Slouching Towards DC, Part 2: A "Balanced" Policy

In part 1, I laid out some hints of what the Obama Administration has in mind for a new federal housing policy that would “reset the rules of the market” and engage in a “fundamental rethink” not just of the mechanics of housing finance, but of the objectives of housing policy themselves.  The Treasury now has all of the comments that it requested from the public and we can expect to see a proposal from the Administration sometime this fall or early next year.

In this post, I’d like to engage in the purest conjectures about what such a policy might look like.  I know that assumptions are dangerous, and any conjecture at this early stage is more likely to be wrong than right, but… hey, this is fun.  (If you’re a real estate and politics geek like me anyhow.)  So here we go.

Sustainable Homeownership

The first phrase that suggests a fundamental rethink is “sustainable homeownership”, which appears to be the new policy direction at least within the Administration:

Officials in a new Office of Capital Markets and Housing Finance set up in Treasury are studying options for reform, and generally have concluded that federal policy should focus on what they call “sustainable homeownership” and not on simply boosting the homeownership rate.

What might such a thing look like?

I suspect there will be two major components to a “sustainable homeownership” policy: changes to federal subsidies for housing, and tax policy.

Fannie Mae and Freddie Mac (as well as VA loans and the FHA) all amount to what is effectively a subsidy for homeowners through the mechanism of creating low-cost, low-downpayment mortgages.  Whatever your opinion of Fannie/Freddie might be, it’s hard to deny that the GSE’s have had a stabilizing effect on the mortgage market, and have encouraged affordable mortgages (some might argue, underpriced mortgages, leading to the bubble).  The 30-year fixed mortgage seems hardly possible without implicit or explicit government guarantees to investors.

I think it’s more likely than not that Fannie and Freddie will be formally taken over by the government, merged into a single government-chartered entity (like the FDIC or the CPB) with the mission of making some types of homeownership affordable.  NAR suggested as much in its answers to the seven broad questions, but NAR wants the new entity to cover all types of housing, in all types of markets.  I think the Administration will stop short of that commitment.

Instead, I expect the new Fannddie will focus on providing a secondary market only for the safest mortgages — low LTV (loan-to-value) loans with heavy documentation.  The interest rates for such loans may actually be kept fairly low, as Fannddie will not be a profit-seeking company, but a government entity in all but legal form.  The implicit guarantee that underlie Fannie & Freddie will be made explicit.  I could see the FHA, HUD, and even the VA surrender the parts of their portfolio pertaining to housing finance to the new Fannddie, in order to focus the efforts of the Agencies on low-income housing (read, rentals).

I cannot imagine the new Fannddie getting involved at all in the high end luxury market (however that’s defined).  I cannot imagine that the new lending standards under Fannddie will be looser than the ones currently prevailing at major mortgage banks; if anything, “sustainable homeownership” implies that the standards will be tougher, requiring lower debt-to-income, greater stability in income, more assets, and lower LTV (read as, higher down payments).  To deal with the issue of foreclosure, strategic default, and the like, I cannot imagine that the loans made under Fannddie — a government chartered entity, rather than a private for-profit company — will be anything but recourse to the borrower, with limited dischargeability in bankruptcy.  Such mortgage debt is likely to have similar characteristics to tax liens.

Tax policy is also likely to play a large role.  The mortgage interest deduction looks like it will either be eliminated altogether, or significantly limited.  For example, we may see a cap — say $250,000 or $300,000 of the underlying mortgage.

Since the mortgage interest deduction mostly benefits the well-to-do who (a) have higher mortgages, (b) have higher income levels, and (c) itemize deductions, it is effectively a subsidy of wealthier homeowners.  Due to the politics around mortgage interest deduction, I judge that it is more likely that we’ll see a cap of some sort; few people will cry tears that homeowners with $800K mortgages in La Jolla can only deduct the interest on $300K of the loan.

In fact, it strikes me as likely that the elimination/curtailing of the mortgage interest deduction may be seen as the primary revenue source for the rental support programs that will form a larger part of the new national housing policy.

The combined effect of these policies — and the likely thousands of other new rules and regulations — will be to shrink the pool of buyers only to those who can easily afford to take on significant debt.  And everyone will take a step down in price levels: luxury buyers today are the mid-range buyers of tomorrow, and the starter home buyers of today are the long-term renters of tomorrow.  The hit to mortgage interest deduction is not likely to deter the higher-income buyers that the “sustainable homeownership” policy wants, and making mortgages more difficult to get naturally lowers the risk.

But what about the millions of lower-income families who will find it impossible to buy a house under the “sustainable homeownership” regime?  Well, that’s where the expansion of rental comes in.

Balanced Policy: Rental Support

The Obama Administration is already moving on this.  The 2011 budget includes a $350m Transforming Rental Assistance initiative that should be seen as a pilot program for the larger rethink.  In fact, the Administration itself views the TRA as a “signature initiative” that will take many years to implement fully.

The entire TRA program is fascinating for some of the extras it incorporates, such as stronger organizing rights for tenants, and the requirement of a “green” study, but the essential core of TRA (and the PETRA on which it is based) is to convert existing public housing which tend to be tenant-based subsidies into project-based subsidies.  I’m simplifying a great deal here, but essentially, the Federal government would enter into a long-term contract (20 years) for a stream of payments to the public housing authority (PHA) that guarantees a profit.  With this revenue stream, each property can go raise money from the capital markets like a private multifamily developer could (although with greater security of cashflow since the United States more or less guarantees it).

