in alignment with the belief of the majority of Americans, who
believe that the homeownership is a smart investment in the long term. Numerous surveys show
that home-owners are more likely to be satisfied with the quality of their family and community
life than renters, and most renters aspire to home ownership.
The recent financial crisis caused numerous foreclosures due to the defaulting of
homeowners on their residential mortgages. Foreclosure is a legal proceeding in which the bank
takes possession of a mortgaged property when the borrower does not meet his or her contractual
obligations to pay.
The choice of whether to own or rent a home is a major decision and should be given
careful consideration. However, due to the credit policies of lenders, a person cannot be
approved for a loan to buy a home if he/she has faced foreclosure within the last three years.
That person is required to rent a home for at least three years before re-applying for home
ownership.
In 2010, the homeownership rate was 65.1 percent nationally, having decreased by 1.1
percentage points since 2000. This decline in the national homeownership rate is the same as
during the years of the Great Depression. Still, the 2010 homeownership rate remains the secondhighest rate since the collection of tenure data began in the census of 1890 (U.S. Census Bureau,
2011). American attitude about homeownership remains strong even during the housing crisis.
According to a survey conducted by Move, Inc., an online real estate company, four out
of five (81.7 percent) Americans consider housing to be a critical piece of the national economic
recovery (Move, 2011).
LITERATURE REVIEW
The literature on the current economic crisis and its macroeconomic impact is growing
rapidly, although there is substantial variation across the studies in terms of their focus on
different variables, methods, and sample periods. There are different views of outlook for
recovery in U.S. real estate markets. Some researchers believe that the U.S. economy in a deep
recession and might even worsen. Others state that the housing market has reached its bottom,
and the economy is transitioning from a rescue phase to a recovery phase (Singh and Bruning,
2011). The background of the current financial crisis has been reviewed by Du, Wu, and Yang
(2010).
Lane and Milesi-Ferretti (2011) examined whether the cross-country incidence and
severity of the 2008-2009 global recession is systematically related to pre-crisis macroeconomic
and financial factors. They found a relationship between pre-crisis domestic financial factors
(fast private credit growth) and external imbalances (current account deficits) on the one hand
and the decline in the growth rate of output and domestic demand during the crisis.
The impact of housing choice on future household wealth was analyzed by Hennessey
(2003), whose study provides a financial model that can be used to analyze the impact that the
‘rent or buy’ decision has on wealth. The study suggested that home ownership might not have
the positive impact on household wealth that most Americans perceive to be the case.
Hatzius (2008) examined the link between home prices and foreclosures. The study
estimated the impact of declining home prices and credit supply reduction on real GDP growth,
and found that an additional 15 percent home price decline from 2008 levels would cause
residential mortgage credit losses of $750 billion over 2007-12 and lower real GDP growth by an
average of 2.6 percent per year. The study suggested that the crisis impacts the economy in the
following ways. First, the decline in residential construction reduces aggregate output. Second,
declining income in the housing sector decreases consumer spending. Third, negative wealth
effects or a mortgage liquidity effect caused by declining home prices lowers the private
consumption. Fourth, losses on mortgage credit reduce the credit supply to households and
nonfinancial businesses. The analysis suggests that increasing the supply of credit would soften
the current economic conditions. “The Treasury Department had committed $700 billion in
government capital injections into financial institutions through its programs; further injections
could significantly soften the current credit squeeze.” (Hatzius, 2008)
Tsay and Zera (2010) constructed an indifference curve from combinations of house
prices and mortgage payments, designed to better understand whether to buy a home now or wait
until later.
Gerardi, Lehnert, Sherlund, and Willen (2008) analyzed whether housing market
participants underestimated the sensitivity of foreclosure rates to price changes. The study
suggests that analysts generally understood the possibility of falling prices, but assigned a low
probability to that outcome. Additionally, lenders must have expected either that house price
affordability would not collapse or that subprime defaults would be insensitive to a big drop in
house price affordability house price affordability.
Swagel (2009) reviewed the governmental policy response to the 2007-2009 financial
crisis. His paper addressed the legal, political, economic, and time constraints faced by
government agencies in addressing the crisis. Policymakers had to choose between numerous
proposals, including options of: whether to buy assets, insure them, inject capital into financial
institutions, or expand federally guaranteed mortgage refinance programs. There were also
proposals that would allow refinancing for low- and moderate-income homeowners through
loans guaranteed by Federal Housing Administration that would have changed to the tax code to
forgive the tax due from a borrower whose debt is canceled by the lender. This would have
improved the operations of Fannie Mae and Freddie Mac through the continuation of financing
provided by these government-sponsored enterprises. The study suggested that, from a political
and economic point of view, the ensuring of loans by government agencies is preferable to direct
capital injections in financial institutions, and that the Treasury response to the crisis was
appropriate to the economic conditions.
