Arnold Kling  

It's Gambling, and it's Wrong

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With those words, I believe I shifted the debate at yesterday's hearing.

I was referring to buying a home with a low down payment. The example I used was a $200,000 home with $5000 down.

I received a lot of pushback. Senator Merkley of Oregon said that in his working-class neighborhoods with $200,000 homes, hardly anyone could afford a 20 percent down payment of $40,000. Housing advocate Janneke Ratcliffe said that in 2010, fifty-seven percent of home purchases were made with down payments of less than 10 percent.

In citing those facts, they want me to react by being more tolerant of low-down-payment home purchases. Instead, my reaction is:

YIKES!

Where are all the affluent, financially prudent home buyers, who can afford a 20 percent down payment? If there are not many of them out there, what does that say about the financial health of the middle class these days? Or, if there are a lot of them out there but they are sitting out this housing market, presumably they are pessimistic about house prices....What if they know something?

Ms. Ratcliffe cited statistics for what she claimed were low-down-payment loans done "right" over the past decade that have only experienced a 5 percent default rate. In response, I argued that a 5 percent default rate is high, which is a strong point. However, an even stronger point would have been:

The 5 percent default rate is only the tip of the iceberg of the devastation those loans have called. Think of all the people who did not default, but who still owe more on their mortgages than their houses are worth. Their lenders may not be unhappy. But thanks to you, those households now have negative savings. And you are proud of that? You should be ashamed of that.

Now that might have been uncivil. But the point that leverage works both ways is worth emphasizing. If you buy a house with 2 percent down and the price goes up, you win. If the price goes down, you lose. You may have less down side than up side, because you can default on the loan and make the lender eat much of the loss. But it is still gambling.

Another way of making the point would have been to ask Ms. Ratcliffe and the Democratic Senators if any of them eats their own dog food. That is, if buying a home that costs 20 times your net worth is so good for the working class, is that what you yourself have done? Have you levered up in housing to 20 times your net worth?

Housing advocates who pose as friends of the middle class are instead perhaps its worst enemies.


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COMMENTS (20 to date)
Brian Puj writes:

I haven't gotten a chance to watch the video, but did you ask them what they thought there was any chance that housing prices were so high in those neighborhoods because borrowers were able to lever up? Easy access to loans does nothing for "affordability", it just rewards people who have already bought by pushing prices higher.

MikeP writes:

Indeed.

If buying the house required a subsidy -- whether a direct subsidy such as a tax deduction or a convoluted subsidy such as an implicit guarantee to a GSE -- then the house is economically unaffordable.

If buying the house didn't require a subsidy, then it's just a shift in a paper price, making no material difference to the buyers but transferring money from taxpayers into developers' pockets.

Shayne Cook writes:

Dr. Kling:

Your testimony was excellent and exactly 'on mark' - well done - as is this post.

In response to Sen. Merkley's point (and others' similar implications), I would also add that the $200,000 home is a residual artifact of the past ten years. It's quite likely that that $200,000 home isn't 'worth' $200,000. Home prices have NOT fully re-priced to sustainable levels even now. And they won't be fully re-priced to sustainable levels until the residual government intervention in housing markets is cleared or stabilized.

One other point I would make, that should give you additional rhetorical 'ammunition' should you again be asked "whether ALL investments should be precluded from financing ..." is that a HOME has both an INTRINSIC value and an INVESTMENT value to its owner. Much of the discussion on the housing finance topic considers only investment value and completely disregards intrinsic value. (Actually, your reference to the 50% margin requirements for stock investments was quite good by itself. Again, well done.)

wintercow20 writes:
Where are all the affluent, financially prudent home buyers, who can afford a 20 percent down payment?

We only put $5,000 down on our $180,000 home. I kept the rest of the cash to help my brother-in-law make ends meet, to take care of our in-laws and to have enough cash to put our two kids into catholic schools in case for some reason our income will not cover all those things. The latter runs us $5,000 per year now, and will double when they enter grade school. This is the cheapest house in any place people would want to raise a family in our city - I suppose we could rent, but not where we live.

