How To Save The Housing Market: Destroy Houses

If you close your eyes and try to imagine Middle America, you might picture Lakewood, Ohio, a working-class suburb of Cleveland whose orderly residential streets, tidy houses with postage-stamp lawns and median household income of $44,000 are the very foundation of the American Century. With good public schools, an economically diverse population, multiple parks and 33 churches, it’s been home to generations of families in the Cleveland area. “It’s got it all,” says Jacob Stoll, 35, who grew up on the Lake Erie shoreline and runs the family insurance business on Lakewood Avenue.

Now cut to a 30-ton yellow excavator tearing down those homes. Neighbors come out to watch the spectacle as dilapidated row houses and elegant turn-of-the-century Victorians collapse in plumes of dust. It’s an increasingly common scene since local authorities began acquiring foreclosed properties 20 months ago. Wreckers paid by county and municipal officials have taken down 12 of Lakewood’s homes, another 11 will be demolished in the coming months, and more are on the way out. A thousand of Lakewood’s 12,000 one- and two-family homes are in some kind of financial distress, with 600 of them delinquent on their taxes, 200 sitting vacant and another 200 in foreclosure.

(See pictures of foreclosed homes being demolished in Cleveland.)

To hear Lakewood’s mayor, Mike Summers, tell it, the demolitions are a good thing. “We’re not gonna miss these houses,” Summers, 57, said in mid-August after taking the controls of a wrecker to splinter the lath-and-plaster walls of a single-family home at 1549 Lakewood Avenue, across the street from Stoll’s house. Beginning in the mid-1990s, 1549 Lakewood flipped from one absentee landlord to another as mortgage bundlers packaged it with other properties and sold them to investors. Lakewood officials have tracked some holders of local mortgages as far afield as Pakistan. After the 2008 housing collapse, 1549 Lakewood became a criminal-nuisance property. “The place was falling apart,” Summers said.

But Lakewood’s demolition derby is about something bigger than nuisance properties: it’s an attempt to save the town’s economy as a whole. Like the rest of the country, Lakewood is still struggling to recover from the shock of the 2008 collapse. With a 6% drop in tax revenue, a $3 million drop in state funds and an 8.3% unemployment rate, the town needs to find a new way out. Razing houses, officials say, will increase competition for the remaining homes, driving up real estate values. That, in turn, will make it easier for homeowners to refinance to cheaper loans, freeing up spending and boosting consumer confidence. “It’s a matter of supply and demand,” says Dennis Roberts of the Cuyahoga Land Reutilization Corp., a quasi-government-controlled nonprofit, or land bank, that is overseeing the destruction of more than 645 homes in and around Cleveland.

(See pictures of struggling Cleveland.)

Partly destroying a city to save it would have been unthinkable just a few years ago. But across the country, economists and politicians are embracing increasingly radical ideas as a seemingly obvious fact gains consensus. America can’t get out of its economic doldrums until it fixes the problem that caused the crisis in the first place: housing. “The recovery will never turn into an expansion that we are comfortable with until housing has turned,” says Mark Zandi, chief economist for Moody’s Analytics.

Watch TIME’s video “Foreclosures in Cleveland: Taking on Banks and Blight.”

The problem is that three years on from the crisis, housing is getting worse, not better. New numbers show home sales falling, and the number of Americans behind on their mortgages is once again rising after modest improvement. While Washington has been focused on the federal debt, the U.S.’s $9.12 trillion of consumer real estate debt — down 10% from its 2008 record but still about triple what it was in 1999 — has been the real drag on recovery. According to private-sector and government economists, national home prices have plummeted 40% from their highs five years ago, the largest drop ever, worse even than during the Great Depression, wiping out $7.1 trillion of housing wealth (still most Americans’ largest asset). That has left 14.6 million homeowners in the U.S. with mortgage debt greater than what their house is worth, according to Zandi. Deeply underwater homeowners, government and private economists say, hamper the economy in several key ways. For starters, they can’t walk away from their homes to find jobs somewhere else, which is one reason the unemployment rate remains as high as it is. More broadly, underwater borrowers spend a disproportionate amount of their income servicing their debt every month, leaving less money to pump into local businesses; and even when they have extra cash, they are disinclined to spend it because they worry about their budget and future economic uncertainty. When they are forced to walk away and foreclose, often because of losing a job and with it the ability to pay the mortgage, it dumps more cheap supply onto the housing market, further constraining prices. Home prices have dropped 4.4% in the past 12 months. Since the beginning of 2007, homeowners have lost 5.2 million houses to foreclosure or in distressed sales, according to Moody’s Analytics. Some economists predict that as many as 5 million homeowners still struggling to make payments will move into foreclosure before the crisis ends.