Tatom (2009) argued that the government:
“has reacted chaotically by creating new lending programs that have transformed its
credit supply from government securities to private financial institutions, and in the
process, violated the first rule of central banking to lend liberally in a liquidity crisis. This
failure, compounded by providing a backstop to questionable securities, has slowed
market adjustment and risks lengthening and deepening the financial crisis.”
The study suggested that an overall foreclosure rate of 4 to 7 percent would, at most, represent a
range from $400 to $700 billion. Some estimates indicate that banks have already raised enough
capital to offset the capital losses. At the end of the third quarter of 2007, banks held nearly $4
trillion in: residential mortgages ($2.2 trillion), home equity loans ($0.6 trillion) and mortgage-
backed securities ($1.2 trillion), which is about 30 percent of total banking assets, and 40 percent
of mortgages.
METHOD
This case study will be based on a scenario with a fictionalized household that recently
faced foreclosure and due to credit restriction policies, cannot get a loan to buy a new home, and
therefore, rented their primary residence for three years. The financial model described above by
Hennessey (2003) will be applied to estimate the wealth of households renting a home versus
owning a home over a three-year period. Given this estimation, the impact that credit restriction
policies have on the economy was then calculated.
This qualitative study includes:

Descriptive statistics that will review the background of financial crisis and foreclosures.

Secondary Data Analysis that will review the statistical data that indicates housing
market conditions over the period from 2009-2011.

Research population: US housing market

Sampling: housing market in Prince William County, VA
Data Collection and Analysis
This study used the financial model, also referred as the housing choice model, developed
by Hennessy (2003), which includes the following variables:
Table 1. List of Variables in the Housing Choice Model
Variable
Symbol
Brief description
Household Wealth
WN
Household wealth at the end of year N
House Price
Co
Purchase price of house + closing costs
Closing Costs
CC
All fees required to finalize the purchase (lawyer fees,
mortgage insurance, points)
Down payment
DP
The percent of the purchase price paid by the household
Mortgage Rate
km
The interest rate on the mortgage over the amortization
period
Amortization Period
n
The total period the household takes to pay off the
mortgage
Ownership Cost
Ot
Cost of owning the house in year t, includes mortgage,
property taxes, maintenance and repairs
Rent
Rt
Cost of renting in year t
Security Deposit
SD
Deposit required at the beginning of rental agreement
Net Downpayment
NDP
Cost Inflation (%)
ft
Net cost of buying
invested
NCI
The difference between the down payment and the
security deposit
Rate at which costs and rent increase in year t
The sum of the yearly series of net cost of buying
invested over the period of analysis
House Appreciation Rate
(%)
iH
Rate at which housing appreciates in value
Rate of Return
iF
Return earned on the investment in financial assets
Selling costs
SCn
Cost of selling the house at the end of the period of the
analysis (includes real estate commission and closing
costs)
Capital gains tax rate
Tcg
Marginal tax rate on capital gains income of the
individuals claiming the capital gains
Marginal tax rates
Tm
The tax rate of the individual claiming the mortgage
interest and property taxes against income
Period of Analysis
N
Total period of analysis
The Hennessy model is adapted to this research to analyze the impact of renting a home
versus owning a home for the three year period indicated. The adapted version of this model
includes some of the variables with the following values:
Table 2. List of Variables in the Adapted Housing Choice Model
Variable
Symbol
Value
Household Wealth
WN
To be calculated
House Price
Co
$250,000 (average price of a single family house
with three bedrooms and two bathrooms in
Prince William County, VA. Source: multilisting services, www.mris.com)
Downpayment
DP
0% (assumed to be 0% for qualified borrowers
similarly to some of loans generated/insured
loans by the Government agencies)
Mortgage Payment
MP
$1,247 (calculated using mortgage calculator)
Property Taxes
PT
$2,500 (average 2011 property tax for the
comparable houses in Prince William County,
VA. Source: public tax record, www.mris.com)
Maintenance and Repairs
MR
$300 (average spending on maintenance and
