Expand the Housing Tax Credit

• House prices are declining across the entire nation and show no indication of improving soon.

• Without expanded policy help for housing, the nation risks a longer and deeper recession.

• Expanding the housing tax credit passed earlier this year could be the key to spurring sales and stabilizing house prices.

Despite indications that the worst of the financial crisis and economic downturn is over, conditions remain extraordinarily fragile. Hundreds of thousands of jobs are being lost each month, and the unemployment rate will soon be in double digits. Calls for policymakers to pull back efforts to shore up the economy are very premature. Rather, policymakers must remain aggressive or risk a much longer and deeper recession.

The need for more policy help is clearest with regard to the housing crisis. National house prices have plunged more than 30% since peaking over three years ago and are now back to levels seen in late 2002. House prices are falling in all but a handful of the nation's 392 metro areas and across the housing market, from low- to high-priced homes. Most disconcerting, the price declines show no indication of letting up.

The resulting loss of household wealth is enormous and weighs heavily on consumers' willingness and ability to spend. Since the peak in housing wealth, homeowners have lost more than $5 trillion in home equity, and close to 15 million homeowners—more than a fourth of all those with first mortgages—are estimated to be under water; their homes are worth less than they owe. With nest eggs so cracked, households are in no mood to spend more.

The combination of millions of underwater homeowners and millions of unemployed workers is leading to an unprecedented number of foreclosures. Some 3.5 million homeowners are on track to default on their mortgages this year, taking the first step in the foreclosure process. Defaults since the crisis began total around 7.5 million. The financial pain to these families and their communities is extraordinary and adds to the monumental woes of the financial system. As long as house prices fall and foreclosures rise, financial institutions will remain reluctant to extend credit to anyone, strong as well as weak borrowers. And without ample credit, the economy will struggle.

Stable but low

Many hope that as house prices fall, affordability will improve, attracting buyers and ultimately stabilizing the market. Affordability has indeed improved and has helped to stabilize demand, but at very low levels. Sales of new and existing homes are as low as they have been since the early 1990s, and almost half qualify as distress sales, including foreclosures and short sales.

Even this level of sales will be in jeopardy if the recent sharp runup in mortgage rates isn't reversed soon. Such a reversal seems increasingly unlikely, as the Federal Reserve appears reluctant to intensify its efforts to get mortgage rates down. The Fed has committed to purchasing $1.75 trillion in Treasury bonds and Fannie Mae and Freddie Mac loans and debt. This tactic worked for a while; fixed conforming loan rates fell as low as 4.7% this spring. But with mortgage rates up nearly a percentage point since then, policymakers don't seem inclined to increase their commitment. Some at the Fed view the higher rates as evidence that the economy is improving and therefore doesn't need additional help, while others are nervous that investors believe the Fed's buying will fuel high inflation in the future.

Rising mortgage rates are already undermining another policy effort to stimulate mortgage refinancings. The Obama administration has recently given Fannie and Freddie authority to refinance mortgages with loan-to-value ratios up to 105%. This is an important change from the 80% loan-to-value ratio previously required, since many homeowners have suffered such large drops in value that they no longer can refinance into another conforming loan. Despite the new rules, most Fannie and Freddie loans are no longer candidates for refinancing at current mortgage rates, since most have coupons close to the current market rate of 5.5%.

Efforts to stem the surge in foreclosures are off to a disappointingly slow start. The Obama administration's plan provides monetary incentives to mortgage servicers and owners to temporarily reduce monthly mortgage payments for qualified homeowners. But for various reasons, the plan has resulted in very few modifications. More are expected later this year as kinks in the plan are worked out, but odds are high and rising that the effort will fall short as declining house prices and rising unemployment reduce the number of homeowners eligible for a loan modification.

Breaking the spiral

The increase in interest rates has come at a particularly unfortunate time, just as an $8,000 tax credit for first-time homebuyers—part of the fiscal stimulus passed earlier this year—was expected to have its maximum benefit. To qualify for the credit before it expires December 1, buyers will have to sign a sales contract by late summer, meaning they should be shopping now. The tax credit was supposed to spur additional purchases soon; the goal was to break a deflationary, self-reinforcing cycle in which prospective buyers wait for prices to stop falling before buying—causing prices to drop even more.

Nervous policymakers are contemplating what to do next. One idea is to expand the housing tax credit. Under legislation now being debated in Congress, the credit would be increased to $15,000 for all homebuyers and would be extended for a year. Although this incentive wouldn't end the housing crisis, it would be very helpful, particularly if combined with a more concerted effort to promote meaningful loan modifications and stem foreclosures.

Based on simulations of the Moody's Economy.com macro model, the expanded tax credit, if extended through the end of 2010, would increase 2010 sales by almost 600,000. This in turn would generate $33 billion in additional real GDP, lifting growth in 2010 by about 25 basis points. That would translate into $56,000 in real GDP generated for each additional home sale. Benefits would flow to a range of hard-pressed industries, including mortgage lenders, real estate firms, insurance companies, property maintenance and repair businesses, and building supply retailers.

An expanded housing tax credit won't be cheap; it would cost taxpayers an estimated $36.5 billion. This implies that the one-year multiplier—the bang for the buck—is approximately 0.9. This compares with multipliers of 1.5 and above for government spending and 1 for most temporary individual tax cuts. It is measurably higher than most temporary business tax breaks, whose multipliers are generally no higher than 0.5.

The multiplier probably underestimates the tax credit's economic benefit, given its timing. The maximum benefit would occur next summer, when buyers would have to take advantage of it before it expires. This is just about when the fiscal stimulus will wind down and the economy could well be having difficulty adjusting. The job market should be more stable and excess housing inventories reduced by then, enhancing the credit's effectiveness in stimulating home sales, stabilizing housing values, and perhaps even jump-starting homebuilding (given lower inventories). Ultimately, a self-sustaining economic expansion will not fully take hold until house prices hit bottom.

There is one important caveat to this analysis: Since the housing tax credit will have already been extended once, homebuyers may think it will be extended again. For the credit to be effective, it will be vital for policymakers and the housing industry to convince the public otherwise. It will be particularly counterproductive if the industry lobbies to make the credit permanent, arguing that home sales could be hurt in 2011 after it expires. Assuming policymakers are able to deflect such calls, expanding the housing tax credit soon would make a meaningful contribution to ending the housing and economic crises.