Introduction

The United States federal government has a century-long history of promoting homeownership through subsidies to housing finance that are both direct (to homeowners) and indirect (through mortgage markets) (Slivinksi 2008). Following the recent, severe decline in house prices, spike in foreclosures, and related financial crisis, policymakers are discussing how to reform aspects of U.S. housing finance policy to create a more stable housing market.

In doing so, there are two main questions that policymakers and the public should consider: Is it desirable to promote homeownership, and, if so, how should policymakers go about it?

The Potential Risks of Promoting Homeownership

Policymakers historically have taken as given that it is desirable to encourage homeownership. However, the evidence on the benefits of homeownership is not conclusive, and the costs to individuals and society are often deemphasized.

What are the potential costs of homeownership? First, homeownership can be a costly option for households who need or desire mobility. Selling a home entails significant transaction costs. As a result, homeownership makes a household relatively more dependent on the health of the local job market. From a macroeconomic perspective, the inability or unwillingness of some households to sell their homes may act as additional sand in the gears of economic recovery from a recession. One result of the recent housing decline has been a large number of homeowners who are "under water" on their mortgages; they owe more than the home is currently worth. Even prior to the recent experience, households with negative equity were half as likely to relocate as other homeowners, according to one New York Fed study (Ferreira, Gyourko, and Tracy 2010), and states with the greatest incidence of negative equity during the initial years of the recent housing downturn experienced greater declines in residential mobility (Caldera, Sanchez, and Andrews 2011).

In addition, homes are far from the safe route to wealth they are often billed as for at least three reasons. First, while national house price averages have historically followed an upward trend, the past several years represent a painful lesson that house prices will not always rise. Second, and more importantly, local house prices are much more volatile than national averages, especially in large coastal cities. Third, homeownership leads a household to place "too many eggs in one basket" in regard to their portfolio of investments. Owner-occupied housing is typically the single largest investment one makes in a lifetime. While households can diversify their financial investments relatively easily — by holding an indexed security that tracks the overall market, for example — there are relatively few methods available to the average homeowner for protecting their portfolios against the risk that their housing asset will fall in value. As a result, one effect of subsidizing homeownership is to increase the attractiveness of a risky asset whose risks are hard to diversify.

Renters, by contrast, may be somewhat protected from adverse economic conditions. Economic theory suggests that the price of renting housing services will fall in recessions simply because demand for local housing should fall as well. Renters can more easily relocate in search of better job prospects or in response to declining neighborhood conditions, helping themselves and helping the overall labor market to function more efficiently. Lastly, renters often are explicitly protected against the risk of physical damage to their dwelling. Even if landlords pass the costs of insuring against these risks on to tenants, landlords may be able to obtain that protection more cheaply, especially if they own many properties.

For these reasons, the conventional wisdom that equates renting to throwing away one's money is misleading. Renting buys flexibility, a potentially better-diversified portfolio of assets, and a degree of protection against local economic fluctuations. For some households these advantages will be worth more in the long run than a housing asset, and a larger rental market may reduce the degree to which the economy as a whole is exposed to housing market risks.

Given the potential drawbacks of owning and the benefits of renting, why subsidize homeownership? A common argument is that homeownership creates beneficial side effects that economists call positive externalities. For example, many studies have documented that neighborhoods with a large proportion of owner-occupied homes tend to have better upkeep, higher-performing schools, lower crime, and greater civic involvement (For example, see summary provided by the National Association of Realtors in 2010.) The relevant question for policymakers is whether any positive externalities generated by additional homeownership are likely to outweigh the costs. If so, a case can be made for subsidizing homeownership.

However, the magnitude of the externalities is uncertain. It is difficult to tell whether homeownership is responsible for creating these benefits. As future sellers, homeowners clearly have incentive to invest in their own properties and their communities. It may even be the case that individuals likely to purchase homes have innate characteristics that make them more likely to invest in their communities in other ways. But individuals induced through policy to enter homeownership will not necessarily share these characteristics. Researchers have found it difficult to separate these effects. Without strong evidence, it is questionable whether those alleged externalities should be a basis for policy.

Below we address the costs of the two main avenues that U.S. housing finance policy has historically followed: indirect subsidies of housing finance through the mortgage market, particularly through the Government Sponsored Enterprises (GSEs), and direct-to-consumer incentives, most notably through preferential tax treatment of homeownership.

Dealing With the GSEs

Since their creation as private entities in 1968 and 1970, respectively, the GSEs Fannie Mae and Freddie Mac have existed to make mortgages cheaper and more widely available. Operationally, they do so by purchasing mortgages from lenders, thereby freeing up lenders' funds to extend additional credit to other borrowers. With the mortgages they buy, the GSEs create and guarantee mortgage-backed securities (MBS), some of which they hold as investments and some of which they sell to investors.