repairs on national level, American Housing
Survey for the United States: 2009, U.S. Census
Bureau and U.S. Department of Housing
and Urban Development)
Rent
Rt
$1,800 (average rent for comparable houses in
2011 in Prince William County, VA. Source:
multi-listing services, www.mris.com)
Security Deposit
SD
$1,800 (1 month rent)
Mortgage Rate
km
4% (as of December 4, 2011, fluctuating daily)
Cost Inflation (%)
ft
3.5% (source: U.S. Census Bureau)
Amortization period
n
30 years
House Appreciation Rate
(%)
iH
0% (assuming house appreciation rate is 0% for
the next 3 year period)
Rate of Return
iF
3% (rate of return on U.S. Treasure bill)
Period of Analysis
N
3 years
Calculations for the wealth of a household when renting a home
The wealth of the household is based on the value of the net down payment invested in
interest earning financial assets at the end of third year, less the future value of the cost of renting
a house at the end of the third year, less the opportunity cost of investing the rent expenses into
interest earning financial assets. The equation can be expressed as follows:
𝑁
𝑊𝑁𝑅
= [𝑁𝐷𝑃 (1 + 𝑖𝐹
)𝑁
− 𝑁𝐷𝑃] − ∑ 𝑅𝑡 − [𝐸 (1 + 𝑖𝐹 )𝑁−𝑡 − 𝐸]
𝑡=1
The cost of renting at the end of third year is the sum of monthly rent payments adjusted for
inflation:
𝑅𝑡 = (𝑅𝑡 ) ∗ (1 + 𝑓𝑡 )𝑡−1
The cost of renting for the three year period is $67,094 and is calculated as following:
𝑅1 = $21,600
𝑅2 = 21,600 ∗ (1 + 0.035) = $22,356
𝑅3 = 21,600 ∗ (1 + 0.035)2 = $23,138
3
∑ 𝑅𝑡 = $67,094
𝑡=1
E is the difference between cost of renting and cost of owning a house:
𝐸 = 𝑅𝑡 − 𝑂𝑡
After calculating the cost of owning the house (shown below) E equals $54,656.
E = 67,094 - 12,438 = $54,656
The wealth of the household renting the house is negative, and it equals -$68,900 as follows:
𝑊𝑁𝑅 = − 166 − 67,094 − 1,640 = −$68,900
Calculations for the wealth of a household when owning the house.
The wealth of the household owning the house is based on the value of the house at the
end of three year period, less the future value of the cost of owning, less the opportunity cost of
investing ownership costs in interest earning financial assets, is as follows:
𝑁
𝑊𝑁𝑂
𝑁
= 𝐶𝑂 (1 + 𝑖𝐻 ) − ∑ 𝑂𝑡 − [𝐸 (1 + 𝑖𝐹 )𝑁−𝑡 − 𝐸]
𝑡=1
The ownership cost at the end of third year is the sum of the mortgage payments, property taxes,
and maintenance and repairs, adjusted for inflation:
𝑂𝑡 = 𝑀𝑃𝑡 + (𝑃𝑇1 + 𝑀𝑅1 )(1 + 𝑓𝑡 )𝑡−1
Unlike the Hennessy (2003) analysis, this study does not take into consideration the tax savings
associated with the mortgage interest tax deduction and deduction of property taxes due to the
uncertainty about whether there is a tax incentive for the household to itemize their deductions.
The cost of owning the house is equals $53, 589 and is calculated as follows:
𝑂1 = 14,964 + (2,500 + 300) = $17,764
𝑂2 = 14,964 + (2,500 + 300)(1 + 0.035) = $17,862
𝑂3 = 14,964 + (2,500 + 300)(1 + 0.035)2 = $17,963
3
∑ 𝑂𝑡 = $53,589
𝑡=1
Similarly, the wealth of household owning the house is equals $198,051 and is calculated as
follows:
𝑊𝑁𝑂 = 250,000 − 53,589 + 1,640 = $198,051
The study implies that the household’s expenses are $13,505 or 25% lower when owning the
house. When owning the house, on average, the household could contribute to GDP $13,505 by
consuming more goods and services and/or to investing over the three year period.
Calculating the impact that credit policies have on the U.S. economy
Consumption is the largest component of GDP and there are many approaches to
calculate GDP. The expenditure approach calculates GDP as follows:
GDP= Consumption + Investments + Government Expenditures + Net Exports
To illustrate the magnitude of the impact credit policies have on GDP, this study used the
number of foreclosures in Prince William County, VA. The number of foreclosures is the
number of bank owned homes (inventory) that were offered for sale in Prince William County in
2011. As of December 4, 2011 the number of foreclosures was 843 households that lost their
homes in 2011 and would have to rent a home for at least 3 years, because lenders would not
approve them for a loan to buy a new home.
The estimated loss to U.S. economy, due to credit policies, is $11,384,715 and is calculated
by multiplying number of foreclosures by estimated average household’s consumption as
follows:
843 x $13,505 = $11,384,715
The study implies that the contribution to GDP by Prince William County would have been
$11,384,715 more over the next three years only if financially capable residents could get
approved for a loan regardless of whether or not they had recent foreclosure.
