Monday, January 23, 2017

Should Renters Subsidize Homebuyers and Banks?

Should renters subsidize homebuyers and banks?
That question may sound rhetorical. But judging by the reaction to President Trump’s action on the subject, a surprising number of people would answer it in the affirmative.
Last Friday after the inauguration, the Trump Administration announced that it was canceling a planned 0.25% cut in Federal Housing Administration (FHA) mortgage insurance premiums. The cut had been announced by the Obama Administration less than two weeks earlier, but had not yet been implemented. Thus, Trump’s action was a return to the status quo that existed at the start of 2017.
It’s a complicated issue, so it’s easy for politicians and journalists to obscure the reality of what’s going on here and advance a political agenda.
For instance, Senator Chuck Schumer (D-NY) used it the opportunity to attack Trump for being a hypocrite. “One hour after talking about helping working people and ending the cabal in Washington that hurts people, he signs a regulation that makes it more expensive for new homeowners to buy mortgages,” Schumer said.
Meanwhile, left-leaning media outlet The Intercept described Trump’s decision as a tax increase on middle-class homebuyers that helps the banking industry.
Both of these takes are misleading, but it’s not obvious why unless we understand the underlying mechanics of the FHA program.
What Does the FHA Do?
The FHA does not give out mortgages directly. Instead, it offers mortgage insurance to borrowers that protects lenders if the borrower defaults. In other words, the FHA provides a government guarantee that a loan will be repaid.
This government guarantee allows FHA-insured borrowers to get generous and forgiving loan terms that probably would not be available otherwise. Borrowers can qualify for an FHA-insured loan with as little as a 3.5% down payment and with a credit score as low at 580 (on a scale from 300 to 850). In this way, the program expands the opportunity to own a home to more people–people with less savings and/or riskier credit histories.
FHA mortgage insurance is not given away for free. Borrowers pay for the FHA mortgage insurance as part of their monthly mortgage payments, as a percentage of their overall loan. But the American taxpayer is on the hook as well. If  the FHA has to pay out more in default claims than it has received from insurance premiums–because it has charged premiums that are too low–then taxpayers are left with the bill.
Importantly, a taxpayer bailout is not just a theoretical outcome. The FHA actually received bailout to the tune of $1.7B as recently as 2013, as it struggled to recover from the repercussions of the Great Recession.
Who Benefits?
The generous terms offered under FHA-insured loans expand the pool of potential borrowers and homeowners, in line with the FHA’s mission. At least on the surface, this directly helps those borrowers. To the extent that FHA insurance allows these borrowers to get access to financing on better terms than the private sector would offer on its own, the program acts as a subsidy to those borrowers.
The insurance premiums paid by the borrower to the FHA offset the value of the subsidy. If the insurance premiums are higher, all things equal, the net value of the subsidy is lower and vice versa. Thus, Obama’s decision would have increased the value of the subsidy and Trump’s decision canceled it.
That said, it is worth debating whether the FHA program is really helping borrowers in the long run. It helps them afford something they could not otherwise afford. That sounds like a benefit, but we must remember that it’s not making the house itself cheaper or increasing their own income. In effect, it’s just allowing them to take out a much larger loan, with a lower down payment, than they otherwise could.
If house prices suffer even a modest decline, that means these same borrowers could quickly find their mortgage underwater, owing more than the house is worth. Similarly, if they lose their job, they might find themselves falling behind on mortgage payments. In other words, just because the FHA makes more people able to buy a house, it doesn’t mean they can actually afford it. In the last crisis, there was certainly no shortage of people who stretched to buy expensive homes and got wiped out because of it.
While the overall impact on borrowers is up for debate, the FHA program offers clear benefits to other groups. Banks and mortgage lenders benefit from having an expanded pool of borrowers that come with a government loan guarantee. Reducing the mortgage fee premium would have expanded the pool of borrowers further by reducing the monthly mortgage payment required. All else equal, this means more borrowers would have been able to buy a house, and borrowers who could already afford a house could have afforded a larger one.
In this way, Obama’s decision to cut premiums would have benefited banks by giving them more potential customers. Trump’s decision to cancel the cut means that banks will no longer receive that benefit.
The same story applies to real estate professionals and the homebuilding industry. These groups would prefer FHA premiums were as low as possible because it maximizes their potential customer base. Therefore, Trump’s decision to cancel the premium reduction prevented them from getting an additional benefit.
As noted above, the taxpayer is ultimately on the line if the FHA fails. Accordingly, one group that is harmed by reducing FHA premiums is the taxpayer. Lower premiums would cause the FHA to be in a less stable financial position, which in turn makes a future bailout more likely. Taxpayers thus benefited from Trump’s decision to cancel the premium reduction.
Obviously, the best scenario for the taxpayer is if the FHA didn’t exist to demand a bailout in the first place. But the next best thing is having the FHA run in a financially conservative way.
Why Renters Lose
The other group impacted is renters. This group is unambiguously harmed by the FHA program. And the degree of the harm increases as the premiums charged decline. This occurs in two ways.
First, renters are harmed by the FHA as taxpayers. If the FHA requires another bailout like it did in 2013, renters will ultimately be paying for a share of it.
Second, renters are forced to pay inflated rent prices that are caused by the FHA. The mechanism here is less obvious, but no less real. Recall that the FHA enables people to buy homes who could not otherwise afford it. This results in a higher effective demand for homes than would otherwise exist, driving housing prices higher. And as housing prices rise, rent prices follow. Thus, renters are paying higher rent each month than they would be in the absence of the FHA program.
This leads us to the very perverse effect of the FHA program. Generally speaking, renters tend to be poorer than homeowners. Similarly, people (renters) whose low income and/or poor credit histories render them ineligible for FHA loans are poorer than people (homebuyers) who are eligible. So when the FHA benefits homebuyers and banks at the expense of renters, this amounts to an upward redistribution of wealth from the poor to the less poor. As the insurance premium rates are decreased, this upward redistribution effect is increased.
So finally, we arrive back at our original question:
Should renters subsidize homebuyers and banks? Or said another way, should the relatively poor subsidize the relatively rich?
Whether you’re a libertarian, a progressive, or something in between, the answer should be no.
And it follows that Trump’s decision to cancel the FHA premium reduction warrants praise, not criticism. Knowingly or not, he just prevented an unjust system from becoming more unjust.

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