Response to “Shouldn’t We Rescue Housing?”

The article “Shouldn’t We Rescue Housing?” (NYT 10/18/08) by Joe Nocera endorses a recently proposed plan by Messrs. Glenn Hubbard and Chris Mayer to prop up falling housing prices and introduces us to a new initiative with similar designs authored by Mr. Daniel Alpert. Each of these proposals mistakes the core problem facing our economy as being falling housing prices. Our real problem is that housing in the United States remains dramatically overvalued relative to the fundamentals which determine home prices.

As damaging as falling housing values are to the economy, they are symptoms of the artificial price appreciation which occurred during the mania of the Housing Bubble. Price declines are inevitable and necessary to restore sustainable economic stability. Asset prices are determined by fundamentals which affect value, not by government initiatives designed to prop up prices at arbitrary levels.

In setting the stage as an advocate for propping up house prices, Mr. Nocera dismisses the prospect of moral hazard from such a bailout under the assumption that “you would have to be an absolute idiot to repeat the folly of the housing bubble”. Mr. Nocera is not a student of history or of human nature. Modern civilization is defined by bubbles created and perpetuated by such idiots. We as a society had supposedly learned our lesson from the Internet Bubble’s collapse. Yet, in a few short years we had replaced it with the largest bubble in human history. Mr. Nocera may have been referring more specifically to the Housing Bubble being a real estate focused lesson whereas the Internet was a stock market event. This observation ignores that the Japanese recently demonstrated for our benefit how real estate bubbles can occur and how long-lived and damaging they can be.

Bubbles have always and will always exist. They tend to be more prominent in capitalist, free market economies where yield chasing capital pursues what is, in its perception, the best source of risk-adjusted returns. To imply that after centuries of evidence to the contrary we have suddenly learned our lesson is naive.

With respect to the specific errors that contributed to “the folly the Housing Bubble”, evidence of their recurrence throughout recorded history is abundant. Government has never understood the danger of intervention in free markets or recognized the law of unintended consequences. Competing, profit seeking companies will always extend their activities up to and beyond the point where these activities are viable. This is the nature of capitalism. It is predictable and represents the inevitable cost of such a system. As for individual investors, they will always act as a herd, formulate forward looking expectations based on historical performance, make use of leverage to the extent that it is made available and make speculative decisions in the pursuit of treasure and glory.

If the government made available 100% LTV mortgages with 5 year, 2% teaser rates to all Americans does the author believe that millions of people wouldn’t take advantage because they had learned their lessons? At some point when housing values make sense relative to historical ratios, income levels, rental rates, investor expectations, perceived risk, housing supply and demand and inventories for sale even I would happily take advantage of such an offer. I wonder whether Mr. Nocera would?

Imagine if Congress decided, in the wake of its failure to provide the American Dream of “homeownership” to those lacking adequate credit, to turn its attention to providing the American Dream of “owning your own business” to subprime borrowers. The Small Business Administration (SBA) already acts like Fannie Mae by insuring loans made by lenders for business purchases. At present, a business buyer must have good credit, make a down payment of at least 20% and service market interest rates of approximately 7%. These terms obviously deny to people without credit, capital and cash flow access to this form of American Dream. They also resemble the requirements to buy a home pre-1995. What would happen to the value of small businesses if Congress replicated the conditions that triggered the Housing Bubble? Subprime borrowers could access the market, put nothing down and service teaser rates at 2% for years to come. Sign me up! Within a short period of time prices of businesses would rise as demand increased dramatically. Profit seeking buyers would flood the market, values would decouple from fundamentals like revenue, cash flow and earnings, momentum would beget momentum investing and we would have the next great American Bubble. People would say “this time is different”, “it’s a new paradigm” or some other creative delusion designed to dismiss the reality that, regardless of which decade it is or what asset class is involved, as long as individuals are free and capital is allowed to pursue profit bubbles will exist. Given the proper amount of government intervention a bubble, even in housing, could start tomorrow.

Mr. Nocera does make a prescient observation in stating that “this financial crisis is going to cause an entire generation to become debt-averse, as our parents were after the Great Depression”. I couldn’t agree more. What Mr. Nocera fails to recognize is the implications of those changing expectations and perceptions with respect to housing. Prices are determined by a myriad of fundamentals. Maybe no more important of which is perception of risk and expectation of future performance.

