How Mortgage Finance Affects the Urban Landscape

Mortgages Are Not Like Other Loans

Four out of every five Americans live in urban areas, so it is not surprising that housing dominates the landscapes of US cities. Most Americans see home ownership as the key to their financial progress, and most rely on mortgage financing to buy dwellings, because saving enough to buy a home outright would take too long. The mortgage market dictates the rate of home ownership, which in turn influences the stock of housing, as well as other factors like population density. The government has almost always been involved in the mortgage market, given its socioeconomic impact. The availability of mortgage credit was a large factor in the dramatic rise in homeownership rates during the boom period of the late 1990s and the early 2000s.

“The 2000s witnessed an enormous boom-bust cycle in the residential real estate market, followed by the sharpest contraction in the overall economy since the 1930s.”

Most collateralized loans require both an initial margin and a maintenance margin from the borrower; those enable the lender to call the loan as soon as the collateral appears to be worth less than the loan. In a mortgage, the initial margin is the down payment, which establishes the loan-to-value (LTV) ratio, and that determines the interest rate. The lower the LTV ratio – or in other words, the larger the down payment – the more favorable the interest rate. Because mortgages, unlike other collateralized lending, don’t call for a maintenance margin, the drop in a home’s value to below that of the loan outstanding creates negative equity for the borrower.

“For many owners, and for the great majority of renters, purchasing a home will mean obtaining a mortgage.”

American mortgages are usually long-term loans, typically amortizing over the course of 30 years. Unlike in several other developed countries, mortgages in the United States can be nonrecourse – that is, lenders have only the proceeds from the sale of a mortgaged property with which to satisfy their loan, and they may not sue the borrower for any deficiency if the home is worth less than the loan. Homeowners can cash in the equity they’ve built up in a property through price appreciation and payments by refinancing their mortgages and using the proceeds however they like, but that can create a higher risk of default. Multiple loans can use the same property as collateral, but this arrangement can complicate matters among lenders during interventions aimed at assisting a distressed borrower. Usually, borrowers can’t move a mortgage from one property to a different property or pass their mortgage along to the buyer of their home.

Owner Occupiers

Given the relative scale of the purchase, for most people, owning a home requires either making many years of “consumption sacrifices” or obtaining a mortgage, and usually both. As such, the availability of credit and the terms of that credit determine, to a large extent, the level of homeownership versus the demand for rental housing.

“Negative equity is a more important consideration for mortgages than for other types of collateralized loans.”

The down payment required for ownership sets a ceiling for the maximum credit available to the borrower. A smaller required down payment means that borrowers can buy a more expensive house. The interest rate will determine how much that credit will cost the borrower each year: Lower interest rates make larger debt more affordable.

“The mortgage market has long featured a prominent role for both explicit and implicit government influence.”

Taxation plays an important role in the affordability and attractiveness of mortgage financing, most significantly through the US federal tax deduction of interest paid on mortgages. But even barring mortgages, US tax treatment favors owner-occupiers over renters. A primary residence is omitted from bankruptcy settlements, estate tax calculations, and eligibility assessments for Medicaid and student loans. These aids increase the demand for homeownership and thus for mortgage credit, which provides greater benefits as the level of debt increases.

Supply and Demand

Although destruction, abandonment and demolition do occur, reducing the supply of homes isn’t feasible in the face of falling demand; rather, prices drop for existing homes. When demand increases, prices rise, but how much they increase depends on how able and ready a particular area is to increase its stock of housing. Favorable tax treatment and positive changes to mortgage rates or down payment amounts cause the housing demand to rise. In areas where supply can’t match this demand, prices can go up rapidly. These higher prices, in turn, make special tax treatment much more valuable.

“One important way that mortgage finance can affect the urban landscape is through its effects on the extent and distribution of homeownership.”

From a public policy perspective, this means that wealthier people, who can afford more expensive properties, gain the bulk of the housing benefit. As home prices rise, so does the down-payment requirement, which mostly affects young borrowers on modest incomes. The rate of home ownership in Canada, the UK and Australia – which have eliminated mortgage interest tax deductions – is still similar to the US homeownership rate of 65.2% as of the end of 2013.

Access and Distribution

That doesn’t explain how homeownership and access to mortgage credit vary among income, ethnic, racial and age groups in America. Households with incomes lower than the median have a homeownership rate of 50.2%; for Hispanics, the rate is 45.5%; for blacks, it’s 43.2%; and for under-35 households, it’s 36.8%. Antidiscrimination laws prevent lenders from using ethnicity or race as decision criteria, and lenders can’t “redline,” or withhold mortgages from areas based on residents’ race or ethnicity. However, research in Boston indicated that lenders showed bias toward nonwhites in their loan decisions in 1990. Legislation such as the Community Reinvestment Act obliges federally insured banks to provide credit to low-income communities, and that has helped improve ownership rates in disadvantaged areas.

“Research “shows large and persistent differences in homeownership rates by race and ethnicity: The black-white and Hispanic-white gap is never smaller than 25 percentage points.”

When mortgage lending, including subprime mortgages, accelerated in the early 2000s, lower down-payment and credit score requirements, poor documentation of income and assets, and initially low teaser rates with high rate resets became more common. Many less-informed, low-income borrowers were unaware of the true extent of their future payments. Studies have shown that such lending was much more prevalent in lower income areas with a predominance of nonwhite consumers.

“Home equity is the primary component of nonpension wealth for most seniors.”

