IMF Frowns on Mortgage Tax Deduction. Recommends Return to Basics

by devteam April 7th, 2011 | Share

There have been six major banking crises in developing countries since the mid-1970s, all were associated with housing booms followed by busts according to an InternationalrnMonetary Fund (IMF) Global Financial Stability Report to be issued next week.  </p

The degree to which these cycles havernbeen associated with financial instability differs among countries due in partrnto important differences in countries’ housing finance systems, including thernrole of government.  However, where recessionsrnare linked to housing booms and busts, those recessions are on average morernsevere and last longer than those that are not. rn </p

IMF released twornchapters in its report titled Durable Financial Stability: Getting There from Here.  One chapter is devoted to the role of a country’s housing sector on thernstability of its economy as a whole.rnThe IMF study looks at characteristics of the housing markets in dozens ofrncountries, both “advanced” and “emerging” to determine whatrncharacteristics correlated with instability in the housing market and foundrnthat boom/bust cycles were caused or at least magnified by several factors:</p<ul class="unIndentedList"<liExcessiverncompetition and aggressive lending often associated with deregulation; </li<liCapitalrninflows that sustain the supply of credit to households while leading tornvulnerable funding for lenders and borrowers;</li<liAnrnextended period of low monetary policy rates</li</ul

Thernrelationship between rising house prices and mortgage credit growth,rnparticularly in advanced economies, was amplified by government participationrnin housing finance.  Subsidies tornfirst-time home buyers, tax deductibility of capital gains on housing, andrngovernment provision of mortgage guarantees or credit tend to amplify housernprice swings by exacerbating both the boom and the subsequent bust.  There are indications that certain tax breaksrnto homeowners are particularly likely to distort demand and lead to volatilityrnin house prices.  The report chides thernObama Administration for failing to recommend elimination or modification ofrntax deductions for home mortgage payments in its recent plan to reform the housingrnfinance system, calling that policy “both expensive and regressive.”   </p

Thernstudy specifically faults the U.S. for the role private label securitizationrnplayed in the housing crisis because of its association with deterioration inrnunderwriting standards and incentive problems. rnOnce the crisis began, it also led to a situation in which servicersrnhave had little incentive to renegotiate loans because of the compensationrnmodel in their contracts.  The reportrnsuggests that the US might do well to adopt the covered bond model which hasrncontributed to safer mortgages in Europe and could complement securitization asrncapital market mortgage financing.</p

Goingrnforward, the report suggests that both advanced and emerging economies would dornwell to return to basics; solid underwriting standards consistent across variousrntypes of lenders; prudential limits on loan-to-value ratios and debt-to-incomernratios, and “better-calibrated” government participation.</p

Thernreport says that the later means that government participation should have lessrnfocus on direct provision of credit and more concern about system effects andrnexternalities.  It would also rely onrnmore targeted measures to achieve social objectives such as affordable housingrnfor low-income households.  Somerncountries, the report says, might want to reconsider their focus onrnhomeownership; good-quality rental housing could be a better option forrnlow-income households.  This could bernaccompanied by more level tax treatment across owner-occupied and rentalrnhousing and reassessment of tools such as mortgage interest deductibilityrn”which should be capped and apply only to first mortgages on primaryrnresidences”</p

IMFrnmakes some additional suggestions for housing finance reform specific to thernU.S including enhanced internal risk management at financial institutions and improvedrnunderwriting standards and supervision. rnHousing related tax expenditures should be reviewed and the role of therngovernment sponsored enterprises (GSEs) reassessed so as to create a more levelrnplaying field in the mortgage markets. rnIt applauds most of the administration’s recent recommendationsrnincluding winding down the GSEs by gradually raising their insurance guaranteernfees, reducing their investment portfolios, and lowering the conforming loanrnceiling.  The report also comes downrnsolidly in favor of one of the three options for government involvement inrnhousing finance suggested by the Administration – a privatized system plusrnpublic catastrophic reinsurance with first-loss insurance coverage from privaternsources  “The option is likely tornprovide the lowest-cost access to mortgage credit and would make governmentrnparticipation (and taxpayer exposure) explicit. rnHowever, pricing the catastrophic insurance will be challenging givenrnthe need to avoid overinvestment in housing that would exacerbate distortionsrnand contingent liabilities.</p

Governmentrnguarantees for securitized mortgages need to be continued for the near termrngiven the Resignificant remaining uncertainty in the mortgage markets andrnsubstantial swings in the cost of financing could be particularly damaging  However, government guarantees should bernexplicit and fully accounted for on the government’s balance sheets.  Over the medium term the GSEs should be woundrndown to make way for private-label securitization to reemerge as a viablernoption.

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About the Author


Steven A Feinberg (@CPAsteve) of Appletree Business Services LLC, is a PASBA member accountant located in Londonderry, New Hampshire.

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