clip_image002

Popular Economics Weekly

Much analysis has already been done on the causes of the housing bubble, but little done on helping to cure it. Nobel economist Professor Joseph Stiglitz’s just published FREEFALL is perhaps the most comprehensive analysis of what went wrong. He blames deregulation for allowing most of the excesses, since everyone—not just homeowners—over borrowed, and wants more stimulus spending that benefits Main Street jobs rather than Wall Street financiers.

Most of the stimulus spending to date has been either to prop up the financial system (TARP), and/or retain jobs, such as the $785 billion for ARRA, the American Recovery and Reinvestment Act.

The Fed’s $1.3 billion purchase of mortgage-backed-securities has kept down interest rates, but regulators are still pushing lenders to tighten their credit standards. The latest change is a maximum debt-to-income ratio limit of 45 percent of gross income. To date, this hasn’t helped to lower foreclosure rates, so defaults are still at record highs.

Part of the problem is there is still little agreement on the causes of the housing bubble. This is compounded by past and current Fed Chairmen saying they have little control over asset bubbles.

But in fact the cause of the housing bubble—and consequent recession when housing collapsed—was no different from that of any other bubble-caused recession. Too easy credit was extended that caused a huge oversupply of housing to be built and sold. Many more homes were built than could be justified by economic fundamentals, in other words.

And so when the Fed began to raise interest rates again in 2006, it popped the bubble of the subprime and Option ARMs as mortgage payments rose from their artificially low initial rates and borrowers began to default. Since banks had loaded up on these toxic loans, they could no longer service their normal business clients when those toxic assets were drastically devalued. That is, normal credit dried up and so business activity began to shrink.

clip_image004

How is real estate doing? New home sales fell 4 percent, but housing permits rose 10 percent; the second month of improvement, auguring higher residential construction next year.

Despite weakness in starts in the latest month, homebuilders are somewhat optimistic based on permits. Housing permits continued last month’s rebound rising 10.9 percent in December after a 6.9 percent comeback the month before. The December pace of 653,000 units annualized was up 15.8 percent from a year-ago. Both single-family and multifamily permits were up monthly in December.

But it is very unlikely that there will be a strong rebound in housing construction until the record number of vacant housing units is reduced. The vacancy rate has continued to climb even after housing starts fell off a cliff. Initially this was because of a significant number of completions. Also some hidden inventory (like some 2nd homes) have become available for sale or for rent, and lately some households have probably doubled up because of tough economic times, according to ECONODAY.

clip_image006

Then how can government help solve the housing crisis? Firstly, it is obvious from the high vacancy rate that there is still an oversupply of existing homes. And it is the record low interest rates plus the homebuyers’ tax credit—now extended through June—that is spurring home purchases. So the Fed should continue to hold down interest rates through 2010, at least.

There has also been talk of reducing principal loan balances for those millions of loans now underwater. But neither lenders nor the U.S. Treasury have been eager to embrace that option, according to the Wall Street Journal in a recent column, for fear it will precipitate more foreclosures:

“… Assistant Treasury Secretary Michael Barr … suggested that there would be a risk that such a [principal] program would change a lot of borrowers’ behavior. “Most people, most of the time, make their mortgage payments … even if they’re underwater,” Mr. Barr noted. “You have to be quite careful not to design a program that induces more people to walk away” …

Anyway, it is payment reductions that have been the most helpful to borrowers to date. But the reduced rates have to be fixed for at least 5 years, before any rate adjustment occurs. There should also be an interest-only option, and rates should be in line with current rates, which are 3.50 to 3.75 percent with a 5-year fixed rate conventional ARM for a 1 point origination fee.

Harlan Green © 2010