Tuesday, 16 February 2010 01:04

Housing Death Spiral, Pt. II

by Manuel Rodriguez

Local governments and real estate trade groups acknowledge that they are extremely worried about the inevitable withdrawal of federal assistance from the US housing markets.

The New York Times, reports here, that cities hit hardest by the collapse of the real estate bubble face significantly more distress in the coming years, as the federal government gradually removes the massive subsidies that have prevented a complete collapse of the residential real estate market, and with it, the economy. To the extent that the real estate market is functioning at all, it "is doing so only because of the emergency programs, which have pushed down interest rates on mortgages and offered buyers a substantial tax credit."

Notably, that aid has included the following:

  1. The Federal Reserve has purchased over $ 1 trillion in mortgage securities to provide liquidity to the mortgage markets. These purchases have also forcibly and artificially pushed down mortgage rates. The scope of these purchases is unprecedented.
  2. The Federal Housing Administration insures loans from buyers that have provided only minimal down payments. Studies note that buyers having little "skin" in the housing game are the first ones to walk away from their properties.
  3. The first time buyer home tax credit, which is set to expire in the spring of 2010. This credit has merely cannibalized sales from one period to another, as buyers attempt to take advantage of the credit. The net effect of the expiration of this credit will be that future sales will dip by the same number of sales that were driven by the tax credit. Essentially, the tax credit has robbed sales from future periods to artificially inflate the current period. These are little more than timing differences.

Given the unprecedented scope of federal assistance, many analysts argue that federal support cannot be withdrawn for at least 5 years. Indeed, if housing sales are currently anemic given the massive subsidies being provided, what will happen when those subsidies are withdrawn? If sales can only be sustained through artificial "priming" of the real estate marketplace, what is the outcome when federal assistance is removed? Will sales collapse and another massive dip occur, and roll-back price points to 1996, 1997 or 1998 levels? It is important to remember what occurred to the automative industry. Once the artificial effects of the asset consumption bubble were removed, sales plummeted over 40% to barely 10 million cars per year, from a high of nearly 17 million at the their peak. Why would the housing market be immune from the same collapse?

The obvious answer is that it's not, and the federal government will be forced to keep these programs in place for years, possibly even a decade. The distortions created by these programs will not, by themselves, re-inflate the asset bubbles, but they will prevent prices from dropping to the point where housing becomes affordable for America's middle class. Until this occurs, until underlying income strictly correlates with housing prices, no significant improvement in the residential real estate market will occur.

Interestingly, the federal government may be fueling the next housing collapse, as low-income and middle class buyers, the principal target's of the tax credit and FHA's efforts, could abandon their homes in droves should the economy fail to gain momentum or housing values continue to stagnate. Given the impending wave of resets on option-ARM loans totaling nearly half a trillion in the next 2-3 years, and the commercial loan refinancing crisis, estimated at nearly $1 trillion over a 3-5 year period, the government will face grave difficulties preventing an outright collapse.

Which evil is ultimately worse, continue printing money,  insuring bad loans to marginal buyers and eventually fueling runaway inflation, or ending subsidies and allowing the housing and commercial markets to correct to sustainable levels? The answer is obvious.



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