Since World War II housing prices had been stable and rose annually on a national basis. Homeownership was perceived to be safe, a route to wealth accumulation and the American Dream. Perception of risk is a huge determinant of an asset’s value. Based on fifty years of history and recent years of accelerating appreciation many potential buyers expected housing values to continue to rise. Few buyers or investors believed that the asset class could decline in value and certainly not by material amounts. It was the perception of low risk and the expectation of rising prices that allowed the bubble to grow and sustained overvalued housing prices.

At present, house values have never been more volatile, are falling at the fastest rate in US history and buying a house has arguably never been more risky. Increasingly people are coming to terms with the prospect that housing prices may continue to fall. Irrespective of this realization, Americans now understand that houses are risky investments and their values can collapse. For decades to come the perception of risk, expectations of future performance and prospect for material capital losses will materially affect housing values.

Mr. Nocera argues that if the government doesn’t do something that the economy will remain in chaos. As uncomfortable a reality as this may be, the economy will remain in chaos irrespective of government action. What the government can do is to take actions to slow down the market clearing mechanism thus lengthening and deepening the crisis. The Japanese have been criticized for adopting and perpetuating a banking system that did not allow markets to clear following their housing bubble, resulting in a lost decade and 15 consecutive years of falling real estate prices. Yet individuals like Mr. Hubbard and Mr. Nocera want the government to impede the market function and attempt to prop up prices at arbitrary levels.

What would have happened if the government had attempted to fix the prices of Internet stocks during 2000? Would it have worked? Absolutely not! No amount of government intervention would have prevented overvalued Internet stocks from collapsing. But the government might have succeeded in lengthening and deepening the economic impact. Instead, the government initiated another form of intervention by reducing interest rates to record lows and stoked the already robust housing bubble. Another historical proposal might have been an attempt to prop up stock prices in 1929. During the 1920s prices were inflated by 10% margin requirements, interest rates as low as 1% and wild optimism generated by historical returns. After the crash no amount of government intervention could have artificially propped up stock prices. Did the Japanese system which perpetuated bad loans and prevented the market from clearing have a beneficial impact on the economy? The fact is no amount of government interference can fix prices in a free market economy when the fundamental determinants of value support an equilibrium price below the governmentally targeted level. Any initiative that has the effect of doing so only lengthens and worsens the problem.

Mr. Nocera introduces us to and advocates a plan created by Daniel Alpert to save housing. The plan involves the government allowing underwater home owners to forfeit their deeds to lenders. Former owners would be required to rent the properties back from lenders for a period of five years and would be provided with the option to repurchase the homes at the end of the rental arrangement at fair market value.

Both Messrs. Nocera and Albert agree that “prices wildly overshot the true value of the home” during the bubble but argue that this phenomenon “has to be prevented on the way down”. While I empathize with their concern that foreclosures have the potential to “cause housing prices to fall so hard that they will drop below the real value of the shelter”, that potentiality is so distant from the current reality of wildly overvalued housing that to formulate dramatic, market distorting government policy to prevent it is horribly counter-productive. The price inflation of the past 10 years did not represent an increase in the perceived value of shelter, but was solely attributable to the perception that the investment component of housing value was rising. Prices have barely begun to fall relative to their dramatic run-up that saw the nation’s housing stock more than double in value. In states like California and Florida, and in cities such as Boston, New York, Las Vegas and Washington D.C. prices could decline dramatically from current levels and still be above the inflation adjusted and income adjusted levels seen before the bubble began. To argue that we have begun to approach the value of housing as shelter and that we should interfere with the market clearing mechanism as a response defies economic understanding.

I want to give Mr. Alpert the credit he is due. He has correctly identified one of the most damaging threats facing our economy. The huge number of ARMs and Option ARMs due to reset through 2012 and the increasing number of mortgages that are or will be underwater represent a large, steady and highly visible source of foreclosures. Mr. Alpert understands how the housing market clearing mechanism works and that the presence of foreclosures forces prices lower. I give him credit for trying to defuse these economic time bombs, but I reject the plan he proposes.
The extent of my understanding of Mr. Alpert’s plan I owe to Mr. Nocera’s description. I do not want to short change his well intentioned efforts to positively affect this economic unraveling. That said, his proposal focuses on the oversupply of housing stock as the primary cause of the current predicament of falling prices. His plan is designed to allow for a five year time-out to allow the economy to absorb that excess supply. While it is an interesting proposal it ignores the reality of the forces that led to the bubble, the impact of his plan on the economy and the reality that housing prices will fall regardless of attempts to remove foreclosures from the equation.