The GSEs receive an implicit subsidy from the government. As soon as the two GSEs began issuing MBS in the 1970s and early 1980s, markets widely expected that the government would provide the GSEs with emergency funding in the event of financial trouble, effectively guaranteeing that their creditors would be paid. As a result, investors have for decades been willing to lend to Fannie Mae and Freddie Mac at lower interest rates than to most other corporations. (The expectation of implicit backing was proven correct in the recent crisis when the GSEs were seen to be headed for failure and received government support that protected bondholders from loss.)

With an assumed government backstop, the GSEs and the institutions that funded them had reduced incentive to ensure that the mortgages they indirectly financed could withstand a nationwide decline in house prices. Given the large impact of GSE activities on the U.S. housing market, the GSEs' bias toward risk helped to similarly distort the incentives of other housing market participants. In the view of the Richmond Fed, this was a key component of the financial crisis of 2007 and 2008 (Lacker 2011). These risks were spread throughout the financial system as securities backed by mortgages were traded, repackaged, and resold among investors worldwide.

The subsidy the GSEs enjoy due to implicit government support is substantial. Economist Wayne Passmore of the Federal Reserve Board of Governors estimated the market value of that subsidy to be between $122 billion and $182 billion (Passmore 2005). Passmore concludes that more than half of those gains are likely retained by GSE shareholders rather than passed through to homebuyers in the form of more affordable mortgage financing, though other estimates vary.

Implicit guarantees also transfer housing market risk to taxpayers from the households, lenders, and investors that choose to enter into housing-related contracts. The combined liabilities of Fannie Mae and Freddie Mac exceeded $5.5 trillion in 2008, just under the total amount of U.S. Treasury debt held by the public that year. In 2009, Federal Reserve Bank of Richmond researchers estimate that Fannie Mae and Freddie Mac comprised nearly 13 percent of the total federal financial safety net — which itself includes well over half of the entire financial sector — even before Fannie Mae and Freddie Mac were placed into conservatorship (Malysheva and Walter 2010). The GSEs have received more than $150 billion in taxpayer funds since then. Before conservatorship, the government support of GSEs was implicit, meaning it did not appear on Congressionally approved budgets. If the GSE safety net were made explicit and more visible, taxpayers might very well view its size as unacceptable.

There is now a consensus among policymakers — illustrated by a recent proposal from the U.S. Treasury and the Department of Housing and Urban Development (U.S. Treasury and HUD 2011) — that at least some of the support that the two GSEs provide to the housing market must be unwound, potentially by dissolving Fannie Mae and Freddie Mac. A key principle of this discussion to date has been that private capital must have a larger role in housing finance, as the implicit subsidy provided to the GSEs has historically hindered the ability of private parties to compete.

In the Richmond Fed's view, eliminating that subsidy would be the most effective way to ensure an effective and stable market for home mortgages. For the reasons listed above, it would be better if most housing finance was unaffected by the distortions caused by government safety net support. Nonetheless, as reform proceeds a key risk is that a similar government-created entity or function could crop up in place of the GSEs, that is, one that similarly enjoys the market perception that it would be rescued in the event of failure. Policymakers should work to prevent these expectations from arising. To the extent that the government continues to support housing finance, the terms should be made explicit. Firms receiving support should be charged premiums to offset the subsidy it provides to them, and they should be regulated appropriately (Lacker and Weinberg 2010).

Rethinking the Nature of Subsidies to Homeowners

There is somewhat less consensus about how to reform other aspects of housing policy. The federal government has a long history of supplying direct-to-consumer support of housing finance, most notably in the form of favorable tax treatment of owner-occupied housing investments relative to financial investments. A key example is the long-standing mortgage interest tax deduction, which has existed since 1913 and was strengthened in the mid-1980s.

A common argument in favor of homeownership is that it promotes savings since households can build equity by making monthly mortgage payments. Ironically, however, most of the government's policies, especially the deductibility of mortgage interest, subsidize the accumulation of housing debt rather than equity.

It is true that debt may be beneficial to a homeowner if house prices rise, but if they fall, homeowners can find themselves owing more than they could sell the home for, making default and foreclosure more likely. Negative equity has been one of the strongest predictors of the record number of foreclosures in the recent housing downturn. When a large number of people own homes in which they lack substantial equity, the stability of the aggregate economy becomes more sensitive to house price changes, as we have seen. A San Francisco Fed study shows that developed nations that experienced greater increases in household leverage in the recent episode experienced faster house price appreciation and larger subsequent declines in household consumption following the housing bust, a phenomenon that research has found to also exist across U.S. states (Glick and Lansing 2010).

