Since the biggest financial collapse in world history was built on credit related to housing, it’s pretty obvious that we should be paying very close attention to that market. The reasons are complex, but a recovery must be based on the liquidation of bad debt. The sooner that happens, the quicker a recovery will happen.
When we mean “liquidation of debt,” we are talking about a mountain of credit built on the housing bubble. This phony bubble wealth permeated the entire economy. When homeowners saw the price of their homes rising, they saw it as a source of capital to use for a variety of things — but let’s face it, most people spent it.
New stores opened, malls were built, financial institutions grew, cars and boats, second homes, vacations and restaurants all flourished. Credit card debt mushroomed. Home mortgages were increased to pull cash out for spending. Yes, some of it went to good things, such as our children’s education, helping our aged parents and paying off bills. But the reality was that our debt kept growing.
The clever lads created even more phony wealth under the guise of insurance, but as we found out, companies such as AIG really had no idea how large their obligations were for credit default swaps written against almost any financial risk. And these instruments were further leveraged without understanding the magnitude of these triple-counted obligations or their relationship to housing.
It all comes back to housing as the fuel for the 70 percent of our economy that was consumer spending. The thought was that housing has always gone up, and if it went down, it really never went down if you averaged growth since the post-World War II period. A drop of 10 percent? Never has happened. 20 percent? Not even a sixth deviation possibility.
My thesis has been that this was all fueled by the Fed through monetary policies that created and supported the bubble. Aided and abetted by governmental policies and financing schemes that favored housing and risky loans. This was not a “free market” phenomenon. Far, far from it.
My thesis also has been that we can’t recover until all this bad debt is liquidated, and capital generated by savings is created and ultimately invested in profitable enterprises. It would be a mistake to rekindle the bubble. But, as we know, that’s what our government is trying to do. The government creates uncertainty as it flails around with programs, spending and debt schemes to revive the economy. As a result, mark-to-market accounting is a thing of the past, and banks are guarding their balance sheets, corporations are sitting on a lot of cash, cutting costs and becoming leaner, and Mr. and Mrs. America still favor savings and debt instruments over equities and spending.
The big question: Is the housing market bottoming out? Because once it does, debtors and debt holders will then have a handle on how great their losses are. When the bottom is falling out, it is difficult to get lenders to lend if they are afraid their remaining cash reserves will be needed to shore up the bank because of loan losses. The holders of subprime debt find it difficult to value their assets while housing values are still dropping.
Lenders have been shepherding their cash, reducing debt obligations, and cutting back lending and new investments because they don’t know how deep their hole will be until housing bottoms out. Keynes called this a “liquidity trap.” More reasonable people, especially the Austrian school economists, call this a reasonable and necessary response to uncertainty.
The Fed and the federal government have been flogging this liquidity trap issue without let up, and basically credit is still drying up. A 0.25 percent Fed funds rate is basically a negative rate, and they still can’t get banks to lend. The Fed’s balance sheet is at a record high. It has bought $850 million of mortgage-backed securities. They are injecting cash into lenders. They have basically suspended mark-to-market accounting.
In the third quarter, the FDIC reported that bank lending still contracted by 3 percent: Loans and leases held by U.S. commercial banks have declined for 10 straight months, falling to $6.7 trillion as of Oct. 28 from $7.2 trillion at the end of 2008, according to a separate statistical release from the Fed. Commercial and industrial loans have dropped to $1.37 trillion from $1.6 trillion, commercial real-estate loans have declined to $1.66 trillion from $1.72 trillion, and consumer loans have fallen to $847 billion from $857 billion at the end of last year.
What do banks do? They have decided they would rather hold Treasury paper instead of make loans.
This is what makes Ben Bernanke, Timothy Geithner and Lawrence Summers lose sleep at night. ”It’s supposed to work, dammit!” Maybe this is why Summers is always falling asleep. No matter what they’ve tried, they can’t get banks to lend. I think they are very worried about this, and while they say the economy is recovering nicely, they are crossing their fingers at the same time.
Back to housing.
I have been saying that I think the housing market is finding a bottom. I thought that low prices and rising affordability were the main drivers of the housing market. If this were so, then housing prices would reflect real market valuations, and this would finally bring about the liquidation of assets and debt wastefully invested during the prior artificial credit cycle. Lenders would know where they stood financially and would liquidate bad assets and rebuild their balance sheets. No more waiting around wondering what the Fed or the government would do to save housing.
