Government policy makers are discussing plans to help approximately 3 million homeowners avoid foreclosure by providing them with low interest rate loans. This initiative is expected to be similar to the FDIC’s response to the recent IndyMac Bank failure where mortgage holders facing foreclosure received restructured loans with interest rates approximating 3% for a period of five years.
Such intervention is misguided, would perpetuate the housing collapse and lengthen the economic downturn. It was precisely access to low interest rate, adjustable mortgages that got these distressed homeowners into trouble in the first place and distorted housing prices. Private institutions no longer offer such irresponsible mortgages because they encourage speculation, are prone to default and decouple home prices from the fundamentals of value. Yet the government is about to rely on similar low interest rate, adjustable loans to “fix” the foreclosure problem.
Such an initiative ignores the fact that government interference in the housing industry during the 1990s created the economic incentives which caused the Housing Bubble. Politicians pursuing a social agenda distorted the housing market by pressuring Fannie Mae, Freddie Mac and lenders to issue low down payment, low introductory rate, adjustable mortgages to subprime borrowers.
The government proposal relies on the same Ponzi Scheme logic that perpetuated the Housing Bubble. The only way that such an initiative would work is if housing prices stabilize and rise over the next five years. This is the same flawed assumption that allowed affordable mortgages to work during the Housing Bubble. Theoretical equity gains from assumed price appreciation were expected to allow adjustable mortgage homeowners the ability to avoid foreclosure.
The proposal assumes that temporarily removing foreclosures from the market will stabilize housing prices. This assumption is preposterous. The presence of foreclosures does drive home prices lower at a more rapid pace than would occur in their absence. But what foreclosures really accomplish is to force the housing market to clear. If houses weren’t overvalued prices wouldn’t be collapsing. Home prices appreciated during the Housing Bubble to unsustainable heights and no amount of government interference will keep them from returning to sustainable valuations.
The government proposal ignores that home prices are not falling solely because of foreclosures. Almost every fundamental determinant for the market value of houses today is less favorable than that which existed in the late 1990s. The supply of houses is higher as there are more vacant homes in the United States than at any time in history. Demand is lower as subprime mortgages are no longer widely available. Credit is tighter and terms more restrictive. Highly leveraged, 100% loan-to-value and low interest rate adjustable mortgages are less prominent. Houses are no longer perceived to be safe investments. Potential buyers no longer expect houses to appreciate rapidly. Cultural and social values attached to homeownership are being eroded. Market forces will drive prices lower irrespective of the presence of foreclosures and in spite of government intervention. Foreclosures accelerate the resolution of the overvaluation problem by forcing the market to clear.
As the economy contracts, unemployment rises and home prices continue to fall, more foreclosures will follow. There are millions of economic time bombs spread out through 2012 that will explode into foreclosures as adjustable rate mortgages reset. Once we have bailed out 3 million owners facing foreclosure today, how are we reasonably going to turn down future distressed homeowners? The government will be forced to perpetually bail out mortgage holders as defaults continue for years to come.
Imagine what kind of behavior this government intervention will encourage? Why would anyone who can afford to pay their mortgage do so if defaulting provides access to government-subsidized, low interest rate loans? I am sure that there will be some restraints on the issuance of such loans to prevent widespread abuse, but at the margin the government will encourage defaults.
And what benefit will be produced by such a government program? Homeowners facing foreclosure can not pay market interest rates and have no equity in their homes. If either of these preconditions did not exist, defaults could be avoided. Foreclosures will not be avoided, but simply delayed for five years until government-subsidized interest rates reset. Politicians have recognized the dangers of looming foreclosures. Instead of resolving these structural impediments to an economic recovery, the government appears intent on further delaying the market resolution of these distressed properties to devastating effect.
The market will not forget this government sleight of hand. There will be a persistent negative overhang on housing as every day brings these distressed homes closer to reentering the market. Potential buyers will understand this dynamic and restrain house purchases. And what would happen five years after the plan’s implementation? A dramatic increase in the supply of distressed houses for sale would be harmful to the recovering housing market and economy. The proposed foreclosure bail-out would cause another government created housing disaster.
There are actions that the government can and should take to deal with millions of impending foreclosures. Owners that are appropriate for workouts should actively be engaged for the sake of economic efficiency. Economist John Geanakoplos of Yale has proposed an elegant mechanism for facilitating this process which prevents government distortion but allows homeowners to avoid preventable foreclosures.
The foreclosure process should be streamlined. The legal process takes too long, is expensive and acts to exacerbate and extend the pain of home losses. Every day that a home is navigating the foreclosure process costs the lender money. Neighborhoods suffer blight and declining property values as homes sit vacant and deteriorate. Government should facilitate the foreclosure process, not delay it further.
It would be extraordinarily valuable for government initiatives to resolve the structural foreclosures which are spread out over the next several years. These remnants of the affordable mortgage boom functionally act like economic time bombs and ensure that homeowners will default when interest rates reset. Prior to resetting, the favorable terms of these adjustable mortgages delay inevitable foreclosures because introductory interest rates are affordable. These impending foreclosures should be resolved not further delayed though government intervention.
