How to Free Up the Housing Market

I think everyone should be able to buy a home. To me, that is a fundamental opportunity. I differentiate that from a fundamental right, because rights persist even after you squander your opportunities. (I also place education and health care under the category of fundamental opportunities.) My dilemma is that I also believe in free markets, and free markets do not necessarily guarantee everyone the opportunity to buy a home.

Congress recognized that in 1977, and passed the Community Reinvestment Act to basically force banks to loan more money to risky borrowers. Other people have covered the chain of events in more detail, but basically whenever you force someone to make risky investments, bad things are going to happen eventually, like the current housing and credit crisis.

There has to be some sort of economic incentive that would allow the free market to function efficiently, but would still provide the riskiest borrowers an opportunity to buy a home. Let's examine how such an incentive would look.

First, there must be a home available. This is only a problem if the highest price someone is able to pay is lower than the lowest price a builder is willing to accept to build a house that meets their needs. Let's assume this is the case for a worst case analysis.

Second, there must be credit available. There are two competing interests here. The lender needs a high enough interest rate to compensate for the extra risk, or he will not be willing to loan the money, and the borrower needs a high enough loan amount to cover the purchase price with a low enough monthly payment to be able to afford it. Note that the borrower doesn't really care what the final purchase price is, as long as the monthly payments continue to remain affordable. Problems arise when the desired interest rate drives the monthly payments too high. The naive solution is to force the banks to loan at the lower interest rate, which we already know is not an efficient solution.

So, we need a way to lower the monthly payment, while keeping the purchase price and interest rates at high enough levels to satisfy the suppliers. There's a technical economic term for this amazing solution: the down payment.

Now, you might think that I already knew the answer, and purposely built up to it for dramatic effect. Actually, I didn't know the answer until I wrote the first sentence of the previous paragraph, and it probably surprised me more than it surprised you. I thought I was going to come up with an ingenious idea that would revolutionize the industry, and instead I reinvented an idea that is so old we have forgotten why it exists.

However, it makes perfect sense. Not only do down payments reduce the monthly payment, they also prove you can afford a certain amount of extra expense, thus reducing the risk, and they also provide instant equity in the home, which reduces the risk if you need to move or refinance. What was the biggest thing missing during this subprime mortgage crisis? Significant down payments. It turns out they're good for something after all. Could we still have had a housing bubble and the associated spate of foreclosures? Sure, but the impact would have been much less severe.

So what should we encourage the government to do to prevent another mortgage crisis in the next generation of homebuyers? End this risky and inefficient regulation, and let the market set the prices, but encourage them to focus more on down payments than on gimmicks and high interest rates. I think mortgage companies could really benefit by offering some sort of down payment savings accounts which automatically qualified them for a mortgage after a certain term. We need to get away from this culture that everyone is entitled to get what they want right now.

Government could also do a lot to encourage saving for mortgage down payments. Not taxing our savings would be a start. Not taxing business investment in general, so the bank could pay higher interest rates, would be ideal. The fair tax would accomplish both those goals. I keep finding more reasons to like it.