Inexperienced borrowers often paid cash to mortgage brokers, who also received commissions from lenders. Many people who ended up with subprime mortgages shopped around less and thus paid a lot more for their loans than other borrowers. One study showed that brokers were less likely to respond to mortgage queries from minorities than from whites. Other research found that real estate agents also differentiate among potential buyers, showing black and Asian buyers far fewer homes than comparable white buyers.

Life Lived Through the Mortgage Contract

In general, younger households require more flexibility in their housing arrangements so they can respond more easily to job opportunities. Rental properties are also more likely to be in areas that suit younger people, with proximity to work and entertainment. These preferences change for families that want to be closer to schools and desire more space and outdoor area. While some young purchasers would qualify for a mortgage on an income basis, affordability is still a huge issue when paying for rent while trying to save for a down payment. Young households from poorer families find it far more difficult to accumulate that initial margin. Because property ownership is one of the most common ways of amassing wealth in the United States, obstacles on the road to getting a mortgage only increase inequality.

“Homeownership is widely recognized as a tool for wealth building among lower income households because the monthly payment on an amortizing mortgage serves as a form of forced saving.”

At the other end of the age spectrum, the aging of the baby boomers means an unprecedented number of pensioners over the coming decades. While homeownership is relatively lower for younger households, it increases with age and peaks at more than 80% for those over the age of 65. Members of older generations will depend on the equity in their homes – a major portion of their assets – to finance their longer life expectancies. They have several options to turn that equity into cash. First, they can sell their properties and downsize, but that may not be palatable for people with an emotional attachment to their homes. Foregoing home maintenance expenses is another method, but that’s not an optimal choice. Releasing equity via a new mortgage or home equity line of credit could leave the homeowner with higher monthly payments.

“Subprime mortgage lending was disproportionately made in nonwhite and poorer neighborhoods. These loans…turned out to be much quicker to default during the bust phase of the housing cycle.”

The reverse mortgage offers homeowners aged 62 or older a way to realize the accumulated equity in their homes without the pressure of monthly payments. In fact, the loan is repaid only when they relocate, sell the house or die. An added benefit is that the loan is nonrecourse, so loved ones aren’t left with a debt burden if the sale proceeds fall short of the loan amount. Insurance premiums reduce the risk of negative equity due to falling prices or long-lived homeowners. Aging householders don’t commonly use reverse mortgages, despite these advantages, but this remains an important channel of equity release if needed.

The Negative Side of Home Equity

One obvious side effect of the housing bust was large-scale negative equity. At the end of 2009, almost one in four borrowers owed more on their mortgage than their property was worth. By the end of 2013, that figure had almost halved, due to real estate prices recovering, borrowers repaying debt and banks repossessing properties. Despite this, negative equity still has a number of important long-term implications for American communities.

“At younger ages, borrowing constraints are most important, while at older ages, the ability to draw down housing equity is the biggest concern.”

Householders can stop making payments on a home with negative equity, even if they have the means to continue to pay their mortgage. While these “strategic defaults” appear to have accounted for only a minority of defaults in the period following the financial crisis, they increased the natural levels of foreclosures and restricted defaulters from re-entering the housing market for many years.

“In addition to a diminished incentive to invest in their homes, pervasive negative equity could lead to underinvestment in local public infrastructure.”

Negative equity also severely affects the turnover of housing stock, since selling a home in negative equity means that the borrower somehow has to make up the mortgage shortfall. The decline in the turnover rate grows as negative equity increases, which has a follow-up effect on people’s mobility as well as on labor markets. Turnover is important to communities: When people move, they tend to spend for related needs, which helps improve their local economies.

“Recent decades have seen substantial increases in income inequality that may well be exacerbated by the current system of mortgage finance and by some aspects of housing-related public policies, including the tax code and mortgage industry regulation.”

Another important side effect of negative equity is that homeowners reduce their investment in improving and maintaining their dwellings because they won’t see any return from the investment, either immediately or into the future. This is especially true if a risk of default exists, whereby the lender would benefit from the investment. One report suggests that negative equity could cause as much as a 74% reduction in housing investment.

Foreclosure

Negative equity inevitably led to a sharp increase in the rate of foreclosures – from 0.6% of all mortgages at the beginning of 2007 to 3.9% in 2012. Subprime lending practices in particular added to this spike in foreclosures, particularly in poorer neighborhoods. Borrowers who invested in property due to easy credit were also more inclined to enter foreclosure as soon as those investments turned sour. Delinquencies in property tax payments and tax lien foreclosures are another consequence of negativity equity. The fall in property tax revenue can also affect local services and make areas with high foreclosure rates more undesirable.

“The development of new mortgage forms is costly, while the benefits are difficult to capture privately.” (economist Robert Shiller)

Foreclosures can create an unfortunate contagion effect, whereby the prices of surrounding houses fall as the area becomes saturated with available and often rundown properties. Foreclosures can impair borrowers’ credit scores for years, adversely affecting their financial future. Studies also show that children who have had to change schools after a foreclosure often end up in less academically advantaged schools.

American mortgages in their current form haven’t changed in 80 years, but the nation’s society and economy have. Restricted access to credit and homeownership worsens income inequality. The disappearance of traditional pension plans means more and more longer-living retirees will have to depend on their homes to cover their rising medical and other expenses. The private sector is unlikely to deliver an improved mortgage that will address these pressing socioeconomic concerns. It falls on government to encourage innovation in housing finance, as it did when it promoted the 30-year amortizing mortgage back in the?1930s.