Regrettably, the housing market is a slow moving behemoth. Its size and glacial pace make it unlikely that overvalued housing prices will be resolved in the near future. As painful as foreclosure driven price declines have been, they have served an important function by accelerating the process by which home prices will reach stable and sustainable valuations. Foreclosures will ensure that an economic recovery begins far sooner than in their absence.
The proposed foreclosure bail-out erects a long-term, structural impediment to a housing recovery. Government intervention which delays the resolution of distressed homes will extend the housing downturn as long as these inevitable foreclosures are kept off of the market. Any government action should be undertaken with a design to facilitate the house clearing process and with an understanding that substantial economic pain resulting from falling home prices is unavoidable.
Friday, October 31, 2008
Wednesday, October 29, 2008
The Influence of Foreclosures on Housing Market Prices
When foreclosures are present in material numbers they determine the market for houses and place continuous downward pressure on prices. Much has been made of recent increases in existing home sale volumes. The media and uniformed analysts have interpreted these rising transaction volumes as evidence of stabilization, a market bottom or a recovery. Of course each of these announcements accompanies the news that prices have fallen dramatically. Anyone with a basic understanding of economics realizes that when prices fall, transaction volumes increase. Rising volumes aren’t positive from the perspective of the market stabilizing, although they are a signal that the markets are clearing. It is the presence of a material and growing number of foreclosures in the market which is driving volume increases and price declines in the existing home market.
Banks and lenders are not in the business of owning and administering homes. Lenders incur substantial costs associated with ownership including taxes, insurance and maintenance. Furthermore, lenders are compelled by regulators to divest themselves of such properties quickly. Lenders price foreclosed properties to sell. Unlike owners, banks do not have a reserve price, a mortgage balance to pay off, a misperception of the home’s value or price maximization as their goal. Lenders want to be rid of properties in a timely fashion.
To achieve the goal of divestment, lenders price homes at substantial discounts to current market prices. This discount varies by market but may be 10% to 30% relative to trailing, comparable transactions. In the presence of foreclosures, buyers generally don’t pay the existing market price. Potential buyers have the opportunity to purchase discounted foreclosed properties. Even in the instance where a buyer transacts with a non-distressed seller, the buyer has the ability to set the price at discounted levels due to the presence of foreclosed properties in the market. The seller must make concessions to compete with foreclosures.
The effect of foreclosures is to perpetually force the “market price” of houses lower as long as there is a steady and material supply of distressed, bank-owned properties. There is no reason why prices would stabilize in such an environment until values return to levels supportable by incomes and competitive with rents. If house prices get cheap enough, buyers will return regardless of price trends, future expectations or the presence of foreclosures. Unfortunately, these price levels will not be realized in the near future given the extraordinary appreciation experienced since 1996.
Banks and lenders are not in the business of owning and administering homes. Lenders incur substantial costs associated with ownership including taxes, insurance and maintenance. Furthermore, lenders are compelled by regulators to divest themselves of such properties quickly. Lenders price foreclosed properties to sell. Unlike owners, banks do not have a reserve price, a mortgage balance to pay off, a misperception of the home’s value or price maximization as their goal. Lenders want to be rid of properties in a timely fashion.
To achieve the goal of divestment, lenders price homes at substantial discounts to current market prices. This discount varies by market but may be 10% to 30% relative to trailing, comparable transactions. In the presence of foreclosures, buyers generally don’t pay the existing market price. Potential buyers have the opportunity to purchase discounted foreclosed properties. Even in the instance where a buyer transacts with a non-distressed seller, the buyer has the ability to set the price at discounted levels due to the presence of foreclosed properties in the market. The seller must make concessions to compete with foreclosures.
The effect of foreclosures is to perpetually force the “market price” of houses lower as long as there is a steady and material supply of distressed, bank-owned properties. There is no reason why prices would stabilize in such an environment until values return to levels supportable by incomes and competitive with rents. If house prices get cheap enough, buyers will return regardless of price trends, future expectations or the presence of foreclosures. Unfortunately, these price levels will not be realized in the near future given the extraordinary appreciation experienced since 1996.
Wednesday, October 22, 2008
Economic Distortions Caused by the Housing Bubble
For a decade the Housing Bubble dramatically distorted economic activity. These distortions and their impact on the economy as they unwind have important implications for the length and severity of the current downturn.
A Dramatic Increase in Leverage Underwritten By Unsustainable Asset Values
During the Housing Bubble the amount of debt attributable to houses increased in real and relative terms by a degree never before seen in history. The value of the housing stock in the U.S. more than doubled as it expanded by in excess of $9 trillion. Under normal circumstances such an increase would have contributed to a substantial expansion of home equity for existing owners. Instead, during the most dramatic period of real estate appreciation in our history the ratio of debt relative to the value of housing increased dramatically.
