The Section 8 Rental Subsidy Disaster

A potential disaster is brewing in the nationþs chief federally assisted private housing program. Over the next seven years, subsidy contracts will expire on more than 700,000 apartment units that receive assistance under the Department of Housing and Urban Developmentþs Section 8 rental subsidy program or its predecessors. The mortgages on these buildings are insured by the Federal Housing Administration (fha), an agency of hud. If Congress does not renew the subsidy contracts, owners are likely to default on their mortgages, leaving fha to pay insurance claims on $18 billion in outstanding mortgages to the private lenders.

Congress has already targeted hud for big budget cuts. There is no prospect that these contracts will be renewed at their current subsidy levels. The impending result is all too obvious. As owners default on their mortgages, the federal government will be stuck with the bill. Meanwhile, hundreds of thousands of low-income families could find their lives disrupted as owners defer maintenance or shut down the properties.

The Clinton administration has called attention to the matter and proposed far-reaching reforms. It estimates that those reforms would, in the long run, save almost $5 billion in todayþs dollars. But Congress has yet to address the problem seriously.

What Went Wrong?

The Section 8 program was launched in 1974 by the Nixon administration to encourage more private developers to build housing for low-income Americans. Under the þproject-based" Section 8 program, which expanded earlier efforts along the same lines, hud entered into rental subsidy contracts with the developers, typically for 20 years. Eligible families pay 30 percent of their incomes toward rent; hud pays the remainder of the rent directly to the developer. To induce developers to participate in Section 8, fha guaranteed the mortgages they got from banks or thrifts. Developers also received substantial tax benefits. Section 8 was popular because it fostered the construction of housing for more than 1 million low-income Americans. But the program involved something of a "Ponzi scheme" element to keep it going. If the subsidies were cut, the scheme would collapse. The owners might default on their mortgages, and the fha would be left to pay claims. Policymakers acknowledged this flaw in 1983, and hud stopped entering into new Section 8 contracts with owners. Instead, hud began assisting tenants directly with portable vouchers, in the process both providing tenants more choice and lowering the per-person cost of housing assistance. Today some 1.5 million American households use portable vouchers to help pay their rent.

But what happened to all those pre-1983 properties with subsidy contracts? When they were new, most provided excellent quality housing, though often at an excessive cost per unit. Even today, most provide decent housing. But, as they aged, many ran into financial and operating problems. For years, hud and Congress kept the Ponzi-like scheme going by layering on added subsidies when projects got into financial trouble.

But the situation couldnþt last and it wonþt. The problem is that roughly two-thirds of the properties are now over-subsidized—they receive federal subsidies based on rents above those on comparable nonsubsidized units in the same neighborhood. The over-subsidization problem grew slowly as many owners ran up costsþcosts that the program gave them little incentive to controlþand thus required larger subsidies to keep their projects afloat. But it has now taken on serious proportions. More than 40 percent of the properties now have assisted rents exceeding 120 percent of average market rents in their locations. The General Accounting Office has found Section 8 apartments renting for twice as much as nonsubsidized apartments across the street. In Casper, Wyoming, for example, two-bedroom subsidized apartments rent for $880 a month, while larger unsubsidized apartments with more amenities rent for as little as $425 a month. Even worse, some tenants would like to leave the complexþfor more satisfactory housing at lower cost to the governmentþbut cannot because their rental assistance is tied to their current units. It makes no sense to pay owners more than they would get in a free and competitive market. The only reason the practice has continued is policymakersþ fear that many owners would have to default on their mortgages if their subsidies were capped at market-level rents.

Some observers argue that the current system needs only some fine-tuning to lower costs. But the systemþs two fundamental flaws do not realistically permit such optimism. First, the interlocking subsidies of mortgage insurance and rental assistance insulate Section 8 properties from market forces. And, second, because the rental assistance is tied to specific units, hud cannot walk away from the properties: it must absorb any cost increases. In effect, the system creates two hostages: tenants to their units and the federal government to keeping the system afloat.

Proposals to control subsidy costs through better enforcement or tighter funding formulas will fail to eliminate all inefficiencies because they require a continued bureaucratic structure to administer the program. Market rent levels, which send the proper signals to owners and tenants, can be achieved only through competition, not by government fiat.

Efforts at Reform

Early in 1995 hud proposed replacing the expiring Section 8 contracts with portable housing vouchers and leaving landlords free to rent their units for whatever the market would bear. To assist property owners in the transition, fha would agree to write down, in advance of default, the mortgages in those cases where market rents could not cover operating costs and mortgage payments and to take the þhit," paying out claims. But hudþs proposal was opposed by both property owners and tenant groups. Some owners feared that hud would treat them unfairly in the renegotiation process and were concerned that the mortgage writedowns themselves would trigger a tax liability. And despite hud studies showing that more than 80 percent of voucher recipients find suitable housing, some tenantsþ organizations worried that many residents, especially minorities, the elderly, the handicapped, and those with large families, would be unable to find adequate housing in other buildings. Tenants were also distrustful of assurances from hud that elderly and handicapped families, in particular, could remain in their units under any voucher plan. Because the high-cost Section 8 contracts expiring in 1996 covered fewer than 1,000 units, Congress elected to put off facing the problem squarely. It did not, however, pass the buck completely. It renewed the high-cost subsidies only for one year and gave hud authority to "demonstrate" the benefits of restructuring the program and writing down mortgages before default on 15,000 units. But the demonstration expires at the end of September 1997 and thus leaves more than 700,000 units awaiting action—236,000 units expiring in 1997.

