Fix The House And You Fix The Mess

"I'm living so far beyond my income that we may almost be said to be living apart." - E.E. Cummings

As I have mentioned in many previous blog posts that in order for the economy to turn and get on a solid footing there has to be a recovery in real estate.  The real estate market makes up more than 10% of total GDP and when you factor in all the subsidiary businesses that number increases to more than 15%.  It is one of the largest employers in the United States and provides most of the world with their nest egg.  A continually depreciating housing market points to trouble and unless we can solve this one problem there will be a long period of slow growth ahead.

The problem with falling prices is that they exacerbate the problem.  Irving Fisher was a Yale University professor who published a paper in 1933 entitled "The Debt-Deflation Theory of Great Depressions."  In this paper he produced the theory that the pressure from excessive debt forces distressed selling by creditors which results in a broad decline in asset values, profit, output and employment.  The problem is that while asset values shrink the level of debt remains fixed.  As long as prices continue to decline there is a larger and larger incentive to default on the debt and walk away from the asset.  The lender takes the asset back but the value of this asset is now less than the balance owed so they rush to offload the asset dragging the price lower thereby setting off more defaults.  We are seeing this first hand at present and the cycle has yet to end mainly due to the problem of over-leverage.

Banks at the peak of the market got greedy for fee income and loosened the underwriting standards just at the time that they should have been tightening them.  The result is that they are now having to write-off billions in mortgage values.  This is crimping their balance sheets and so the Federal Reserve is providing them with capital.  Even so the banking industry is still reeling from the mess and and have now been forced to tighten the underwriting criteria making it harder and harder for a strapped consumer to obtain a loan.  This reduces the demand for housing resulting in continued prices declines.

This will all come to an end once the price of housing falls to a level where it pays to buy over rent and I believe that we are rapidly approaching that level, however as with most falling markets it does not reach a rational price and stop.  It often overshoots the mark before turning around however once the market prices are too low this creates demand from speculators and investors.  If we take a look at the current inventory of housing that is underwater (the owners owe more than the house is worth) it will take at least another two or three years to clear out this inventory before pricing stability is achieved.

Another fly in the ointment is the Federal Housing Administration (FHA) insured loans.  One of the outfalls of the housing crisis was the bankruptcy of private mortgage insurers so the FHA stepped in.  To date the FHA has backed more than $1.1 trillion in home loans.  Without this backing the housing crisis would have been exacerbated but now it appears that the FHA itself may be severely short of funding to handle this level of burden.  Some analysts estimate that the FHA is more than $50 billion in a hole while others estimate that number to be closer to $100 billion.  Unless the housing market can stabilize this could be another disaster waiting to happen and one in which the taxpayer will once again be on the line to pay for.  Removing the support of the FHA will undermine any recovery in the real estate market as lenders will be even more skittish to lend than they currently are.

On the plus side interest rates are at historic lows.  This means that those that can afford to buy a house are paying as little in interest as has ever been recorded.  This has always been a catalyst to house price appreciation and I believe that it will once again assist in supporting the market however it is the lack of liquidity that is the current constraint.  Tied to that is a high level of unemployment and this nasty combination is causing the drag on the housing recovery.  I remember a number of years ago the Economist magazine writing that the world property markets had increased by over $30 trillion.  While a lot of that gain has been eliminated the hangover from that party will drag on for a while and cannot be repaired by a few trillion dollars of Federal Reserve input.

Keep a close eye to the data that comes out of this sector as an indication that the market is on a strong footing will point to good times ahead however the economic indicators are pointing to a long period of slow growth ahead of us and one that has plenty of potholes to derail any form of a recovery.