As property values rose potential buyers would normally have been prevented from or have found it increasingly difficult to purchase houses. Homes become less affordable relative to incomes, capital available for down payments and the required cash flow necessary to service mortgage debt. Buyers relied on increasing percentages of debt to purchase higher priced houses. This capital was available for a myriad of reasons including government intervention, the Federal Reserve’s decision to lower interest rates, yield hungry foreign capital seeking risk-adjusted returns, the magic of securitizations, and a full continuum of companies working to facilitate the creation of mortgages and execute home sales. In many cases, especially during the mania of the last several years, people borrowed 100% or more of the perceived value of the property to finance purchases. Others took out Option ARMs which resulted in debt levels far in excess of the transaction value of the home.
Another “financial innovation”, the ability to monetize theoretical equity gains through home equity loans, further exacerbated the leverage problem. Owners with rising equity and expectations of further increases cashed out their paper gains in favor of current consumption. As such, theoretical equity gains from rising prices were diminished or erased. This is the equivalent of Internet investors in 1999 borrowing money secured by unsustainable stock values in order to finance the consumption of motorcycles, boats, vacations and flat screen TVs.
As prices have fallen the theoretical equity gains are evaporating but the debt which was incurred remains. As leveraged as the asset class was at the height of the Housing Bubble, every day it becomes more leveraged as prices fall and equity disappears even more rapidly. One in six mortgages in America has a balance in excess of the home’s value. Homeowner equity is at the lowest level as a percentage of total home value in U.S. history.
This extraordinary level of debt has dramatic implications for the economy as home prices continue to fall. Consumption is effected. Consumer confidence is eroded. Consumer focused businesses suffer. Unemployment rises. That debt must be serviced and repaid. When it can not be serviced or if owners decide it is not in their best interests to do so, foreclosures result which further erode home prices and destroy the capital base of our lending institutions.
The Wealth Effect of Rising Home Prices
Consistent and rapidly rising home prices distorted the economic decisions of home owners. As home values rapidly appreciated, leveraged equity returns had a dramatic wealth effect. When people gain wealth they choose to consume more goods and services. As 100 million U.S. households experienced rising house values the impact of the bubble affected the entire economy. These people spent more money. Many of these decisions may not have even been consciously attributed to rising house values.
Rising values also dramatically distorted the U.S. savings rate. Americans consistently lowered their rate of savings as the Housing Bubble persisted. The savings rate dropped to zero and then went into negative territory during the worst of the mania. Such decisions seemingly made sense to homeowners as their wealth rose regardless of individual savings rates. Why save a small percentage of your paycheck when the consistent appreciation of your home increases your net worth by many times that which you could ever save on an annual basis?
Having an even greater impact on the economy was the rise of home equity loans. Individuals could monetize their increasing equity for current consumption. The government’s tax policies further incentivized this activity. For anyone with a credit card balance, the prospect of accessing a home equity loan was an obvious benefit. Instead of paying recurring fees and high interest rates a home owner could borrow low interest rate equity loans and deduct the interest for tax purposes. Based on trailing performance and with the expectation of future gains, most borrowers expected rising home values to effectively pay off the loans.
Home equity loans constituted approximately 3% on consumer spending from 2002 through 2005. This source of consumer spending has been removed from the economy. The record low savings rate further fueled the Housing Bubble driven consumer boom. Not only is this increased consumption gone, but Americans will have to increase the rate of savings to pay back debt, make up for years of missed savings and restore equity in their houses. Such activities will further damage consumer spending. Even conservative people who didn’t over borrow or access home equity loans may reduce spending due to negative wealth effects from falling prices, stock market losses, rising unemployment or impaired consumer confidence.
The Direct and Indirect Economic Impact of the Housing Bubble
The impact of the housing boom on the industries that constructed new housing, facilitated mortgages and executed home transactions was profound. While these segments are small relative to the total economy, their impact was dramatic, extended far beyond those specific sectors and dominated economic gains at the margin.
Home construction, mortgage facilitation and sales functions created millions of jobs. The impact of these incremental jobs was material. These people produced goods and services, shopped in malls, ate at restaurants, bought houses and paid taxes.
Employers that serviced homebuilders including carpenters, painters, furniture manufactures, roofers, landscapers, electricians, plumbers, wallboard manufacturers, sales people and marketers directly benefited from these activities. Real estate brokers, appraisers, mortgage brokers, investment bankers, ratings agencies and title companies were enriched by increased transaction levels. Many other businesses were affected by the increased employment, higher expenditures and non-direct, iterative effects of prosperity.
Unfortunately this homebuilding episode was an economic distortion. The demand for incremental housing supply was driven by ill-advised government agendas, dangerous, inappropriate and highly leveraged mortgages, speculative investors, optimistic buyers and massive availability of cheap capital. Today we have the largest inventory of empty housing units in our country’s history.
There is no reason to believe that these economic benefits will persist. We have already seen massive layoffs and contracting economic activity in the most affected geographies. The employment benefits from the Housing Bubble will vanish as related industries return to activity levels last seen in the 1990s.
