It comes as no surprise that a great debate surrounds the fate of the $8,000 first-time home buyer tax credit which was originally part of the $787 billion economic stimulus package signed by President Obama in February and is set to expire November 30 of this year.
At first glance, the credit has been enormously successful. The IRS reports that so far 1.4 million households have claimed the new tax credit as first-time home buyers. The subsidy program has generated a great deal of activity, helping stabilize the U.S. housing sector.
With the expiration date rapidly approaching, supporters of the tax credit fear that the housing recovery may stumble in the absence of this housing subsidy. Opponents believe that extending the program would be costly, expressing concerns about excessive government spending and a run-away federal budget deficit. They also believe that a tax credit program does not solve the problems of the housing sector; it only postpones dealing with those problems.
It is a fact that the tax credit program has been expensive. Over $14 billion have already been allocated to the program and Economy.com Chief Economist, Mark Zandi, estimates that a 6-month extension would cost an additional $15 to $17 billion. However, participation in the program has been high; some 1.8 million households are expected to participate in the program before it expires. Zandi estimates that the tax credit will add nearly 400,000 new and existing home sales by the time of its scheduled expiration. The National Association of Homebuilders more conservatively projects 165,000 more home sales than would have occurred. Opponents correctly point out that although the program generated 400,000 additional home sales (using Zandi’s estimates); another 1.4 million households took advantage of the tax credit even though they would have purchased a home in the absence of a tax credit. That is taxpayer money not well spent.
Although opponents of extension offer a convincing case, I believe there is a stronger case to be made for extending the tax credit. The housing sector continues to be in a fragile state; home values on a year over year basis continue to fall, home inventories remain in excess, and a meaningful number of households either lack the confidence, financial wherewithal and/or credit/underwriting requirements to purchase homes. Not surprisingly, the tax credit program and the Federal Reserve’s mortgage debt purchase program (keeping mortgage rates near historic lows), combined to mitigate some of these market problems, boosting home sales and pushing the housing sector onto a definite but wobbly recovery path. If the government were to pull back on these programs, the housing sector is at risk of taking two steps backward.
Extending the housing subsidies does a great deal more good than harm. The projected $15 to $17 billion cost of extending the tax credit program for another 6 months pale in comparison to what the costs would be if the housing markets go in retreat once again. According to most research studies, the housing sector influences about 15 to 20 percent of GDP growth. If housing activity stumbles, so does the appliance industry, the furniture industry, the building industry and so on. In other words, if the housing sector retreats so may the U.S. economy which could end up costing the American taxpayer a great deal more money than the cost of a six month extension.
Ever since both programs were launched earlier this year, both new and existing home sales have trended upward, while the pace of home price depreciation has slowed. More importantly, the fundamentals in the housing markets improved during this period. I cannot overemphasize how important fundamentals are to the long-term health of the housing sector. It was the collapse of market fundamentals that led to the Great real estate contraction these past several years. Affordability conditions deteriorated, mortgage loans were approved using irresponsible underwriting practices, most real estate investment activity was speculative, home inventories climbed to excessive levels, and household wealth plummeted, to name a few.
The current tax credit program is, effectively, buying time for market fundamentals to return to health; and an extension would likely build on those improvements. For example, new and existing home inventories are falling and making progress but are still excessive and need to fall further. The months’ supply for existing homes fell to 8.5 months in August from a peak of 11 months posted in November 2008. While the 2.5 month drop represents great progress, 8.5 months’ supply is still considered excessive. Months’ supply generally hovers in the 5 to 7 month range in a well balanced, healthy housing market. There is also a threat that a rise in foreclosure filings over the next several years, due to rate resets on option ARM and interest only mortgage loans, could add to an already excessive supply of homes. This likely development highlights the importance of sustaining a healthy pace of home sales.
Similarly, rebuilding household wealth takes time and it is first beginning to show improvement. Household wealth rose by $2 trillion to $53.1 trillion in the second quarter of this year, the first increase since 2007. However, household wealth is still $12.2 trillion below its $65.3 trillion peak posted in the third quarter of 2007. The large loss of household wealth over the past several years has inhibited consumer spending, particularly on big ticket items like automobiles and homes. Buying some time for households’ net worth to post further gains in the coming year is likely to bolster future home sales.
Other fundamentals such as affordability and mortgage rates are already in position for a housing expansion. Affordability measures (as measured by the National Association of Realtors’ housing affordability index) are near record highs and mortgage rates are hovering near record lows. Further, mortgage underwriting practices are now more fundamentally sound compared to the frenzied boom years.
What harm is served if we extend the first-time homebuyer tax credit program another 6 months so that market fundamentals can continue to improve? Opponents of the extension believe that it is appropriate to compare the tax credit program with the just recently expired Cash for Clunkers program. They point out that in the Cash for Clunkers program people, who might have purchased a car later in the year, rushed to purchase cars in anticipation of the program expiring. As a consequence, dealer traffic slowed to the lowest levels in nearly three decades after the program ended. They fear that a similar bleak scenario could play out for the housing industry.
Comparisons between the two government programs are misguided because market conditions in each industry are so different. Unlike the housing industry, the automobile industry never experienced a collapse in market fundamentals. Automobile prices never ballooned, automobile inventories never surged, and automobile financing practices never strayed from basic underwriting fundamentals. The automobile industry is down because of a severe economic recession, massive job losses, reduced household wealth and incompetent management and planning. It is no surprise that the Cash for Clunkers program proved to be a temporary fix. A more realistic remedy for the automobile business (other than ill-advised government bailout money) is for the economy to expand and create jobs and for the major U.S. automobile manufacturers to improve efficiencies, cut production, consolidate and develop more realistic business plans. Conversely, if the homebuyer tax credit is extended at least another six months, we do not anticipate a dramatic fall in home sales. This is because we expect market fundamentals to improve while the tax credit is active, strengthening the demand for homes and driving down home supply.
At present, there are a number of bills before Congress that would extend the tax credit–some offered by the House of Representatives and some offered by the Senate. A popular Senate bill proposes to extend the tax credit program for six months. Most of the House bills extend the credit for one year; some even propose a doubling of the credit to $15,000. As of this writing, the Obama administration has not taken a side on potential legislation. Opponents and supporters of an extension are sure to engage in fiery debate over the next month. Let’s hope that the debate focuses on how best to accomplish a complete recovery for the housing sector rather than focusing on the short term costs of getting there.