Tax Consequences of the Great Unwinding
by Byrne Hobart
In retrospect, we’ll view the last forty years as a bizarre aberration: during that time, speculation on an enormous scale was tolerated, celebrated, and even subsidized. The fact that this speculation occurred in residential real estate made it all the more insidious and dangerous.
Looking over the last forty years (from when Fannie Mae was privatized to when it collapsed), it’s clear that tax incentives played a huge role in creating the mortgage market, and in inflating the value of the real estate that fueled this market.
The mortgage interest tax deduction made it seem smarter to invest money in a home rather than another means of savings. Of course, a tax exemption doesn’t make homes any more comfortable, or improve the view: it just means that, relative to other investments, they’re easier to borrow against. If they’re easier for anyone to borrow against, their price will be higher than it otherwise could be — so the interest tax exemption did not so much make homes a better investment as make them a worse investment you were compensated for making.
That tax exemption alone would have been enough to inflate home prices, but only Fannie and Freddie could turn it into a self-sustaining disaster. Fannie Mae and Freddie Mac were slightly different entities with the same approximate goal: they were to make mortgages affordable to everyone by buying them, repackaging them, selling some, and holding on to the others. In principle, that’s not a big deal: anyone who had the money to overcome the regulatory hurdles could have promised to buy and trade mortgages, and for the same reason.
The difference is that Fannie and Freddie both had an implicit government guarantee: it was assumed that since real estate was so important to the American economy, they wouldn’t be allowed to default. “It was assumed” begs the question of who did the assuming and why. The approximate process was that when Freddie and Fannie were first created, they were closely related to the government; it was fair to assume that the Feds wouldn’t charter a new mortgage buyer only to let it flop a year or two later. But over time, Fannie and Freddie maintained this perception through aggressive lobbying. Freddie Mac spent up to $15 million each year on lobbyists, and Fannie Mae was not far behind at $10 million per year. They were both able to make their case more frequently than the average opponent, making it hard to get rid of their various advantages even had it been an option.
The combination of a de facto guarantee on their debt, and a subsidy on the mortgages they bought with it, made Fannie Mae and Freddie Mac a large and constantly growing force in the US mortgage market. Any newspaper will tell the story of their collapse, and the attendant collapses of other large companies involved in the same market.
What we don’t know is what comes next. All of their lobbying could very well have established enough momentum to keep the mortgage tax exemption in place indefinitely, but the debt guarantee is likely to disappear. This means that even though mortgages will still be tax-efficient, their rates will be higher and it will be much more difficult to get long-term, fixed-rate loans. The immediate tax consequence is likely to be negative, though: that implicit guarantee was the linchpin in a lot of transactions involving poorly-considered purchases of overpriced homes. As those homes get sold, the implicit-turned-real guarantee means that taxpayers will be on the hook for the losses. Avoidable, in principle, but some bad policies end up being best at entrenching themselves, and American tax treatment of homes seems to be one of them.