Conclusion
A decade of unsustainable housing appreciation dramatically distorted economic activity. The Housing Bubble created a legacy of extreme home leverage, deflating housing prices, negative wealth effects, declining economic activity and rising unemployment. The implications as these distortions unwind make it unlikely that the U.S. economy will avoid a prolonged depression.
A Dramatic Increase in Leverage Underwritten By Unsustainable Asset Values
During the Housing Bubble the amount of debt attributable to houses increased in real and relative terms by a degree never before seen in history. The value of the housing stock in the U.S. more than doubled as it expanded by in excess of $9 trillion. Under normal circumstances such an increase would have contributed to a substantial expansion of home equity for existing owners. Instead, during the most dramatic period of real estate appreciation in our history the ratio of debt relative to the value of housing increased dramatically.
As property values rose potential buyers would normally have been prevented from or have found it increasingly difficult to purchase houses. Homes become less affordable relative to incomes, capital available for down payments and the required cash flow necessary to service mortgage debt. Buyers relied on increasing percentages of debt to purchase higher priced houses. This capital was available for a myriad of reasons including government intervention, the Federal Reserve’s decision to lower interest rates, yield hungry foreign capital seeking risk-adjusted returns, the magic of securitizations, and a full continuum of companies working to facilitate the creation of mortgages and execute home sales. In many cases, especially during the mania of the last several years, people borrowed 100% or more of the perceived value of the property to finance purchases. Others took out Option ARMs which resulted in debt levels far in excess of the transaction value of the home.
Another “financial innovation”, the ability to monetize theoretical equity gains through home equity loans, further exacerbated the leverage problem. Owners with rising equity and expectations of further increases cashed out their paper gains in favor of current consumption. As such, theoretical equity gains from rising prices were diminished or erased. This is the equivalent of Internet investors in 1999 borrowing money secured by unsustainable stock values in order to finance the consumption of motorcycles, boats, vacations and flat screen TVs.
As prices have fallen the theoretical equity gains are evaporating but the debt which was incurred remains. As leveraged as the asset class was at the height of the Housing Bubble, every day it becomes more leveraged as prices fall and equity disappears even more rapidly. One in six mortgages in America has a balance in excess of the home’s value. Homeowner equity is at the lowest level as a percentage of total home value in U.S. history.
This extraordinary level of debt has dramatic implications for the economy as home prices continue to fall. Consumption is effected. Consumer confidence is eroded. Consumer focused businesses suffer. Unemployment rises. That debt must be serviced and repaid. When it can not be serviced or if owners decide it is not in their best interests to do so, foreclosures result which further erode home prices and destroy the capital base of our lending institutions.
The Wealth Effect of Rising Home Prices
Consistent and rapidly rising home prices distorted the economic decisions of home owners. As home values rapidly appreciated, leveraged equity returns had a dramatic wealth effect. When people gain wealth they choose to consume more goods and services. As 100 million U.S. households experienced rising house values the impact of the bubble affected the entire economy. These people spent more money. Many of these decisions may not have even been consciously attributed to rising house values.
Rising values also dramatically distorted the U.S. savings rate. Americans consistently lowered their rate of savings as the Housing Bubble persisted. The savings rate dropped to zero and then went into negative territory during the worst of the mania. Such decisions seemingly made sense to homeowners as their wealth rose regardless of individual savings rates. Why save a small percentage of your paycheck when the consistent appreciation of your home increases your net worth by many times that which you could ever save on an annual basis?
Having an even greater impact on the economy was the rise of home equity loans. Individuals could monetize their increasing equity for current consumption. The government’s tax policies further incentivized this activity. For anyone with a credit card balance, the prospect of accessing a home equity loan was an obvious benefit. Instead of paying recurring fees and high interest rates a home owner could borrow low interest rate equity loans and deduct the interest for tax purposes. Based on trailing performance and with the expectation of future gains, most borrowers expected rising home values to effectively pay off the loans.
Home equity loans constituted approximately 3% on consumer spending from 2002 through 2005. This source of consumer spending has been removed from the economy. The record low savings rate further fueled the Housing Bubble driven consumer boom. Not only is this increased consumption gone, but Americans will have to increase the rate of savings to pay back debt, make up for years of missed savings and restore equity in their houses. Such activities will further damage consumer spending. Even conservative people who didn’t over borrow or access home equity loans may reduce spending due to negative wealth effects from falling prices, stock market losses, rising unemployment or impaired consumer confidence.
The Direct and Indirect Economic Impact of the Housing Bubble
The impact of the housing boom on the industries that constructed new housing, facilitated mortgages and executed home transactions was profound. While these segments are small relative to the total economy, their impact was dramatic, extended far beyond those specific sectors and dominated economic gains at the margin.
Home construction, mortgage facilitation and sales functions created millions of jobs. The impact of these incremental jobs was material. These people produced goods and services, shopped in malls, ate at restaurants, bought houses and paid taxes.
