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Wednesday, September 12, 2012

Reduce, Refinance, and Rent? The Economic Incentives, Risks, and Ramifications of Housing Market Policy Options

Sean M. Hoskins
Analyst in Financial Economics

The bursting of the housing bubble in 2006 precipitated the December 2007-June 2009 recession and a financial panic in September 2008. With the housing market seen as a locus for many of the economic problems that emerged, some Members of Congress propose intervening in the housing market as a means of improving not only the housing market itself but also the financial sector and the broader economy. Critics are concerned that further intervention could prolong the housing slump, delay recovery, and affect outcomes based on the government’s preferences. Three frequently discussed proposals for the housing market are (1) reducing mortgage principal for borrowers who owe more than their homes are worth, (2) refinancing mortgages for borrowers shut out of traditional financing methods, and (3) renting out foreclosed homes.

Principal reductions have the potential to improve the housing market by minimizing disruptive defaults and foreclosures. However, by shifting the debt burden from the borrower to the lender, principal reduction may negatively impact financial institutions that would have their investments’ principal balances reduced. Principal reduction, nonetheless, might improve the broader economy if it stimulates consumer spending, diverting income from debt repayment to spending on other goods and services.

Legislation introduced in the 112th Congress to reduce mortgage principal includes H.R. 1587, H.R. 3841, H.R. 4058, and S. 2093. The Federal Housing Finance Agency (FHFA), the regulator and conservator of Fannie Mae and Freddie Mac, decided against allowing the enterprises to reduce principal for mortgages that they guarantee.

Large-scale refinancing helps borrowers who are current on mortgage payments to refinance into a new mortgage with a lower interest rate. Because refinancing generally helps borrowers who are current, it is unlikely to have a major effect on the housing market, but it may prevent some foreclosures that could occur in the absence of a refinance. In addition, refinancing has the potential to have a larger effect on the economy by stimulating consumer spending. A mortgage refinance could lower a borrower’s monthly payment, freeing up more income for non-housingrelated spending. Some of the additional spending of borrowers may come at the cost of the financial sector. Although some financial institutions may lose investment income from refinancing, others could benefit from the increased business associated with refinancing.

President Obama, in his 2012 State of the Union address, proposed streamlining the existing program to refinance Fannie Mae and Freddie Mac loans and establishing a new mass refinancing plan for non-Fannie Mae and non-Freddie Mac loans. Congressional proposals for large-scale refinancing of Fannie Mae and Freddie Mac loans include H.R. 363, S. 170, and S. 3085.

Renting out foreclosed homes currently held by banks and other financial institutions has the potential to stabilize housing prices by reducing the supply of homes on the “for sale” market. However, this policy depends on house prices increasing in the future such that, when the rented properties are eventually sold, they are sold in a healthier market. Unlike principal reductions and mass refinancing, renting foreclosed homes does not reduce existing homeowners’ payments or increase their disposable income. Any impact on consumer spending is likely to be indirect through stabilizing house prices and preserving neighboring homeowners’ equity.

FHFA implemented a pilot project to convert foreclosed homes into rentals. Legislative proposals to expand the renting of foreclosed properties include H.R. 1548, H.R. 2636, and S. 2080.

Date of Report: August 28, 2012
Number of Pages: 43
Order Number: R42480
Price: $29.95

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