If the only problems in the housing market were foreclosures and oversupply our predicament would not be so precarious. Mr. Alpert forgets that we also had an oversupply of properties during the latter years of the Housing Bubble. Prices continued to rise because there was robust demand, plentiful credit and readily available subprime, 100% LTV and teaser rate mortgages. Housing was thought to be low risk and people expected property values to increase. If we could eliminate our excess supply overnight would prices suddenly stabilize or begin to rise? There is no doubt that one of the forces propelling prices lower would be removed, but the factors which propelled and sustained prices at unsustainable heights no longer exist. Maybe most important are the expectations and perceptions of a society that have been and continue to be altered. House prices will inevitably find an equilibrium with the new mortgage environment, income levels, relative rental rates, current economic realities and changing consumer expectations. Eliminating excess supply may slow the rate of the correction or lengthen the period of time necessary to reach equilibrium but it would not prevent market forces from affecting prices.

Furthermore, Mr. Alpert’s plan does not actually impact current supply. His plan simply removes a highly visible and inevitable source of foreclosures from the market for a period of five years. While those foreclosures are certain to force prices lower they are not the only factors at work. At present we have the highest number of unoccupied housing units in American history. Even more units built during the boom are scheduled to come online in the next 18 months. This is the supply Mr. Alpert expects to be absorbed over the next 5 years. And maybe it will. But what happens to prices during the interim? Excess supply and record high inventories of houses for sale will continue to force housing prices lower. Falling prices may not be as dramatic as if foreclosures were present, but prices will decline nonetheless.

Under Mr. Alpert’s plan lenders would have to immediately book large losses when they take possession of underwater properties. This happens during foreclosures, but lenders who aren’t landlords quickly divest themselves of properties and get back to their core businesses. Mr. Alpert proposes to forcibly turn lenders into landlords and make them hold houses that are declining in value. As these properties continue to fall, further mark-downs would be required and the lender would have no opportunity to extricate itself from this downward spiral. Mr. Alpert proposes to recreate the scenario which played out in the Japanese real estate collapse. Instead of realizing losses and divesting themselves of bad loans, banks held onto bad investments for years, stifling lending, contracting credit and strangling the economy.

Additionally, the market would not simply forget the sleight of hand which removed millions of homes from the market for a known period of time. There would be a huge supply of distressed houses sitting on the books of banks that would re-enter the market five years from implementation. Potential house buyers will understand this reality and be wary of purchasing a home prior to the full supply of distressed houses participating in the market. And what would happen five years and a day from the plan’s implementation? A sudden increase in supply of houses for sale could be disastrous for a housing market and economy trying to regain its footing.
It is hard to say what the owners-turned-renters will do five year from now. If real estate is still falling or perceived to be risky many will walk away. If they have been indoctrinated to the joys of renting at a cost below that of owning, many may choose to continue their penurious new hobby. How many of these people would have chosen to stay in their homes for five years under normal circumstances? Many would have long since moved but for being forced to rent. At the conclusion of their forced servitude many will relocate. To assume that a material number of these renters will choose to repurchase their albatrosses at fair market value when they can buy any house in America at fair market value is silly.

And under such a plan who determines fair market value? What is the mechanism by which it is determined? The lender will want to maximize the sales price. The renter will want to minimize it. Will it be determined by an appraisal? If so, an appraisal by whom? Will the mechanism be some sort of competitive process? Will the renter be required to pay the price submitted by the highest bidder? Why would any potential buyer participate in such a process when the renter has a right of first refusal? Are these lenders, whose business it is to make loans, well suited to running such a process? Will the government dictate a mechanism that favors the former owner-renter? I can imagine dozens of ways that individuals, lenders, companies and investment funds might game such a mechanism not dissimilar to the activities we witnessed during the bubble itself.

No good has ever come from price fixing. Mr. Alpert’s attempt to prop up housing values by preventing the market from clearing has the potential for perpetuating or generating another national housing disaster. The only material impact the plan could have would be to lengthen and deepen the downturn. Home prices remain unsustainably high and will fall dramatically as we return to the credit environment of the early 1990s and the cultural perception of housing persistent in the 1930s. As painful and long lasting as this dramatic decline in housing values will be, we must allow the markets to work. It is tempting to try to avoid such pain with government intervention. But the reality is that intervention designed to prevent the market from working and prop up housing prices will only worsen the damage and lengthen the duration of our present calamity.