The Worst Is Not Over

One of the risks, and perhaps, the irony, of employing the wrong solution to "fix" a problem is that it can make matters much worse.

In my view, that sums up Washington's efforts to address the fallout from the crisis-cum-downturn. Aside from the fact that government actions -- especially those taken with great haste and a limited understanding of the issues involved -- often have unintended consequences, the moves have inspired a false sense of confidence in many of those who've been adversely affected. Instead of making adjustments necessary to cope with what is essentially a secular shift, many have hung on in hope, viewing the events of the past few years as a nightmare that will soon be over. In the meantime, they've used up valuable resources, stuck with inappropriate lifestyles, and failed to make contingency plans.

One area of the economy about which people seem especially prone to wishful thinking is the real estate market. Already, the dip-buyers are moving in, and those who failed to sell at the top and as the market tumbled during the last two years are holding off, expecting the next leg up to take them out at much better levels. But as Martin Hutchinson, Contributing Editor of Money Morning explains in "Don’t Be Fooled by the Housing Market’s False Bottom," they risk ending up in a deeper hole than they are already.

Existing home sales surprised the markets by rising 7.4% to an annual rate of 6.54 million units in November, the highest since February 2007, according to the National Association of Realtors (NAR). That's only 10% below the all-time peak in 2005.

What's more is that house prices, as measured by the S&P/Case-Shiller 20-city Home Price Index, rose for the fourth consecutive month in September before stabilizing in October when prices were flat.

The NAR is inevitably convinced that the worst is over and that housing is due for a rapid recovery, and that home prices will take out 2006's peaks some time in 2011 or 2012.

Not so fast, guys! 
 
The recovery in housing has been boosted by just about every artificial means you can imagine:

• Interest rates have been kept at a historically low level of 0%-0.25% for a very long time.
• Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE), the bankrupt behemoths of housing finance, have been bailed out with what amounts to a blank check from taxpayers.
• The Federal Housing Agency (FHA) went on making mortgages with 3% down payments when nobody else was, thus very likely landing taxpayers with another bill for some large fraction of $1 trillion.
• And the government has been handing out cash subsidies for refinancing houses that were about to be repossessed and $8,000 subsidies for first time buyers - now $6,500 for all homebuyers.

Of course it looks like the housing market has recovered! The question is what happens when some of these subsidies are taken away?

Even if we wanted to provide gigantic subsidies to housing finance in every form for evermore, we couldn't afford to. The U.S. government is running trillion dollar deficits, and something has to change. So at some point the feather cushions that have surrounded every aspect of the housing market will be taken away.

To see how far housing might fall, look at the Case-Shiller index's bottom after the last housing bust in 1989-90 (as the 20-city index did not exist back then, we used the 10-city index). The index bottomed in September 1993 - more than two years after the U.S. economy had begun to recover - at a value of 75.81. Nominal gross domestic product (GDP) rose by 109% between the third quarter of 1993 and the third quarter of 2009.

However, the population rose by about 20%, so nominal GDP per capita rose by 74%. (Real GDP per capita rose by 27%, a pretty mangy performance over 16 years.) House prices can be expected to inflate about as fast as nominal GDP per capita, in a large country like the United States where space is not yet at a premium.

Thus the Case-Shiller Index this time around might be expected to bottom at 132 (75.81 x 174%). Its current value is 157, so we can expect a further 16% drop, even if you assume the bottom is no lower than after the milder housing downturn of 1989-90. That bottom will probably be reached around the end of 2011 if the 1990-93 post-recession pattern plays out.

Oops.

To give you an idea of what that might mean, the Case-Shiller 10-city index passed 132 in June 2002. That means, on average, everybody who has bought a house since June 2002 can be expected to be underwater on the deal when the bottom is reached.

Every mortgage with a 10% down payment made since about April 2003 (when the Case-Shiller index was 147 - 90% of which is 132) would be underwater. Every prime mortgage with a 20% down payment - not that many of these were being made in those years - made after February 2004 would be underwater.

Of course, that's an average. In Dallas, there would probably be few foreclosures beyond those we already have seen, because prices didn't go up so much. On the other hand, in Las Vegas, pretty well every mortgage made since Bugsy Siegel started developing the Flamingo in 1946 would be kaput.

The housing market is unlikely to turn around while there's so much cheap money about, or while the feds are subsidizing home purchases to such an extent. However, at some point next year, reality will hit the U.S. economy and the federal budget - maybe simultaneously.

The house purchase subsidies are likely to be extended for one more six-month period, through December 2010, over the midterm elections, but not beyond that. At some point, the losses on the FHA mortgage portfolio will become large enough that some of them will have to be taken "on budget." And at some point, either resurgent inflation or soaring commodity prices will force Ben Bernanke to raise interest rates - or crash the Treasury bond market because he won't do so.

At that point, reality will return to the housing market too.

Comments

[Doug K]

As a Realtor on the outer fringes of a large metro area, I think housing will not truly "bottom" until at least three years after real unemployment drops back to what it was before the crash. Stimulous efforts appear to have propped up the market in the suburban ring around the metro area but not in the transition zone to rural, or the rural areas outside the metro area.

[buzzsaw99]

So at some point the feather cushions that have surrounded every aspect of the housing market will be taken away...

I see no evidence of this ever. They will doom the currency trying to save the banks.

[Independent Accountant]

I am considering buying a house. Why? To get a 20-year fixed-rate mortgage and "short sell" the dollar. Here in Houston, real estate does not look expensive.

[Mountainaires]

Oh, God, how does the NAR get away with these lies, even now?!? It's outrageous and it impacts so many people negatively that one could see a criminal case being made against the NAR for FRAUD. I have neighbors who are in desperate financial straits, trying to sell a house they built [spec house] in 2006 and put on the market right as the bubble burst. They listened to the NAR and got burned, big-time. They're STILL paying the loan for this house, as well as the insurance, heating, water, and lights as they try to sell it, and cannot. They are paying 2 mortgages and it's destroying them. They believed the NAR! All along, the NAR lied at every step of the economic crisis, "Hey, it's all good; there's no problem with sub-prime; there's no housing bubble; housing is bottomed and we're on the upswing, blah, blah, blah.

We really--really--need to EXPOSE the NAR for their lies, over and over and over again if need be, until NO ONE is misled by their lies anymore.

[J. Foster]

Screw your neighbors AND the NAR. Both guilty of greed

[Hal (GT)]

I agree that reality is going to hit sooner or later. All the Gov has done is great a bubble of mammoth proportions with the propping up of housing. You can't have the national debt skyrocketing unchecked and not expect fallout. There is no way to escape the gravity of financial reality except to just wipe out all debt and erase it from the books.

My fear has been that come February we may see another crash of the financial markets. Add to that the unemployment (I don't think the numbers that the gov are reporting are close to the actual numbers) and the continued housing troubles and we could be in for one major trial.

It's one of the reasons I keep an eye on the precious metals. To me they are a good indicator where the big money is forecasting. I use http://www.learcapital.com/exactprice it's free and in real time. What with the Central Banks all becoming net buyers of gold now, I have a suspicion that they know that the future is not looking too rosy and they are looking to protect themselves.