The tenants themselves would, as they are now, be limited to paying 30% of their income towards rent and utilities.  Where there is a gap between the contract rent (HUD approved rents, close to market rents) and what the tenant pays (the 30% cap), the government pays the difference to the landlord.

There are, as one might expect, a number of restrictions and regulations on use, transfer, and foreclosure.  Even if a private lender forecloses on a property that converted under TRA, the low-income requirements would remain in place, and because TRA would be based on new legislation, standard bankruptcy law wouldn’t apply to those cases.

Additionally, private landlords will be provided incentives to open up their apartments to low-income renters, who will receive a subsidy from the government.

I’m barely scratching the surface here, but if you’re interested, start at the links above and read for yourself.  It’s fascinating stuff.

There are three conjectures that can be made here.

First, traditional multifamily financing might slow significantly, or come to an outright standstill, once this new regime is fully in place.  It’s no secret that the commercial real estate sector, which traditionally relied on private capital markets, is hurting.  For lenders to multifamily properties, the key question is stability of occupancy: are the tenants in place, and the cashflow reliable?

If you can think of a more stable tenant than the U.S. government, I’d like to hear about it.  As a result, the properties under TRA (or something like it) should be extremely attractive to commercial multifamily lenders.  Capital should gush into the newly converted public housing projects, especially in major urban markets with high rents (e.g., New York, San Francisco, etc.).  Right now, I can’t imagine that capital gushing in without gushing out of private multifamily developments.

One consequence — and HUD might even be counting on this — could be that a number of landlords will simply go bankrupt when they are unable to rollover their loans, or open their doors to the new TRA-Section 8 tenants in order to secure the coveted stability of government subsidies.  That would certainly meet the stated public policy objective of increasing rental stock for low-income families.

Second, given the stated policy of “sustainable homeownership”, which implies that the government will back away from supporting the financing of residential mortgages (likely through the new Fannddie mechanism), it seems to me that the capital markets are likely to switch over to financing the new TRA-housing projects.  The secondary market for residential mortgages will shrink, but the secondary market for a new kind of CMBS (commercial mortgage-backed securities) on TRA public rental properties will grow.

Third, it really is difficult to imagine that we won’t have a set of national rental regulations before all is said and done.  The TRA includes some extraordinary protections for tenants and tenant organizations.  As the inevitable pressure to open up to subsidized renters hits private landlords as well, it’s nearly inconceivable to me that the HUD and other agencies will long tolerate a huge difference between one set of subsidized tenants (those in TRA public housing) and another set of subsidized tenants (those in private buildings).

The rental-support program is also likely to create some odd incentives in a few high-rent markets, such as New York City.  The median income in Manhattan is $64,217; currently, as long as you’re at 90% of the median income, you qualify for subsidized section 8 housing.  That rule is likely to be carried forward, if not expanded to cover more people who would otherwise have sought to become homeowners. 90% of the median income in Manhattan is $58K; at that point, the maximum you will have to spend is 30% or $17,400 and the government will pay the rest.  Well, a 2BR apartment in Manhattan averages $3,680 per month in rent.

If you make $58K a year, and your boss threatens to give you a promotion and a 10% raise, you should say no, hell no.  If she persists, you should quit in protest.  That 10% raise to $63K will end up costing you well over $26,000 per year in lost rental subsidy.

Regulation and Oversight

The TRA, the recently enacted Finance Reform Act (Investor Protection and Securities Reform Act of 2010), and the overall thrust of a new housing policy all contemplate stricter regulation and oversight of various industries.  For example, PETRA requires properties converted under TRA to submit to fairly stringent oversight by HUD or its designees.  That any reform to mortgage rules would require stricter oversight — especially in light of the stupidity, abuse, and fraud that was rampant in the run-up to the foreclosure crisis — seems obvious.

Whatever else might happen, it seems a safe bet that the mortgage industry will be far more tightly regulated in the future than it is now.

Question for us is, will regulation and oversight stop there?

I personally cannot imagine that real estate professionals would escape more regulation under a new national housing policy that shifts objectives as dramatically as this one would like to.  In arguing for the passage of PETRA, HUD Secretary Donovan argues that streamlining is necessary:

With 13 different programs, each with its own rules, managed by three operating divisions with separate field staff, it does not take a housing expert to see that the patchwork of rules and regulations that families have to navigate today doesn’t make affordable housing more accessible – but less.

Now, that’s with only 13 different programs in three operating divisions.  Real estate brokerages is regulated by not only various federal entities, but 50 state real estate commissions, and each local Realtor Association and each of the 850+ MLS has its own rules as well.

Would a government that deems 13 programs unacceptably complicated really continue to tolerate the patchwork of laws, regulations, and rules that is the contemporary real estate brokerage industry?  Especially when much power and influence would accrue to Washington DC by creating an Office of Real Estate Brokerage Oversight within HUD?

I doubt it.

So I am expecting to see federal regulation of real estate brokers and agents, which could be a good thing or a bad thing, depending on what the actual substance of such regulation is.

Those are my conjectures at the moment.  Of course, if none of these things come to pass, then all of this is worthless.  So in the next part, we turn to a consideration of the politics of housing reform.


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Rob Hahn

Managing Partner of 7DS Associates, and the grand poobah of this here blog. Once called "a revolutionary in a really nice suit", people often wonder what I do for a living because I have the temerity to not talk about my clients and my work for clients. Suffice to say that I do strategy work for some of the largest organizations and companies in real estate, as well as some of the smallest startups and agent teams, but usually only on projects that interest me with big implications for reforming this wonderful, crazy, lovable yet frustrating real estate industry of ours.

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