Incidentally, we have tried to purchase another home to use as a headquarters for a new business and it appears credit has tightened considerably. What we've had to do is to solicit funds from direct investors who don't mind having their money tied up in an illiquid home for a long period of time. That was easier than getting a bank loan.

Floccina writes:
Senator Merkley of Oregon said that in his working-class neighborhoods with $200,000 homes, hardly anyone could afford a 20 percent down payment of $40,000. Housing advocate Janneke Ratcliffe said that in 2010, fifty-seven percent of home purchases were made with down payments of less than 10 percent.

It seems clear to me that the only reason that homes in working-class neighborhoods cost $200,000 is because working class people can get loans with less than 10% down. IMO it would not be a tragedy if buildable lots were cheaper and the median home was smaller.

Richard A. writes:

I think politicians favor subsidizing the banks then pretend they are doing it for the little guy.

One way to make home ownership more affordable is property tax reform--but where are the politicians? One simple reform would be to tax the value of the land but cease taxing land improvements.

david (not henderson) writes:

@Shayne Cook, I would go further.

The Merkley concern about not being able to afford the downpayment on a $200K home assumes that house prices are a given and are independent of policies on downpayments. They aren't. Those $200K homes wouldn't cost $200K if mortgages required a 25% downpayment.

Floccina writes:
Another way of making the point would have been to ask Ms. Ratcliffe and the Democratic Senators if any of them eats their own dog food. That is, if buying a home that costs 20 times your net worth is so good for the working class, is that what you yourself have done? Have you levered up in housing to 20 times your net worth?

Even better ask them would lend money to a wroking person to buy a home that costs 20 their net worth with less than 10% down and give them the load for 30 years at a fixed rate.

Shayne Cook writes:

@david (not henderson)

Precisely.

Dan Weber writes:

I only watched the opening statements, not the back-and-forth.

That which cannot continue must stop. If prices for houses for the working class are too high, those prices will come down, by necessity.

But falling home prices, even if necessary, are seen as a bad thing by politicians.

MikeP writes:

Dan Weber,

Apropos of your comment, Reason's Matt Welch just put up this headline:

Housing Market Fails to Find Bottom Despite Every Attempt to Make Sure it Doesn't

Brad Warbiany writes:

Yes, it's gambling. But why is it *wrong*??

[Stipulate for the sake of conversation that we assume away all the government props under the housing market -- I do agree that gambling with the taxpayer's money is wrong, and it's absolutely inarguable that with the bailouts that's exactly what was going on.]

Buying a house with 20% down is a gamble, just as buying a house with 1% down is a gamble. There are a lot of homes here in CA that have dropped in value far more than 20% from the peak, particularly in the Inland Empire [Riverside, Corona, etc] area. Anyone in those areas who did the "prudent" thing and put 20% down is in far worse shape than those who did the imprudent "gamble" and put 1% down.

The key, and has been pointed out, is that these individual gambles, in the aggregate, can cause wild swings in overall prices by changing buyer behavior. Buyers who can buy at 1% down are taking a smaller downside risk for a higher upside reward. That makes it more likely they're going to gamble, and yes I admit there are negative repercussions to that. And given how many people spend WAY too much of their paycheck on the lottery every week, I think we can argue that for many of these buyers, they likely weren't properly understanding the odds.

But for every 1% down payment purchase that is now 40% underwater, there is another gambler at the table -- the bank. Whether the bank is legally allowed to provide 0-down loans or not is immaterial -- it was a dumb thing to do. For every 1% down payment loan they sell, they're assuming basically the entire downside financial risk of the deal. They underestimated the volatility of the market and should be paying the price now.

I say "should be" because the banks haven't really had to shoulder the downside risks of their own bets either -- the US Taxpayer, Fed, and Treasury are taking care of it for them.