LIMITATIONS
This study has certain limitations. The data regarding foreclosure rate is complicated and
includes foreclosure inventory (REO), new foreclosures (foreclosure starts), and delinquency on
mortgage payments. The foreclosure rate used in this research is REO offered for sale through
Multi-Listing Services (MLS). This rate differs from the actual foreclosure rate and does not
include new foreclosures (not offered for sale yet), so the actual number of foreclosures is almost
certainly higher.
The estimation of economic impact in this study is based on the assumption that the
household facing foreclosure would be financially capable of paying the mortgage on a new
home. Additional research should to be conducted to evaluate the actual financial situation of
households facing foreclosure and their ability to pay a new mortgage.
The wealth of a household was calculated using stable prices, house appreciation / depreciation
rate, which equaled zero percent.
CONCLUSIONS AND RECOMMENDATIONS
The credit restriction policy, which does not allow a person who has had a foreclosure
within last three years to qualify for a loan to purchase a home, conspicuously impacts the U.S.
economy. On average, renting a home is 25 percent more expensive than owning a home in
Prince William County, VA. Due to the credit restriction policy, the estimated loss of private
consumption by residents of Prince William County will be $11,384,715 over the next three
years. The study suggests that, in order to increase economic growth in the U.S., financially
capable persons should be able to be qualified for a new loan regardless of whether or not they
have experienced foreclosure within the last three years, and lenders [should] no longer be
required to practice the restriction policy.
IMPLICATIONS OF THE STUDY
The major users of this study are U.S. government agencies and other policy-making authorities
in the banking, mortgage and housing industries. This study implies that the government should
develop housing lending policies that would allow people who faced foreclosure to buy a new
home as long as they financially capable to pay the new mortgage.
REFERENCES
Du, H., Wu, J. &Yang, W. (2010) On the mechanism of CDOs behind the current financial crisis
and mathematical modeling with Levy distributions. Intelligent Information
Management. 2(2). Retrieved October 25, 2011 from http://go.galegroup.com/ps/
i.do?&id=GALE%7CA222025544&v=2.1≈u=pwpls_remote&it=r&
amp;p= GPS&sw=w
Gerardi, K., Lehnert, A.,Sherlund, S. M., & Willen, P. (2008). Making sense of the subprime
crisis. Brookings Papers on Economic Activity. Retrieved from
http://go.galegroup.com/ps/i.do?&id=GALE%7CA197801526&v=2.1&u
pwpls_remote&it=r&p=PPBE&sw=w
Glaeser, E. L. (2010). Housing policy in the wake of the crash. Daedalus. 139(4). Retrieved
October 25, 2011 from
http://go.galegroup.com/ps/i.do?&id=GALE%7CA240008121&v=2.1&a
p;u=pwpls_remote&it=r&p=GPS&sw=w
Hatzius, J. (2008). Beyond leveraged losses: the balance sheet effects of the home price
downturn. Brookings Papers on Economic Activity. Retrieved from:
http://go.galegroup.com/ps/i.do?&id=GALE%7CA197801528&v=2.1&
wpls_remote&it=r&p=PPBE&sw=w
Hennessey, S. M. (2003). The impact of housing choice on future household wealth. Financial
Services Review. 12. 143-164
Hornstein, A. (2009). Problems for a fundamental theory of house prices. Economic Quarterly
95(1). Retrieved October 25, 2011 from
http://go.galegroup.com/ps/i.do?&id=GALE%7CA202078470&v=2.1&a
p;u=pwpls_remote&it=r&p=GPS&sw=w
Lane, P.R. & Milesi-Ferretti, G.M. (2011). The cross-country incidence of the global crisis. IMF
Economic Review. 59(1). Retrieved from
http://go.galegroup.com/ps/i.do?&id=GALE%7CA254959528&v=2.1&u
pwpls_remote&it=r&p=PPBE&sw=w
Move, Inc. (2011). 2012 presidential elections: 69.6% of Americans said housing will influence
their vote. Retrieved from http://news.move.com/index.php?s=11609&item=81808
Singh, G. & Bruning, K. (2011). The mortgage crisis: Its impact and banking restructure.
Academy of Banking Studies Journal. 10(2). 23-43.
Swagel, P. (2009). The financial crisis: An inside view. Brookings Papers on Economic
Activity. Retrieved from
http://muse.jhu.edu/journals/eca/summary/v2009/2009.1.swagel.html
Tatom, J.A. (2009). The U.S. foreclosure crisis: a two-pronged assault on the U.S. economy.
Economics, Management and Financial Markets. 4(2).
Tsay, W. & Zera, S. (2010). The trade-off between declining house prices and rising mortgage
rates: Buy now or wait until later. Journal of Academy of Business and Economics. 10(3).
U.S. Census Bureau. (2010). Housing characteristics: Retrieved from
http://www.census.gov/prod/cen2010/briefs/c2010br-07.pdf