Employers that serviced homebuilders including carpenters, painters, furniture manufactures, roofers, landscapers, electricians, plumbers, wallboard manufacturers, sales people and marketers directly benefited from these activities. Real estate brokers, appraisers, mortgage brokers, investment bankers, ratings agencies and title companies were enriched by increased transaction levels. Many other businesses were affected by the increased employment, higher expenditures and non-direct, iterative effects of prosperity.
Unfortunately this homebuilding episode was an economic distortion. The demand for incremental housing supply was driven by ill-advised government agendas, dangerous, inappropriate and highly leveraged mortgages, speculative investors, optimistic buyers and massive availability of cheap capital. Today we have the largest inventory of empty housing units in our country’s history.
There is no reason to believe that these economic benefits will persist. We have already seen massive layoffs and contracting economic activity in the most affected geographies. The employment benefits from the Housing Bubble will vanish as related industries return to activity levels last seen in the 1990s.
Conclusion
A decade of unsustainable housing appreciation dramatically distorted economic activity. The Housing Bubble created a legacy of extreme home leverage, deflating housing prices, negative wealth effects, declining economic activity and rising unemployment. The implications as these distortions unwind make it unlikely that the U.S. economy will avoid a prolonged depression.
Propping Up Housing Prices Would Be A Disaster
There is a disturbing chorus of otherwise reputable individuals calling for government intervention in housing prices. This drum beat is concerning as these arguments are based on mistaken conclusions about current home prices and ignore the consequences of such government intervention.
This growing list of individuals includes Columbia's Glenn Hubbard and Chris Mayer, the New York Times' Joe Nocera and David Leonhardt, Yale's John Geanakoplos, Investment Banker Daniel Alpert and a laundry list of economically challenged politicians.
These people have come to recognize that falling housing prices are causing our economic turmoil. Unfortunately their conclusion ignores the reality that housing prices are wildly overvalued based on post-bubble fundamentals. Recent price declines have not reversed the unsustainable gains that occurred from 1996 to 2006. No amount of government intervention can prop up housing prices given the dramatic change in value determining market forces. Even worse, government initiatives which slow price declines or impede the market clearing function will extend the length of our economic downturn and deepen its impact.
How is it that we as a society understand that it is a bad idea to prop up internet stock prices but a good one to attempt to fix prices on housing? How is it that we understand that government can not control prices for gold, oil, a gallon of gas, corn, bread, art, stocks and currencies yet we believe that we can prop up housing prices regardless of supply, demand, mortgage terms, available credit, consumer confidence, perceived risk and expectations?
Recent proposals have called on government to provide "financial incentives to renters to buy homes". This is the scenario which created the Housing Bubble in the 1990s. Widespread proliferation of subprime, 100% LTV and Teaser mortgages caused this mess precisely by encouraging renters to become highly leveraged owners.
I have posted my responses to both Dean Hubbard's propsal (WSJ 10/2/08) and Joe Nocera's article (NYT 10/18/08). Should you have the time and inclination you may find them interesting.
This growing list of individuals includes Columbia's Glenn Hubbard and Chris Mayer, the New York Times' Joe Nocera and David Leonhardt, Yale's John Geanakoplos, Investment Banker Daniel Alpert and a laundry list of economically challenged politicians.
These people have come to recognize that falling housing prices are causing our economic turmoil. Unfortunately their conclusion ignores the reality that housing prices are wildly overvalued based on post-bubble fundamentals. Recent price declines have not reversed the unsustainable gains that occurred from 1996 to 2006. No amount of government intervention can prop up housing prices given the dramatic change in value determining market forces. Even worse, government initiatives which slow price declines or impede the market clearing function will extend the length of our economic downturn and deepen its impact.
How is it that we as a society understand that it is a bad idea to prop up internet stock prices but a good one to attempt to fix prices on housing? How is it that we understand that government can not control prices for gold, oil, a gallon of gas, corn, bread, art, stocks and currencies yet we believe that we can prop up housing prices regardless of supply, demand, mortgage terms, available credit, consumer confidence, perceived risk and expectations?
Recent proposals have called on government to provide "financial incentives to renters to buy homes". This is the scenario which created the Housing Bubble in the 1990s. Widespread proliferation of subprime, 100% LTV and Teaser mortgages caused this mess precisely by encouraging renters to become highly leveraged owners.
I have posted my responses to both Dean Hubbard's propsal (WSJ 10/2/08) and Joe Nocera's article (NYT 10/18/08). Should you have the time and inclination you may find them interesting.
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.
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.
Response to “First, Let’s Stabilize Home Prices”
With respect to the WSJ article titled “First, Let’s Stabilize Home Prices” (10/2/08), Messrs Hubbard and Mayer identify the forces destabilizing the credit markets as falling house prices. The authors believe that government action should be taken to stop this decline and recommend manipulating mortgage interest rates to achieve this goal. Such action would be a mistake.