This year hud and the administration have recommended "Portfolio Reengineering," a scaled-down approach to addressing the impending Section 8 disaster, one that tries to avoid some of the objections made by owners and tenants last year. The new proposal would reduce excessively generous rents to market levels and offer opportunities to local communities to make future subsidies portable, thereby giving tenants more choice. Meanwhile, hud would gain negotiating authority with respect to the mortgages on the over-subsidized properties, saving the government money on subsidy payments.

To meet objections to vouchers from both tenant groups and owners, hud proposes to give state and local governments a say in the decision whether, and at what pace, assistance now tied to individual properties should be converted to portable vouchers. In some cases, for example, a community may decide that continued project-based subsidies are necessary to ensure a neighborhoodþs stability.

hud also recognizes the tax difficulties that renegotiating mortgages creates for owners. Without explicitly outlining how to deal with the problem, it has expressed a "willingness" to discuss with Congress ways to take account of it. The most likely solution would defer recognition of any capital gains from mortgage writedowns until the properties are sold to another party, provided the fha insurance is extinguished and the rental subsidies are restructured. There is a good argument that such tax relief would not widen the budget deficit, since fha would have to accept larger writedowns if owners were not given capital gains tax relief and were able to resist restructuring.

The new Portfolio Reengineering proposal would also permit property owners to apply for fha insurance on their newly restructured loans. The insurance would be properly underwritten based on the new conditions and scored as a subsidy under current "credit subsidy" budget accounting rules.

Initially, hud envisioned renegotiating the thousands of mortgages, one by one, with the owners. It has since realized the daunting nature of this task. It also considered—and then rejected—simply selling the mortgages to third parties to let the market set the writedowns. But this approach would have required the owners of the restructured properties to default first. Instead hud now proposes to transfer, at competitive prices, its guarantee liabilities on a designated portion of the fha-insured mortgages to competitively selected third parties. A wide variety of entities, alone or acting as teams, would be eligible: local and state governments (including state Housing Finance Agencies), nonprofit organizations, private asset managers, and any number of potential capital partners. These entities would then negotiate with lenders and owners to restructure the mortgages, or sell them, depending on the circumstances. These earlier interventions managed by third parties are expected to be more efficient in restructuring mortgages than later interventions by hud. All Section 8 contract obligations and rights would be honored, including the protection of tenants.

Using a trust structure, hud and the third parties would share in the proceeds to the extent that the third parties can do better than the government in restructuring the mortgages and managing the governmentþs liabilities. This way, hud would ensure that the third parties not be given windfalls; meanwhile, hud's share of the proceeds would help rehabilitate dilapidated properties. To make sure the third parties have the right incentives to get the best deals and minimize costs, they would have to pledge some of their own capital to participate.

The scaled-down Portfolio Reengineering proposal is estimated to save taxpayers almost $5 billion in reduced rent subsidies and fha claims payments.

It Is Time for Congress to Act

The demonstration project that Congress approved last year is far from enough. Congress must fix the whole Section 8 problem. As noted, subsidy contracts on approximately 236,000 units, or about a quarter of the entire Section 8 portfolio, will expire in 1997. Contracts on an additional 246,000 units will expire during 1998 and 1999. hudþs latest proposal is a good place to start. At this writing, there is hope that congressional appropriators may authorize hud to restructure mortgages and assistance on projects whose Section 8 contracts expire in fiscal 1997 and whose rents are above market.

Simply renewing expiring contracts for another year, as Congress did last year, will accomplish little. Subsidy costs will continue to go up while properties deteriorate. The longer Congress persists in an incrementalist strategy, the more costly defaults will ultimately be. In addition, continuing to renew expiring Section 8 contracts at their existing, over-subsidized levels leaves ever fewer resources for all hudþs other housing and community development needs.

Ideally, Congress should not stop with the administrationþs latest scaled-back proposal. It should move the entire Section 8 program toward a system of vouchers. Not only are vouchers less expensive than the current bureaucratic system of subsidies, they would give Section 8 tenants the same freedom to move that is enjoyed by everyone else in this country.

Before he announced his resignation from the Senate last spring, Majority Leader Robert Dole announced his support for a policy to "end public housing as we know it" by giving all public housing residents vouchers to enable them to live wherever they choose. hud Secretary Henry Cisneros made much the same commitment last year. If Robert Dole and the Clinton administration can agree on this proposition, then it is time for Congress to agree to it as well.