The Homeownership Gap

June 25, 2010

In 1995, the rate of homeownership in the United States began a steep rise and between 2004 and in 2006, peaked at 69%. As the housing boom collapsed and the recession fueled a sharp rise in unemployment, the homeownership rate fell to 67.2% in the fourth quarter of 2009.  The most recent reading indicates a reversion to the second quarter 2000 level.

As indicated in the chart (click to enlarge), the ongoing decline in the homeownership rate is approaching in magnitude the 2.3 percentage point slide observed in the early 1980s.

The economists at the Federal Reserve Bank of New York produce publications and working papers of interest to policymakers, academics, business and banking professionals, and the general public.  One of these publications is entitled Current Issues in Economics and Finance. 

In a recent edition of Current Issues (Volume 16, Number 5 – May 2010), authors Andrew Haughwout, Richard Peach and Joseph Tracy wrote a study entitled The Homeownership Gap in which they argue that the official homeownership rate from the Census Bureau is overstated in the sense that owners with significant negative equity act more like renters. The authors argue that the official homeownership rate will probably follow the homeownership gap to lower levels leading to “a decline in citizen participation in local affairs, with a concomitant loss of vigilance over the quality and efficiency of public services and institutions.”

The study provides a compelling argument for lower homeownership rates and the resultant consequences for the entire country.

What follows is a synopsis of their study.

In response to the surge in mortgage foreclosures during the Great Depression, the government created the Federal Housing Administration (FHA) and the Federal National Mortgage Association (FNMA, or Fannie Mae) to establish a standard mortgage product; the thirty-year fixed rate, fully amortizing mortgage.

In addition, during the late 1960s and early 1970s, as thrift institutions came under stress from rising inflation, the government played a central role in the creation of the market for mortgage-backed securities. The Government National Mortgage Association began issuing federally guaranteed mortgage pass-through securities backed by FHA and VA loans in 1970. Soon after, the Federal Home Loan Mortgage Corporation (Freddie Mac) started issuing mortgage participation certificates backed by conventional mortgages. Ultimately, the securitization of the bulk of new mortgage loans fell to the government-sponsored enterprises Fannie Mae and Freddie Mac, largely because of the implicit federal guarantee on the mortgage-backed securities and debt issued by these institutions.

All of these government moves, along with the changes in the tax code allowing homeowners to deduct mortgage interest and property taxes and exempt capital gains from taxes on the sale of their homes, were policies enacted to encourage people to become and remain homeowners.

The government’s support for homeownership is based on the view that ownership promotes “economically efficient” action.  In principle, the economic efficiency of an action refers to the ratio of the increase in social utility (or total consumer satisfaction) that it produces to the quantity of the community’s resources that it requires. In other words, government policy (or laws) that produce the greatest return for the resources invested.

Because owners have a financial interest in their property, they have incentives to take measures that will maintain or increase the value of that property. Some measures such as fixing a leaky roof are closely related to the house itself. Others, such as investing resources in the betterment of the neighborhood and the community, have broader beneficial effects on the local area, creating what economists call “positive externalities.” All of these measures will be reflected, or “capitalized,” in stable or rising home prices.

In 2001, William Fischel suggested that these capitalization effects prompt homeowners to act in the best interest of the property and the community.  He promoted the theory called “homevoter hypothesis”, asserting a close connection between homeownership and civic engagement.  The theory promotes the idea that homeowners will take an active interest in the policy decisions of the local government because these decisions affect the long-term value of their property.

However, the authors argue that these incentives will not operate for those that have “negative equity” in their homes.  For these homeowners, any increase in the value of their house will accrue not to them, but to the mortgage lender (up to the value of the mortgage). With little to gain, negative equity homeowners will be much less likely to pursue improvements in their homes or communities. Their situation is essentially analogous to that of renters, who have little incentive to make improvements to the homes they occupy since it is the landlord who reaps the economic benefits.

Large negative equity gaps in homeownership is also leading to the consequence of “strategic defaults” in which a homeowner who can afford to keep a loan current is still defaulting on their mortgage since any future increase in value will accrue only to the lender for many years to come.

The author’s concept of a homeownership gap reflects the dramatic growth in the number of negative equity homeowners; those who owe more on their mortgages than their houses are worth in the current housing market. While the official homeownership rate tabulated by the Census Bureau includes negative equity homeowners in its count of owner-occupied houses, the authors suggest that homeowners with substantial levels of negative equity would need to ramp up their savings by formidable amounts in order to retain their homes or purchase a new home. They calculate an “effective” homeownership rate that excludes negative equity homeowners from the sum of owner-occupied houses and counts them instead as the renters they are likely to become over time.

Their findings indicate that the difference between the official and the effective rates (the homeownership gap) is significant, measuring 5.6 percentage points for the nation as a whole and rising as high as 39 percentage points for the metropolitan areas that have been hit hardest by the housing crisis.

Their main argument is that the current effective homeownership rate is a good guide to the future path of the official rate. That is, unless house prices increase substantially, many negative equity homeowners will in fact convert to renters in the years ahead, and the measured rate of homeownership will decline toward the effective rate.

Homeownership gives individuals a financial stake in the long-run outlook for their homes and communities. A shift in the rate of homeownership may have significant implications for communities throughout the United States.

Posted by Scott R. Lodde

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