The real problem facing our economy today is that house prices remain dramatically overvalued relative to the fundamentals that determine them. Falling housing prices are the solution to this problem and should not be restrained with inappropriate government intervention. The more quickly prices can return to fundamentally sound levels the better. Regrettably, the slow moving housing market, compounded by the extraordinary amount of leverage which we have attached to overvalued houses, will inflict unavoidable economic pain that is unlikely to subside for years.
The authors further assume that housing price declines can be stopped. Yes, “a home price is partially dependent on the mortgage rate”. But it is also dependent on factors including the supply and demand for houses, available credit, the pool of qualified buyers, the terms of available mortgages, perceived risk, expectations concerning future performance, inventory of units available for sale and the presence of foreclosures in the market.
Almost every fundamental determinant for the market value of houses today is less favorable than that which existed in the late 1990s, with the exception of population. The supply is higher as there are “more vacant houses than at any time since the Census Bureau started keeping such data in 1960”. The increase in housing stock has far outstripped the rate of population growth, more than offsetting any potential benefit from a larger pool of potential buyers. Demand is lower as a result of the decline in the availability of sub-prime mortgages. Credit is much tighter. The availability of highly leveraged and 100% loan-to-value mortgages, which had the effect of decoupling housing values from underlying fundamentals, are less available. Houses are no longer perceived to be safe investments. Potential buyers no longer expect houses to appreciate rapidly and are increasingly worried that prices may continue to fall. Changing expectations have eliminated the home’s value as a leveraged investment opportunity. Cultural and social values attached to homeownership are being eroded. And most importantly, with respect to the Hubbard/Mayer argument, marginal effective interest rates are MUCH higher.
Messrs Hubbard and Mayer correctly state that if you lower mortgage rates, housing prices rise. To this end they propose refinancing all mortgages to a government subsidized 5.25% rate. This solution ignores how prices were able to soar to unsustainably high levels. The authors ignore their own argument as the cause of this disaster. Teaser rates associated with ARMs and Option ARM payment choices lowered the marginal effective interest rate of many mortgages to as low as 1%. People with bad credit, could put nothing down and service a mortgage at a 1% rate for years. It was these extraordinarily low effective interest rates and the absence of capital requirements that caused the housing bubble and sustained such lofty valuations.
These factors in many ways reproduced the conditions which contributed to the crash of 1929 but were applied to the housing market rather than the stock market. In the 1920s the margin requirement to buy stock was 10% and interest rates were as low as 1%. The housing bubble was defined by 0% down payments and teaser rates as low as 1%. Given the relatively larger size and greater rate of participation in the residential real estate market, the impact of these conditions was in many ways more widespread and pervasive than that experienced during the stock market bubble of the 1920s.
Now that the market has recognized the excesses of the real estate bubble these affordability characteristics, which disguised dangerous leverage and distorted housing valuations, have disappeared. People with bad credit can no longer access mortgages in large numbers. Highly leveraged and 100% loan-to-value mortgages are no longer prominent. Home buyers are again required to make down payments to buy houses. The era of 1% teaser rates and optional payment plans has ended. Homebuyers are faced with the prospect of putting capital at risk, committing to service a mortgage at higher interest rates (even under the Hubbard/Mayer plan) in an environment where real estate values are high in historical terms and while faced with the prospect that those values may continue to decline. It is not difficult to see why prices are falling at record rates.
Owners of homes, who will directly benefit from the Hubbard/Mayer refinancing plan, will not determine present or future housing prices. It is the homebuyers that will set the market; especially given present supply/demand disparities and the presence of significant foreclosure volumes in the market. The government would have to extend the proposed favorable interest rates to future borrowers to see interest rate related valuation benefits. In fact, a better idea might be to provide subsidized low interest rates only to new homebuyers to encourage transactions, promote liquidity and speed up the housing market’s search for equilibrium.
While proposed refinances would save some current homeowners from default, the majority of foreclosures result from people who bought more home than they could afford. Many buyers could only service the teaser rate or minimum payment on their mortgage and expected to be able to refinance or sell their houses based on an assumption of continued price appreciation. Many borrowers overstated their incomes. Others are now losing their jobs. These people will not avoid foreclosure based on the proposed plan.
Housing transaction volumes are already restrained by a growing number of homeowners who can’t sell their houses because current values are lower than their mortgage balances. Giving subsidized, low interest loans to homeowners will lock the market up further. Some owners won’t sell their houses because the government mortgage interest rate would be lower than that available on the open market. The proposed plan would further prevent the market from clearing by distorting the value of homes for sale as perceived by homeowners who benefit from government subsidized mortgages relative to the perception of wary potential buyers who would pay market mortgage rates. The proposed system would reduce transactions and slow the market’s inevitable march towards equilibrium.
I have not read Mr. Mayer’s recent study of housing costs versus comparable rents, but I agree that relative rental rates have historically been an excellent determinant of fundamental housing value. During the housing bubble rents increased with rising home values. Furthermore, the forces which distorted house prices also influenced the total and relative supply of rental units. Now that housing prices are falling, rents are also decreasing. As such, the current relationship between prices and rents is not a valid justification, in and of itself, for existing house prices. The full continuum of factors affecting value will determine where house prices ultimately stabilize.
