Tight Lending Regulations are a Wealth Subsidy

Part Eight of Kevin Erdmann's Housing Affordability Series

In my last essay of this series, I explored how tight lending standards have removed options for middle- and lower-income households to be homeowners and cut off conduits for supply of new homes.  This appears to have improved housing affordability in terms of price, but the important measure of housing affordability is rent. This lending crackdown caused rents to rise, especially for households locked out of the option of ownership.

How do lending regulations affect homeowners?  Regulations that limit lending act as a wealth subsidy by reducing the cost of housing for more financially secure buyers.

Loose lending standards or low interest rates are broadly recognized as an important factor in the housing bubble that preceded the financial crisis.  On some level, the connection is undoubtable.  Commentators today generally express relief that public policy is more geared toward keeping “bubble” prices from reappearing.  But should monetary policy and federal housing credit programs aim for lower prices?

Here, it is useful to employ a basic financial identity to think about the relationship between yields on investment, rental value, and price for potential home buyers.  Each can be expressed as a function of the others.  Homeowners don’t pay themselves a rent check each month, but we can still infer an effective monthly rental expense of their home based on this financial identity.

Net Rental Value after maintenance and expenses = Rate of return on investment × Price

For a home buyer who doesn’t need a mortgage, the rate of return they require is based on and fixed by their other potential investments.  So for home buyers, a lower price effectively means that a home has a lower rental cost to them in their role as a tenant. 

In other words, mortgage regulations that limit credit access are rental subsidies for buyers who are wealthy enough to buy without a mortgage.  They can live in the same house for less cost. (You could also say they earn a higher rate of return.  The two are interchangeable, arithmetically.  In either case, they are receiving a subsidy.)

The same can be said for buyers who do need a mortgage, but who still qualify for a mortgage under the stricter regime.  If the mortgage market is regulated through exclusion, they also receive a rental subsidy.  Mortgage regulation that decreases the number of qualifying borrowers is a regressive transfer to financially secure home buyers. It is a rent subsidy.  They too can live in the same house for less cost.

Regulations that affect mortgage interest rates have a slightly different effect.  A change in mortgage interest rates changes the rate of return that mortgaged buyers require.  When they purchase a home, they will gain an asset, but that asset will be paired with a new liability – the mortgage.  The interest rate on that mortgage will determine the rate of return they require on the home.

For leveraged buyers, higher interest rates may be offset by a lower price.  If higher mortgage rates lead to lower pressure on home prices from leveraged buyers, then the effect on their ability to afford a home may be small.  If they don’t bid prices up as high because of the higher mortgage costs, then the negative effect of higher interest rates and the positive effect of lower prices might cancel out, leaving the implicit rental cost about the same.

This is one reason why some experts don’t see much value in financial technologies like the Fannie Mae and Freddie Mac mortgage programs, because it seems that if those programs lower interest rates on mortgages, it just ends up pushing up home prices, having no net effect on affordability.  But that is thinking only in terms of price affordability.  Rent affordability is more important.

Thinking in terms of rental value, public policies and market innovations that lower mortgage interest rates can be broadly beneficial to consumers, even if those benefits don’t accrue to the actual borrowers who use those low rates.  That is because higher mortgage interest rates have a similar effect on price as exclusionary lending standards.  Downward pressure on price creates a rental subsidy for home buyers who don’t require a mortgage.

Certainly, there is a strong case to be made for minimizing traumatic transactions that lead to defaults and foreclosures.  Mortgage markets that avoid those are clearly superior.

But public programs and policies that limit access to mortgages come at a cost.  Mathematically, policies that either restrict access to mortgages or increase their cost act as a regressive redistribution of income to wealthy and financially secure home buyers. 

Policy debates should focus on minimizing defaults, but we should not be so concerned about prices.  Pushing up prices is not necessarily a knock against a given program or policy. We should focus on the effects on rental value instead.  Rising home prices mean that there is less of a rent subsidy going to wealthy homebuyers and falling home prices mean that there is more of a rent subsidy to wealthy homebuyers.

If there is one certain effect of generous mortgage markets, it is a higher implicit rental cost for wealthy owners compared to less wealthy non-owners.  Whatever other factors might be considered in an analysis of mortgage and housing markets, this factor remains as a mark in favor of generous lending.

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