Visiting Scholar Allan H. Meltzer

The U.S. Congress and the Bush administration are considering ways to prevent mortgage defaults. Attractive for humanitarian reasons, it is a second or third best option to reduce or eliminate the housing problem.

The main problem in Britain and the United States is an excess supply of unsold houses. As long as the large unsold supply remains, housing prices will continue to fall. The high risk in bundles of mortgages will remain until the market believes it knows how far housing prices will fall. The reason is clear. Falling housing prices increase mortgage defaults. Anyone buying a bundle of mortgages must anticipate that part of the bundle is now worthless and, as prices fall, more will become worthless. Currently, the forward market estimates that U.S. housing prices will fall 11 percent in 2009, in all a decline of 33 percent from the peak in 2005.

Contrary to common belief and repeated misstatement, the mortgage market functions. Bundles are bought and sold daily. The price is around 40 to 50 cents on the dollar. This price allows the buyers to discount the loss they will take if prices continue to fall. Prudent buyers are unlikely to fail to take the discount.

The seller's problem is that selling most of his mortgage inventory will wipe out his equity. Purchases by the Treasury will not help. Unless the Treasury decides to "stick it" to the taxpayers by paying much more than the market price, the seller is no better off than if he sold in the market. That is one flaw in the Paulson plan.

It is not the only flaw. Treasury Secretary Hank Paulson's plan helps banks and lenders. It does not address the problem--an excess supply of housing. Eliminating excess supply will end the housing problem and help the mortgage market because mortgage value depends on house value. Buying or adjusting mortgages will not do much for house prices. And any programme to rewrite mortgages in default encourages more defaults.

To address the housing problem, Congress and the administration should take actions that increase the current demand for housing. For a limited time, say up to the end of 2009, allow buyers to use the value of their down-payment (or some part of it) as a tax deduction. Or, reduce the tax rate for qualified buyers who purchase a house between now and January 2010. Or do both. Give the benefit to all home buyers, including those buying a second or third house.

Some may be speculators. Not a problem. The goal should be to remove the excess supply of houses and condos, not to reward or punish particular groups. Increased housing demand will work to stabilise prices, not immediately but sooner than would otherwise occur. Reducing the excess housing stock reduces defaults by slowing price decline. And it brings nearer the time when homebuilding increases.

Some proposals urge the government to buy mortgages. This does little to remove the excess supply of houses, although it may reduce the number of defaults. But reducing defaults does not stimulate the demand for housing. It helps some who are hurt and may keep the problem from growing, but it does not relieve the problem of existing excess supply.

Congressional leaders talk about helping states with their budget problems or rebuilding infrastructure. The latter takes time to implement. Whatever the merits of these proposals, it is more important now to try to solve the main problem we face. We have to set priorities. Encouraging job growth by financing infrastructure may be in the long-run interests of taxpayers and the public, but there can be no full recovery without an end to the housing problem.

Allan H. Meltzer is a visiting scholar at AEI.