Housing prices generally increase with the rate of inflation and income growth. An analysis of real estate price appreciation during the bubble relative to these metrics indicates that housing prices continue to be overvalued. In many areas house values would have to fall by more than 50% to return to levels before appreciation rates decoupled from fundamentally justifiable levels. Such a decline sounds extraordinary considering our overall historical experience, but it is no more extraordinary than the decade of appreciation which caused our current predicament.
We are presently in a period where housing as an asset class is depreciating. Rational potential buyers will not borrow large sums of money to buy overvalued assets when the expectation is that values will continue to fall, irrespective of artificially low interest rates.
Before we manipulate mortgage interest rates in an attempt to solve problems caused by falling prices, consider the stock market which has declined by more than 20% this year. These falling prices are causing economic pain and are disruptive to the credit market. A comparable solution would be to have the government subsidize margin rates for stock buyers. This would be a terrible idea. In 2001 we experienced another stock market crash which was admittedly complicated by the attacks on September 11th. The government responded by reducing interest rates to generational lows. This action further exacerbated the housing bubble and directly contributed to our current situation. Government manipulation of interest rates with the intentional or unintentional effect of materially influencing asset prices is a bad idea.
It was government intervention designed to realize a social agenda that principally contributed to the current problem of overvalued houses. Proposing further government intervention with the goal of supporting prices at an arbitrary level can not and will not work. The only solution to our present predicament is to allow the markets to clear. We must let housing prices reach an equilibrium relative to the supply, demand, credit availability and more conservative mortgage characteristics of the post-bubble economy, as well as the new risk premium perceptions and performance expectations of potential buyers. Much of the housing gains seen since the late 1990s, when sub-prime and affordability mortgages began to distort the market, will be reversed.
There are steps that the government can take to facilitate the stabilization of the housing market and limit collateral damage to both the credit markets and the broader economy. Any action which would attempt or have the effect to prop up housing prices at an artificial value, though, is counterproductive. Such initiatives will only lengthen, deepen and increase the damage caused by the inevitable march to a sustainable equilibrium. The Japanese have provided us with a useful case study on this subject. Don’t stand in the way of the markets clearing. Any government action should be undertaken with a design to facilitate this clearing process and an understanding that substantial economic pain is unavoidable.
The real problem facing our economy today is that house prices remain dramatically overvalued relative to the fundamentals that determine them. Falling housing prices are the solution to this problem and should not be restrained with inappropriate government intervention. The more quickly prices can return to fundamentally sound levels the better. Regrettably, the slow moving housing market, compounded by the extraordinary amount of leverage which we have attached to overvalued houses, will inflict unavoidable economic pain that is unlikely to subside for years.
The authors further assume that housing price declines can be stopped. Yes, “a home price is partially dependent on the mortgage rate”. But it is also dependent on factors including the supply and demand for houses, available credit, the pool of qualified buyers, the terms of available mortgages, perceived risk, expectations concerning future performance, inventory of units available for sale and the presence of foreclosures in the market.
Almost every fundamental determinant for the market value of houses today is less favorable than that which existed in the late 1990s, with the exception of population. The supply is higher as there are “more vacant houses than at any time since the Census Bureau started keeping such data in 1960”. The increase in housing stock has far outstripped the rate of population growth, more than offsetting any potential benefit from a larger pool of potential buyers. Demand is lower as a result of the decline in the availability of sub-prime mortgages. Credit is much tighter. The availability of highly leveraged and 100% loan-to-value mortgages, which had the effect of decoupling housing values from underlying fundamentals, are less available. Houses are no longer perceived to be safe investments. Potential buyers no longer expect houses to appreciate rapidly and are increasingly worried that prices may continue to fall. Changing expectations have eliminated the home’s value as a leveraged investment opportunity. Cultural and social values attached to homeownership are being eroded. And most importantly, with respect to the Hubbard/Mayer argument, marginal effective interest rates are MUCH higher.
Messrs Hubbard and Mayer correctly state that if you lower mortgage rates, housing prices rise. To this end they propose refinancing all mortgages to a government subsidized 5.25% rate. This solution ignores how prices were able to soar to unsustainably high levels. The authors ignore their own argument as the cause of this disaster. Teaser rates associated with ARMs and Option ARM payment choices lowered the marginal effective interest rate of many mortgages to as low as 1%. People with bad credit, could put nothing down and service a mortgage at a 1% rate for years. It was these extraordinarily low effective interest rates and the absence of capital requirements that caused the housing bubble and sustained such lofty valuations.
These factors in many ways reproduced the conditions which contributed to the crash of 1929 but were applied to the housing market rather than the stock market. In the 1920s the margin requirement to buy stock was 10% and interest rates were as low as 1%. The housing bubble was defined by 0% down payments and teaser rates as low as 1%. Given the relatively larger size and greater rate of participation in the residential real estate market, the impact of these conditions was in many ways more widespread and pervasive than that experienced during the stock market bubble of the 1920s.
