Everyone knows that subprime mortgages lie at the root of our current financial crisis. Lenders originated too many of them, they were securitized amidst an increasingly complex credit market, and the bubble popped. The rest is painful history.
Most commentators have explained the source of the problem by pointing either to faulty federal housing policies – such as Fannie Mae’s affordable housing goals, the Fed’s easy money practices, and the Community Reinvestment Act – or to the imprudent zest for gain among investors who miscalculated risk and kept up the demand for bad mortgages. Both views are correct to varying degrees. These perceptions will shape the ongoing policy debate about needed reforms.
But as this debate advances, we should not lose sight of another consequential, yet mundane, factor in the crisis: the way that regulations raised house prices and created conditions ripe for subprime loans. Regulations may be one of the least debated contributors to the current crisis, and yet their effect on the middle class’s ability to buy homes may arguably have been a key reason why subprime loans flourished in the first place.
In the heated housing market before 2007, a median income family in the U.S. could only afford 40 percent of homes for sale across the country, compared to more than two-thirds of homes in 1997. Banks got creative and helped ordinary families buy overly expensive homes with risky mortgages. In a hot market, the risks seemed low. People never should have purchased homes they could not afford, but at the same time, rising prices were putting homeownership out of the reach of ordinary families such that unconventional loans seemed a convenient solution.
Why were housing prices rising so rapidly? Observers have traditionally held that land scarcity drives up prices by preventing supply from meeting demand. But the more likely answer is that regulations on housing overly constricted supply in many parts of the U.S. Through the groundbreaking work of Wendell Cox at Demographia and scholars such as Ed Glaeser at Harvard and Joe Gyourko at the University of Pennsylvania, we have come to see that rules and regulations drive up housing prices much more than we had originally thought. Blaming supply problems on land scarcity has been a convenient excuse for too long for those who see hyper-regulation of housing as a good thing.
Regulations often limit the number of housing units that can be built on a given lot, or they restrict the number of new home permits that can be issued in a given municipality, making supply a function of rules, not land scarcity. Restrictions to the property itself, such as environmental or design requirements, also raise the cost of construction (see Andres Duany’s thoughtful article on this issue here.).
Increased regulation on housing has been a quiet, but disquieting, trend. For example, Glaeser has shown that only 50 percent of communities in greater Boston had restrictions on subdivisions in 1975, compared to nearly 100 percent today. Housing prices in the Boston area would have been between 23 and 36 percent lower on the eve of the crisis were it not for burdensome restrictions on housing. While the Boston area’s regulatory impulse may be excessive, it is nonetheless emblematic of a national trend. A recent U.S. Department of Housing and Urban Development has found that more than 90 percent of the subdivisions in a recent national study now have excessive restrictions.
According to Harvard’s housing research center, the growing cost of regulations has edged smaller builders out of the construction market and increased the market share of the nation’s ten largest builders from 10 to 25 percent since the early 1990s. This doesn’t mean that the larger builders are happy about restrictions. Bob Toll, president of one of the nation’s largest builders, has said that his company quit building “starter homes” for young families years ago because the margins on small homes grew too narrow due to excessive regulations.
How big is the problem? Most observers have typically agreed that housing regulations account for 15 to 35 percent of a median-priced home in the U.S. These percentages come from a 1991 federal housing commission, and they are likely to have increased considerably since then. If we conservatively use them to calculate the scope of regulations by the time the housing crisis began in earnest in 2007, they suggest that regulations accounted for between $35,850 and $83,650 of a median-priced home. Using the National Association of Homebuilders’ methodology for determining the impact of price increases on home affordability, we can say that regulatory restrictions priced at least 7 million – and as many as 18 million – families out of their local housing markets in 2007. As we have learned, families priced out of their markets still purchased homes – usually with unconventional, risky mortgages.
Of course, not all housing regulations are bad, and zero regulation would introduce unnecessary risks to homeowners. But the increasing rate of regulation in the U.S. represents one of the nation’s larger assaults on the middle class that defenders of “working families” rarely talk about. Conservatives avoid the issue for federalism reasons, since any effective restraint on land-use planners will likely require the federal government’s involvement. And liberals hide from an honest debate about the effects of regulations for fear that it will derail their environmental agenda that relies up on regulations to limit the kind of housing most people want – such as single family homes.
Now that there is an over-supply of housing in the U.S., the problem of housing regulations may seem moot. But if we do nothing about this issue, it will trip us up again in the future. While I served in the George W. Bush White House between 2005 and 2007, economists inside and outside the administration offered mixed – and sometimes completely contradictory – assessments of what was happening in the housing sector. We continued to work on our proposed reforms of Fannie and Freddie and the Federal Housing Administration in an effort to reduce the “systemic risk” but approached it more as a theoretical matter than as a perceived, impending crisis. We even had a HUD-based initiative on reducing regulatory barriers that quietly lumbered along but which we never elevated as a major policy issue. We now know that what we were grossly underestimating the scope of a potential crisis. We should have made housing sector reform a front burner issue.
That is all behind us now, and we can see much more clearly what led to the crisis. We need to look at how rule-makers have for too long been making housing unnecessarily expensive for ordinary families. There is a limit to what the federal government can and should do about local housing regulations, but options exist for President Obama and Congress to consider.
First of all, just as federal agencies are legally required to analyze the environmental impact of new regulations, Congress could require federal agencies to demonstrate the impact of new federal regulations on the cost of home construction. Federal agencies already have the personnel required for the task, and such a requirement would cost the taxpayer nothing extra. Second, Congress should consider new incentives in existing federal law, from highway construction to affordable housing, that would prompt states and municipalities to reduce burdensome regulations in exchange for federal resources. Third, President Obama could issue an executive order requiring federal agencies to amend regulations that have a negative effect on home construction costs. He could also use the same order to establish a task force whose job would be to identify the chief price-increasing regulations in use around the country to inform the legislative process.
If we ignore the problem, as the housing market recovers, regulations will once again make housing more expensive than it should be. Unconventional mortgages will no longer be available due to the current crisis, and we will be back in a familiar debate about “affordable housing” in which the federal government is called upon to subsidize housing that others have made too expensive. In other words we return to the status quo in which we once again increase the role of a government that – under both Republican and Democratic administrations – has gotten ever bigger, more expensive and increasingly intrusive.
Ryan Streeter is Senior Fellow at the London-based Legatum Institute and former special assistant to President George W. Bush for domestic policy.