The emphasis on subsidizing debt also has led to unintended distributional effects. The mortgage interest tax deduction is regressive in nature since wealthier households are more likely to itemize their tax deductions as well as have larger homes and, consequently, larger mortgage interest payments to deduct. In 2006, households in the lowest 60 percent of the income distribution received 3 percent of the mortgage interest deduction proceeds, while the top 20 percent of filers receive more than 80 percent of the benefits (Gale, Gruber, and Stephens-Davidowitz 2007). In addition, theoretical (Cho and Francis 2010) and empirical research (Glaeser and Shapiro 2002) suggests that the mortgage interest deduction doesn't have a large effect on homeownership rates. These findings, combined with the fact that most of the gains go to higher-income households, suggest that the tax benefits tend to go to individuals who were already willing to buy a home. In other words, rather than pushing households into homeownership, the mortgage interest deduction may simply encourage people to purchase larger homes than they were already planning to buy. In addition, as noted, much of the large subsidy provided to the GSEs benefits their shareholders, who typically will not be the same parties policymakers have in mind as targets for homeownership subsidies. It is worth considering instead whether direct assistance to low-to-moderate income households — including, possibly, a focus on renting as an alternative to homeownership — better aligns with social objectives.

Given the pitfalls of subsidizing debt, an arguably better strategy would be to encourage the accumulation of home equity, as through tax-preferred savings vehicles that can be used for a down payment. Such programs provide households with incentive and means to build equity, and hence create the right conditions for the beneficial spillover effects of homeownership. Greater equity also reduces the likelihood of negative equity when house prices fall, thus better insulating the macroeconomy from house price changes.

Conclusion

Absent current government policies, some households would be shut out of the homeownership market. Is that a strong enough reason to maintain subsidies of homeownership? This is the fundamental question facing policymakers concerning U.S. housing policy. In the Richmond Fed's view, it is not clear that the United States should continue to devote substantial resources toward subsidizing homeownership.

Nevertheless, if policymakers still wish to promote homeownership, there are reasons to be concerned about the approach the United States has taken historically. First, support of the GSEs has directed taxpayer dollars toward subsidizing socially excessive risk, while transferring some resources to the already wealthy. Second, tax policy has encouraged consumers to accumulate more mortgage debt and less-diversified portfolios of wealth than they might otherwise hold. Third, both policies, while possibly having helped to expand homeownership, have combined to lead households and financial institutions to take on risks that can jeopardize the economy at large.

Richmond Fed Research and Speeches

Lacker, Jeffrey M. "Innovation in the New Financial Regulatory Environment." Speech to the 2011 Ferrum College Forum on Critical Thought, Innovation & Leadership, Roanoke, Va., April 7, 2011.

Lacker, Jeffrey M. and John A. Weinberg. "Now How Large is the Safety Net?" Federal Reserve Bank of Richmond Economic Brief No. 10-06, June 2010.

Malysheva, Nadezhda, and John R. Walter. "How Large Has the Federal Financial Safety Net Become?" Federal Reserve Bank of Richmond Economic Quarterly, Third Quarter 2010, vol. 96, no. 3, pp. 273-290.

Slivinski, Stephen. "House Bias: The Economic Consequences of Subsidizing Homeownership." Region Focus, Fall 2008, pp. 12-15.

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Other Research

Caldera Sanchez, Aida and Dan Andrews. "To Move or Not to Move: What Drives Residential Mobility Rates in the OECD?" OECD Economics Department Working Papers No. 846, February 18, 2011.

Cho, Sang-Wook and Johanna Francis. "Tax Treatment of Owner Occupied Housing and Wealth Inequality." Journal of Macroeconomics, vol. 33, no. 1, March 2011, pp. 42-60. (Abstract available online.)

Ferreira, Fernando, Joseph Gyourko, and Joseph Tracy. "Housing Busts and Household Mobility." Federal Reserve Bank of New York Staff Reports No. 350, October 2008.

Gale, William, Jonathan Gruber, and Seth Stephens-Davidowitz. "Encouraging Homeownership Through the Tax Code." Tax Notes, June 18, 2007, pp. 1171-1189.

Glaeser, Edward L. and Jesse M. Shapiro. "The Benefits of the Home Mortgage Interest Deduction." National Bureau of Economic Research Working Paper No. 9284, October 2002.

Glick, Reuven, and Kevin Lansing. "Global Household Leverage, House Prices, and Consumption." Federal Reserve Bank of San Francisco Economic Letter No. 2010-01, January 11, 2010.

Passmore, S. Wayne. "The GSE Implicit Subsidy and the Value of Government Ambiguity." Federal Reserve Board of Governors Finance and Economics Discussion Series No. 2005-05, February 2005.

Reforming America's Housing Finance Market: A Report to Congress." U.S. Department of the Treasury and U.S. Department of Housing and Urban Development, February 2011.

"Social Benefits of Homeownership and Stable Housing." National Association of Realtors, August 2010.

Housing Finance Policy
A full list of related research and speeches from the Richmond Fed