Bethany McLean has an excellent column on the FCIC report, concentrating on the explosion of debt among both homeowners and banks. The numbers bear repeating:
From 1978 to 2007, the amount of debt held by the financial sector increased twelvefold, from $3 trillion to $36 trillion…
The end of the housing market’s era of financial sobriety came, by one plausible reckoning, with passage of the Tax Reform Act of 1986. That much-praised legislation ended the tax deductibility of interest on credit cards and other consumer debt but left in place the mortgage interest deduction…
The numbers in the commission’s report chart the surge in housing-related debt: “By refinancing their homes, Americans extracted $2 trillion in home equity between 2000 and 2007, including $334 billion in 2006 alone, more than seven times the amount they took out in 1996.” Of course, all of this came at a cost: “Overall mortgage indebtedness in the United States climbed from $5.3 trillion in 2001 to $10.5 trillion in 2007. The mortgage debt of American households rose almost as much in the six years from 2001 to 2007"”more than 63%, or from $91,500 to $149,500"”as it had over the course of the country’s more than 200 year history.” This was during a period when overall wages were stagnant. To cut the figures a different way, as the commission helpfully does: Household debt rose from 80 percent of disposable personal income in 1993 to almost 130 percent by mid-2006. More than three-quarters of this increase was mortgage debt.
On top of that, Citi was operating at 48-to-1 leverage, if you include its SIVs and whatnot; Frannie had 75-to-1 leverage; and Bear Stearns, with $12 billion in equity at end-2007, was borrowing as much as $70 billion overnight.
What does all this devastating debt have in common? It’s tax deductible against income. The more you pay in debt service every year, the lower your taxable income. And so both banks and homeowners have a strong incentive baked into the tax code to load themselves up with as much leverage as possible.
One of the saddest things about the departure of Paul Volcker from any formal role in the Obama administration is that the strongest voice in favor of ending the tax-deductibility of corporate debt service has now been muted even further. It’s pretty clear that households loaded up on home equity lines largely because they were so attractive from a tax perspective: normally people are pretty shy about putting their homes at risk that way. And banks just threw all risk management out the window, to the point at which the top brass didn’t even know what exactly was going onto their ballooning balance sheets.
When the US revamps its tax code, as it must, it should tax the things it wants less of, like debt and carbon emissions, while reducing taxes on things it wants more of, like income and employees. Yes, that means the mortgage-interest tax deduction must be abolished. But it also means that we have an opportunity, here, to revamp the tax code in a way to improve the systemic stability of the economy. Let’s not waste it.
I don’t think the main reason people loaded up on home equity lines was because of the tax perspective; rather, it was the ability to amortize consumption over long periods, often up to 30 years. For a minimal increase in monthly payments, people were able to buy things they really couldn’t afford. The tax savings were nice, but all that did was slightly reduce the cost of borrowing, which was already ridiculously and artificially low.
Getting rid of the mortgage interest deduction will probably be as politically easy as restructuring social security.
“It's pretty clear that households loaded up on home equity lines largely because they were so attractive from a tax perspective: normally people are pretty shy about putting their homes at risk that way”
Is there evidence of this? I was thinking more that leverage boomed due to a variety of factors – housing became an “investment” in the 2000s, the lack of rising wages (which you mentioned earlier) forced homeowner to look elsewhere for income, etc.
I do agree with the rest of your article though.
Nice rhetorical technique, Felix. When you lead a sentence with “It’s pretty clear that…”, then you stand a pretty good chance of slipping something controversial by the reader without question.
Several factors contributed to the boom in borrowing: (1) Very low interest rates. It can be very tempting to borrow lots of money when it doesn’t cost you much to carry the debt.
(2) Decades of prosperity, almost without respite. When nobody under the age of 50 remembers a real recession, the culture begins to discount that possibility and the implied financial risk. People did not BELIEVE they were putting their homes at risk, because “home prices always rise”. (Except when they don’t.)
(3) Speculative activity in the housing market, driving up prices. Since most purchases are primarily financed through borrowing, then rising home prices is a primary driver of mortgage balances.
The tax deductibility of mortgage interest contributed to factors (1) and (3), but it was hardly the sole driving force.
“From 1978 to 2007, the amount of debt held by the financial sector increased twelvefold, from $3 trillion to $36 trillion” That may sound like a lot, but GDP rose quite a lot from 1978 to 2007. It rose more than six-fold. The financial sector grew faster than GDP, so perhaps this is less surprising. I guess I expect this from the FCIC, but less from McLean or Salmon.
@TFF – I understand what your saying, but I don’t think it’s fair to suggest that Felix sees the home interest tax deduction as the “sole” driving force. He talks quite a bit about the corporate tax deduction in this post, for one, and the resulting effect on corporate leverage.
Having a massive chunk of tax deductible corporate debt sitting around is a pretty dangerous thing when (2) comes into play. Highly leveraged financial institutions who don’t believe bad things can happen to them generally come to terrible ends.
@bwickes – good point, but I think a debt load that increases at twice the rate of GDP is pretty significant. Even if FI leverage didn’t grow (which it did) it’s still a sign of an increasingly bloated financial sector.
I’m with Felix on this one. Mortgage interest deductibility is deadly. It lures people into taking on more debt than they would otherwise, especially in low interest environments. This just inflates the asking price for property, so the “savings” are illusory but the risk is all too real.
It should be ratcheted back as per the Debt Commission’s recommendations, starting at the top and moving down incrementally. No deduction for second homes or investment properties either. One house, up to the (old) fan/fred conforming limits. Period.
strawman, I was responding to the line, “It's pretty clear that households loaded up on home equity lines largely because they were so attractive from a tax perspective.” And I disagree that was a primary driver of mortgage and home equity debt, especially since most people get just a 15% deduction on their mortgage interest. At best it is tangentially related (through driving housing prices higher).
Ending the deductibility of corporate debt is another question entirely. I guess I’ve always assumed that it should be, along with all other corporate expenses. If a bank borrows at 3% and loans at 7%, should it pay tax on the 4% margin (less expenses) or on the full 7% revenue? This admittedly seems to treat corporate debt preferentially to corporate equity, but that is reversed from the investment side where dividends and capital gains are taxed preferentially to bond interest.
What would be the implications of taxing bond interest on both ends? Are there other countries that operate that way?
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