So, in my opinion the gamble may or may not be wise, but it is not in itself wrong. It's a risk/reward calculation and while we assume the housing market to be generally stable and predictable, nothing inherent to the market must make it so. What makes the gamble wrong is that the US Government, with the full faith and credit in their ability to rob the US Taxpayer (or print money if necessary), has agreed to cover everyone's losses.

Arnold Kling writes:

Brad,
Of course an individual may make a free choice to borrow as much as the lender will allow and then accept the consequences. But do you think that's where the Democrats and the so-called affordable-housing advocates are coming from?

Jameson Burt writes:

"Option" rather than "gamble."
You can view the home loan contract as an option to buy,
an option maintained with a monthly payment.
When the current house value gets too low,
you merely cease renewing your option to buy.

Brad Warbiany writes:

Arnold,

No, I don't think that's where the Democrats and the affordable-housing advocates are coming from. They are actively pushing for increased government intervention into the market in order to make it easier for people without savings to buy a home, and yet don't seem to understand that the easier you make it to buy a home, the more prices will be driven up making 'affordable housing' less likely.

My point, though, is that outside of government interference in the market, the "gamble" is no more right or wrong than buying stocks on margin or driving off the sales lot in a new car with no money down -- you're measuring risk/reward, and you may or may not measure it properly or be able to shoulder the downside risk if it occurs.

That in itself is a valid economic calculation for both the borrower and lender. It's not right or wrong, until you start getting a third party insuring everyone's losses with someone else's money.

(Full disclosure, I just bought a house 3 months ago with a 3.5% down FHA loan. I did so fully knowing that there may be downside risk in today's market, and if we have both downside risk and a major life event -- i.e. loss of job -- I might be royally screwed. I probably wouldn't have that loan BUT FOR gov't intervention into the market, but I did take advantage of the gamble because I intend to stay in the home long enough that I like the odds -- and given the downside risk, I do prefer to gamble with the lender's and the taxpayer's money rather than more of my own.)

Ben Hughes writes:
But the point that leverage works both ways is worth emphasizing. If you buy a house with 2 percent down and the price goes up, you win. If the price goes down, you lose.

True, but I think we have to be careful here: I don't think the amount of your down payment has anything to do with your exposure of house price volatility risk per-say. That risk is entirely born on you as soon as you close on the house, regardless of if you paid cash or had a 1% down payment.

So I think this discussion is really a veil for what probably is the real issue: high net worth volatility. Low down payments on homes simply *signal* this ratio being very low in the sense that low down payments likely mean the buyer has relatively low liquid net worth.

If I have $100k in the bank and I put $4k down on a $200k house (where I could have made a 50% down payment), I don't see the mere fact that my down payment was 2% indicative of anything bad per-say. I just might be exceedingly conservative when it comes to cash.

MikeP writes:

I just might be exceedingly conservative when it comes to cash.

Or you might be nominally liberal when it comes to other investments, believing that you'll do better than 5% minus the 1/3 tax deduction if your money is in the stock market.

...or in more houses!

ed writes:

I think you should shoot for a 10%-down standard rather than 20%. I believe that 10% is adequate to get the vast majority of benefits, and it will be a lot easier to get people on your side. Also a sudden transition all the way to 20% might be more than the market can bear.

IMO by far the biggest part of the problem is the very low down payment mortgages, less than 5%. That's how you get a housing bubble, that's how you get unrealistic borrowers sucked in over their heads, that's how you get rampant fraud, etc. Most people will not default if they have skin in the game, and 10% is a lot for most people, and high enough to keep out the riff-raff.

robc writes:

There seem to be a lot of comments assuming mortgages are non-recourse loans.

In the majority of US states, mortgages are recourse loans, which means the downpayment isnt the limit on the downside (although, realistically it is, as you cant get money out of broke people).

Kenny writes:

Arnold – would you be (mildly) uncivil?Provocative enough for comic replay online and on TV. At least once. Please?

I'd love to see a clip featuring you on The Daily Show one night. Teach my liberal and progressive peoples something.

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