Now that the market has recognized the excesses of the real estate bubble these affordability characteristics, which disguised dangerous leverage and distorted housing valuations, have disappeared. People with bad credit can no longer access mortgages in large numbers. Highly leveraged and 100% loan-to-value mortgages are no longer prominent. Home buyers are again required to make down payments to buy houses. The era of 1% teaser rates and optional payment plans has ended. Homebuyers are faced with the prospect of putting capital at risk, committing to service a mortgage at higher interest rates (even under the Hubbard/Mayer plan) in an environment where real estate values are high in historical terms and while faced with the prospect that those values may continue to decline. It is not difficult to see why prices are falling at record rates.
Owners of homes, who will directly benefit from the Hubbard/Mayer refinancing plan, will not determine present or future housing prices. It is the homebuyers that will set the market; especially given present supply/demand disparities and the presence of significant foreclosure volumes in the market. The government would have to extend the proposed favorable interest rates to future borrowers to see interest rate related valuation benefits. In fact, a better idea might be to provide subsidized low interest rates only to new homebuyers to encourage transactions, promote liquidity and speed up the housing market’s search for equilibrium.
While proposed refinances would save some current homeowners from default, the majority of foreclosures result from people who bought more home than they could afford. Many buyers could only service the teaser rate or minimum payment on their mortgage and expected to be able to refinance or sell their houses based on an assumption of continued price appreciation. Many borrowers overstated their incomes. Others are now losing their jobs. These people will not avoid foreclosure based on the proposed plan.
Housing transaction volumes are already restrained by a growing number of homeowners who can’t sell their houses because current values are lower than their mortgage balances. Giving subsidized, low interest loans to homeowners will lock the market up further. Some owners won’t sell their houses because the government mortgage interest rate would be lower than that available on the open market. The proposed plan would further prevent the market from clearing by distorting the value of homes for sale as perceived by homeowners who benefit from government subsidized mortgages relative to the perception of wary potential buyers who would pay market mortgage rates. The proposed system would reduce transactions and slow the market’s inevitable march towards equilibrium.
I have not read Mr. Mayer’s recent study of housing costs versus comparable rents, but I agree that relative rental rates have historically been an excellent determinant of fundamental housing value. During the housing bubble rents increased with rising home values. Furthermore, the forces which distorted house prices also influenced the total and relative supply of rental units. Now that housing prices are falling, rents are also decreasing. As such, the current relationship between prices and rents is not a valid justification, in and of itself, for existing house prices. The full continuum of factors affecting value will determine where house prices ultimately stabilize.
Housing prices generally increase with the rate of inflation and income growth. An analysis of real estate price appreciation during the bubble relative to these metrics indicates that housing prices continue to be overvalued. In many areas house values would have to fall by more than 50% to return to levels before appreciation rates decoupled from fundamentally justifiable levels. Such a decline sounds extraordinary considering our overall historical experience, but it is no more extraordinary than the decade of appreciation which caused our current predicament.
We are presently in a period where housing as an asset class is depreciating. Rational potential buyers will not borrow large sums of money to buy overvalued assets when the expectation is that values will continue to fall, irrespective of artificially low interest rates.
Before we manipulate mortgage interest rates in an attempt to solve problems caused by falling prices, consider the stock market which has declined by more than 20% this year. These falling prices are causing economic pain and are disruptive to the credit market. A comparable solution would be to have the government subsidize margin rates for stock buyers. This would be a terrible idea. In 2001 we experienced another stock market crash which was admittedly complicated by the attacks on September 11th. The government responded by reducing interest rates to generational lows. This action further exacerbated the housing bubble and directly contributed to our current situation. Government manipulation of interest rates with the intentional or unintentional effect of materially influencing asset prices is a bad idea.
It was government intervention designed to realize a social agenda that principally contributed to the current problem of overvalued houses. Proposing further government intervention with the goal of supporting prices at an arbitrary level can not and will not work. The only solution to our present predicament is to allow the markets to clear. We must let housing prices reach an equilibrium relative to the supply, demand, credit availability and more conservative mortgage characteristics of the post-bubble economy, as well as the new risk premium perceptions and performance expectations of potential buyers. Much of the housing gains seen since the late 1990s, when sub-prime and affordability mortgages began to distort the market, will be reversed.
There are steps that the government can take to facilitate the stabilization of the housing market and limit collateral damage to both the credit markets and the broader economy. Any action which would attempt or have the effect to prop up housing prices at an artificial value, though, is counterproductive. Such initiatives will only lengthen, deepen and increase the damage caused by the inevitable march to a sustainable equilibrium. The Japanese have provided us with a useful case study on this subject. Don’t stand in the way of the markets clearing. Any government action should be undertaken with a design to facilitate this clearing process and an understanding that substantial economic pain is unavoidable.
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