I was wrong.
The housing market I now believe is being sustained almost entirely by the Fed and the federal government. This rekindling of the housing bubble is counterproductive and will hinder a real recovery of the economy because an artificially backed market will delay the necessary liquidation of the prior cycle’s malinvestment of capital.
Here is why I changed my mind:
First, 59 percent of new homebuyers are relying on government-backed FHA, Department of Veterans Affairs and Department of Agriculture loans. Most of these sales are driven by the first-time homebuyers tax credit. The tax credit program has been extended through April 2010.
Second, existing home sales are being driven by the tax credit and by foreclosure and short sales. Existing home sales are up 10.1 percent. Distressed sales — mainly foreclosures and short sales — accounted for 30 percent of transactions in the third quarter. And, according to the National Association of Realtors, home sales are being driven by first time homebuyers trying to make the previous November deadline.
This will have a negative impact on future sales. Like Cash for Clunkers, these government-driven sales may just be eating into sales that would have occurred in 2010. Many economists are referring to this phenomenon as “payback.”
Third, mortgage rates are now at 30-year lows. Another Fed-related gift to homebuyers. The average 30-year mortgage rate was 4.95 percent in October, down from 5.06 percent in September, according to Freddie Mac. On Thursday, Freddie said the rate was down to 4.7 percent.
But … home prices are still falling. The S&P/Case-Shiller index of prices fell 8.9 percent for the July-through-September period from a year earlier. That was an improvement from the 14.7 percent drop in the second quarter and the 19 percent decline in the first three months of 2009. Median prices of existing homes fell in 123 of 153 metropolitan areas during the third quarter compared with a year earlier. The national median price was $177,900, down 11.2 percent from the third quarter of 2008. (Don’t ask me to explain the disparity. Case-Shiller and NAR measure this differently.) Last month, the median price for an existing home was $173,100, down 7.1 percent from $186,400 in October 2008.
Thus, despite record interference in the housing market by the government, home prices are still falling. There are several reasons why it is likely that home prices will continue to fall.
Nearly 25 percent of homeowners are upside down with their mortgages. Nearly 10.7 million households had negative equity in their homes in the third quarter, according to First American CoreLogic. This shadow market is huge:
Home prices have fallen so far that 5.3 million U.S. households are tied to mortgages that are at least 20 percent higher than their home’s value, the First American report said. More than 520,000 of these borrowers have received a notice of default, according to First American.But negative equity “is an outstanding risk hanging over the mortgage market,” said Mark Fleming, chief economist of First American Core Logic. “It lowers homeowners’ mobility because they can’t sell, even if they want to move to get a new job.” Borrowers who owe more than 120 percent of their home’s value, he said, were more likely to default. Mortgage troubles are not limited to the unemployed. About 588,000 borrowers defaulted on mortgages last year even though they could afford to pay — more than double the number in 2007, according to a study by Experian and consulting firm Oliver Wyman. “The American consumer has had a long-held taboo against walking away from the home, and this crisis seems to be eroding that,” the study said.
This overhang will continue to drive prices down. There is no way the Feds can force lenders to modify enough loans to make a serious dent in this overhang. It’s imply too big. Eventually the losses from forced modifications will mount and the FHA or any other agency will not be able to pay off their guarantees to lender. Nor should they try.
Mark Zandi, who correctly predicted a crisis in the housing market, but not the crash, said Wednesday, “The housing crash is not over.” He said the lull in foreclosure sales for the past few months, due to the government’s pressure on lenders to modify loans, has resulting in higher prices. He expects Case-Shiller to bottom by the third quarter of 2010 with an overall price decline of 38 percent (now at 32 percent).
“Foreclosure sales will increase, and home prices will resume their decline by early 2010 as mortgage servicers figure out who will not qualify for a modification,” he said.
Zandi said 7.5 million foreclosure sales will have taken place from 2006 to 2011. The majority of these sales, however, have not emerged yet, with 4.8 million foreclosure sales expected from 2009 to 2011.
What this means is that the housing supply, now down to a seven-plus-month supply, will rise again, and prices will continue to decline. We haven’t seen the bottom yet.
— Jeff Harding is a principal of Montecito Realty Investors LLC. A student of economics, he has a strong affinity for free-market economics. This commentary originally appeared on his blog, The Daily Capitalist.
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