(See a slideshow about a photographer’s requiem for the American home.)

The hollowing out of the housing industry has put over 1 million people in the building and related trades (including construction, real estate sales, assessment and DIY retail) directly out of work; the indirect job-loss effect may triple that. But it’s also responsible for a larger chunk of economic malaise, says economist Dean Baker. He figures that for every dollar drop in their houses’ value, homeowners spend 6¢ less on other stuff, resulting in a collective $430 billion drop in consumer spending from the bubble’s 2008 peak, or a 3% hit to the economy. Taken all together, that could be the difference between a recovery and a double-dip recession.

Economists are only now beginning to appreciate just how different this housing-driven recession is from previous downturns. “We’ve never had so many people underwater since the Great Depression,” says Yale economist John Geanakoplos. Then as now, solving the problem required radical action. In 1933, Franklin D. Roosevelt halted the foreclosure tide by inventing things like the 30-year fixed mortgage and creating the Home Owners’ Loan Corporation, which issued long-term government-backed loans to 4 million Americans facing default. Before it was all over, the government had bailed out a full 20% of the country’s mortgages.

See the tales of a lost mortgage.

It’s a figure worth remembering because, as much firepower as we think we’ve thrown at housing, we haven’t done nearly that much, even though housing prices have dropped further this time than when FDR was President. Two and a half years on from the crisis, just 760,000 Americans, or 1.5% of the country’s 51 million mortgage holders, have received modifications through Barack Obama’s signature program, the Home Affordable Modification Program — and nearly half of them have defaulted anyway. After a total of $18 billion in government spending on housing bailouts since 2008, the President declared in early July that the efforts had largely failed: “We’re going back to the drawing board.”

Indeed. In Washington, policymakers have been heard to fantasize about bulldozing 3 million homes nationwide in order to turn the economy around. That won’t happen — at least not yet. But this fall, the Administration is planning to introduce new housing measures as part of a desperate push to speed recovery ahead of the 2012 elections. A debate is under way inside the White House over just how far to go. Economists briefing the Administration are pushing radical housing ideas, and history has already taught us that that may be what’s required to turn around the U.S.’s $18 trillion housing market. Below are four of the most-talked-about proposals and how they’d work.

(See pictures of Americans in their homes.)

1 LIFT THE DEBT BURDEN
Early in Obama’s term, Yale’s Geanakoplos tried to persuade top White House advisers to launch an updated version of FDR’s massive mortgage-release plan by writing down mortgage principal nationwide. The Administration feared it would hurt the banks, which would have been forced to write down the value of the loans on their books. Three years and, by Geanakoplos’ count, 2.5 million evictions later, the argument is increasingly irrelevant. The banks have had to write down the loans anyway, and economists are calling for more bailouts. Now the Administration and the banks say they fear moral hazard — the idea that a bailout for people who haven’t been making their mortgage payments would encourage those who are making them to become delinquent too.

There are ways around that problem. The easiest fix is to refinance home mortgages at today’s historically low interest rates. But a combination of bad credit, underwater loans and banks’ reflexive fear of postcollapse lending means that refinancing is much tougher than it used to be. That, says R. Glenn Hubbard, who was George W. Bush’s top economic adviser from 2001 to ’03, presents a huge opportunity. Now the dean of Columbia Business School, Hubbard is proposing with colleagues Christopher Mayer and Alan Boyce a national refinancing of mortgage debt for the estimated 37 million federally guaranteed loans Americans have with government mortgage issuers like Fannie Mae and Freddie Mac. The issuers would send borrowers an application to refinance at current low mortgage rates; the borrowers would have to be current or become so for at least three months; no down payment would be required; and the government would guarantee the new loans just as it chose in 2008 to guarantee the existing ones, meaning taxpayers would not be taking on any new risk.

A national refinancing effort could slow the number of foreclosures by making mortgage payments more manageable for borrowers who can stay in their homes if they get a few thousand dollars a year in interest savings. It might also stimulate consumer spending — Hubbard estimates $50 billion to $70 billion worth — as homeowners wouldn’t feel quite so pinched. “A national refinancing would be like a large, permanent tax cut which would have a very big effect on the economy,” says Hubbard, who has briefed the Obama Administration since he introduced the idea.

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The Hubbard plan would help bring down interest on payments, but it wouldn’t deal with the fact that so many homes are still underwater. On that score, Harvard professor Martin Feldstein, formerly Ronald Reagan’s top economic adviser, has proposed reducing mortgage debt by cutting the loan principal with a government subsidy issued with very low interest rates. If the market stabilized, Feldstein says, the cost to taxpayers would be $200 billion. The new loan would discourage homeowners from walking away from their houses by making their other personal assets, like bank accounts or cars, also subject to repossession if they defaulted again.

(See pictures of of the Reagan White House.)

Perhaps the best chance for principal reduction may come for those who are current on their payments and have loans with the biggest mortgage servicers. Bank of America, Wells Fargo, JPMorgan Chase and others may soon be forced by state attorneys general, who are seeking a collective $20 billion in penalties for faulty lending, to write down some individual mortgages. “We think there’s a good chance that targeted principal reduction will be part of our deal,” says Geoff Greenwood, spokesman for Iowa attorney general Tom Miller, who is leading the negotiations on behalf of 50 state AGs.

2 RIP OFF THE BANDAGE
Geanakoplos says government should do something simple and perhaps coldhearted: save the good loans and abandon the bad ones by writing down only those 1.2 million deeply underwater loans guaranteed by Fannie and Freddie whose borrowers are still current on their payments. Seriously delinquent loans would be left to fail.

He and other economists in and out of government believe that for many underwater homeowners, even tweaks to the principal won’t be enough to save their homes. “The fact of the matter is that you’ve got some people who are just too underwater, too behind. All it’s going to do is prolong the inevitable,” says one government official involved in principal-reduction negotiations with the banks.

As coldhearted as it sounds, speedy foreclosure is often the fastest and most effective way to get rid of burdensome mortgage debt and boost the economy. Two counties in the metro-Washington area show how. Prices boomed in both Prince William County, Virginia, and Prince George’s County, Maryland, in the mid-2000s. Both had a higher-than-average share of subprime mortgages. And when the bust came, prices in both areas collapsed. The result was mass foreclosure. Prince William had some of the highest foreclosure rates in the country. Prince George’s accounted for nearly a quarter of all foreclosures in Maryland.

Four years later, their stories have diverged. Prices in Prince William County have rebounded nearly 50% from their early-2009 lows. Foreclosures have shrunk dramatically. Multiple offers are back, and it takes just 47 days on average to sell a home. By contrast, home prices in Prince George’s have fallen 18% in the past year, and foreclosures or distressed sales account for about 57% of all transactions.

What happened? Housing economist Thomas Lawler says the problem isn’t too many foreclosures; it’s too few. Looking at the two counties, he found that Virginia is one of the fastest and easiest places in the nation for banks to take houses from borrowers who aren’t paying. Foreclosures came early and often in Prince William. But in 2008, Maryland passed a law that lengthened the foreclosure process to 150 days from just 15. Another law passed in 2010 forces banks to offer more modifications to delinquent homeowners. There are of course other differences between the two counties — Prince William has a slightly lower unemployment rate — but Lawler believes foreclosure rules have been key. “More foreclosures would have allowed the market to clear itself and recover earlier,” he says.

The better housing market has in part translated into a better economy for Prince William County. Prince William’s job market has snapped back faster since the recession, topping out at an unemployment rate of 6.6% in February 2010 before dropping steadily. In June, the latest month for which figures are available, the rate fell to 5.3%, from 5.8% a year earlier. In Prince George’s, unemployment reached a high of 7.9% before dropping in 2010. Recently, unemployment in Prince George’s rose again, to 7.5% in June, up from 7.4% a year ago. Now Democrats and Republicans in a number of states, including Ohio, Colorado and Illinois, are pursuing laws that would fast-track foreclosures.

3 DON’T OWN — RENT
With as many as 5 million more foreclosures still expected by some economists before the crisis ends, the approach of speeding evictions raises an obvious question: Where will these millions of people live? The Obama Administration, which has spent $7.6 billion on housing for the evicted, recently proposed that such people should go back into foreclosed homes as renters.

Since the housing crisis began, economists like Yale’s Robert Shiller have made the point that homeownership in the U.S. has been unwisely fetishized, given that it is a historically bad investment compared with stocks and bonds, costs the government some $100 billion a year in subsidies (in the form of mortgage-interest and property-tax deductions) and covers up fundamental economic problems — like stagnating wages that erode a middle-class lifestyle — with debt.

See 50 milestones in the life of Barack Obama.

The housing crisis presents a good opportunity to rethink homeownership. With rents in many states rising, private investors who think they can make money renting unsold Fannie and Freddie homes have been clamoring for access to them. On Aug. 10, the Treasury Department sent out a notice requesting ideas for just how investors might do that in a way that would reduce the number of unsold foreclosed houses on the market, save taxpayers money on the loan guarantees the federal government has on the homes and improve the properties, among other conditions. Scenarios include outside investors’ buying bundles of unsold foreclosed homes, repairing them and renting them out. Alternatively, the government could maintain ownership, sharing the profits with a private investor who manages the property and splitting the equity when the arrangement liquidates. After the program had run for some time, a final decision would be made on what to do with the houses: keep renting them, sell them or tear them down.

By reducing the supply of houses for sale, the program might cut “credit losses and help stabilize neighborhoods and home values,” said Edward DeMarco, acting director of the Federal Housing Finance Agency.

4 BACK TO THE BULLDOZERS
The Administration’s willingness to consider demolitions as part of the endgame for its rental program suggests that Cleveland’s plan to bring in the bulldozers may be ahead of its time. In 2009 Ohio passed a law that enabled the creation of the Cuyahoga Land Reutilization Corp., which can buy up properties for rehabilitation or demolition. The land is then given to neighbors or to churches and other nonprofits for expansions or is used for community gardens.

It’s a growth market. There are 15,000 vacant properties in the Cleveland area, with more coming every month as the foreclosure crisis worsens. Foreclosures decrease the value of nearby homes by $7,200 on average, according to the Center for Responsible Lending, and vacant properties discourage potential home buyers and attract crime. “In Cleveland or Detroit or Flint, the volume of abandoned properties is so significant, we are never going to have the stability and predictability housing markets need unless we do something about it,” says Frank Alexander, a law professor at Emory University.

There are about 80 land banks around the country, many clustered in Michigan. But a number of states, including New York, have recently passed or are considering laws allowing land-bank development. Ohio’s new law eases land banks’ ability to seize properties that are delinquent on their taxes. The Cuyahoga County land bank has taken over more than 1,000 properties since 2008 and disposed of about 360 of them since 2010, and its bulldozers are active almost every day now. The private sector is getting involved too. In June, Bank of America, eager to look like part of the solution for once, agreed to give 100 homes to the land bank and pay $7,500 per home toward demolition costs. Other banks — Citigroup, JPMorgan Chase and others — are participating elsewhere.

Feldstein, Zandi, Hubbard and Geanakoplos say that without radical actions like those described above, it will take years for the market to stabilize. The effect of the drag could well be a double-dip recession. That’s why the best approach is likely a combination of all of the above policies, boldly pursued. Obama should make Fannie and Freddie offer refinancing-interest reductions for everyone with home loans from the government. He should force principal reductions for those who can still service their government-guaranteed loans. He should encourage speedy evictions for those who will never be able to pay. He should push ahead with plans to rent foreclosed property to provide housing and diminish the supply glut. And for the rest: bring on the bulldozers.

Getting out of the crisis will require one other thing too: perseverance by the millions of Americans who are living with the consequences of decades of crazy lending and borrowing. Jacob Stoll, who grew up in Lakewood, runs the insurance company his grandfather started on Lakewood Avenue and plans to send his two young sons to the same public high school he graduated from, is hanging in there, in part because the city tore down the nuisance property across the street. The police were there twice a day, he says, and he got tired of explaining to his 3-year-old what was going on. “I was about to leave,” he says, but now he’s decided to stay. “I’m a Lakewood guy. I’m not giving up on this city,” he says.