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The United States Housing Bubble

Written By Brian Hicks

Posted February 7, 2008

With Super Tuesday now in the books and the race for the White House now less clear than it was on Monday, one item at least has risen to the top of the agenda in 2008. Just like in 1992 it’s the economy again, stupid.

That makes "mortgage moms" the top demographic to grab in the race to win the nation’s top spot, leaving the last cycle’s "security moms" in the far off dust somewhere.

So forget about Iraq, this year it’s the United States housing bubble and its effect on the economy that has one politician after another falling all over themselves in an effort to grab votes.

Take Hillary Clinton, for instance, because when it comes to pandering to the mortgage moms, she has absolutely mastered it

Recently she unveiled a plan that would not only freeze interest rates on troubled loans for five years, but would also put a moratorium on foreclosures for 90 days. Never mind, of course, that her proposal it would effectively destroy the sanctity of those contracts, because that’s not what matters. In her world, its all about votes and in this regard she’s as game as ever.

But to be fair to Hillary, she is hardly alone on this score. Everyone now–Republicans and Democrats alike– is doing everything they can to prop up the ailing housing market no matter what the eventual costs may be.

That includes the Federal Reserve, who has been cutting rates with abandon in the hopes that a worsening housing market and a recession can be softened merely through a more accommodative monetary policy.

That’s how serious of an issue the U.S. housing bubble has become-especially now that a recession seems certain.

However, regardless of their motives, each and everyone one of their plans will ultimately come up short. That’s because a plan to solve the nation’s housing bubble simply doesn’t exist outside of the marketplace that created it. Government, then, can only prolong the pain.

6 Reasons Why The U.S. Housing Bubble Can’t Be Re-Inflated

In fact, here are six solid reasons why those all of those plans will end up long on rhetoric and short on substance. Together they add up to a market that just can’t be fixed–or jawboned for that matter.They are:

1. Macro-Economic Decline For years now those who have been housing’s biggest bulls have cited a growing economy, low interest rates and low unemployment as the reasons why real estate couldn’t possibly decline. Nonetheless, after peaking in 2005 housing did fall, completely blind to these same conditions.

However, some two years later, the macro-economic conditions have dramatically changed, led not coincidentally by the bursting bubble. That sets up the real estate market for its fatal blow as both a weakening economy and now job losses are beginning to accelerate. That’s a nasty brew that not even historically low rates can fix. These factors alone are enough to send housing lower in the year ahead.

2. The Credit CrunchWhen the money to lend was sloshing all around the globe, rising real estate values were a no-brainer. In fact, those excesses were so large that they helped to turn a normally illiquid asset into a liquid one practically over night.

But with the foreclosures and defaults now off the charts in the U.S., that same pool of liquidity has suddenly gone dry. And as one lender after another has to drain their cash reserves to cover those mounting losses, their pool of deposits to lend against has dropped dramatically.

That means that what each of them can lend in the future will now fall exponentially-to the tune of 10 to 1. That’s the downside of fractional reserve lending. So for every dollar that each lender sets aside for losses that’s $10 that now cannot be loaned out. It is, in short, the workings of banking leverage in reverse. In fact, according to a recent forecast by Washington Mutual, the credit crunch will lead to 40% fewer mortgage originations in 2008 as the dollar volume falls to $1.5 trillion this year from $2.4 trillion in 2007. Forty percent fewer originations?!?!? That’s huge.

3. Lower Rates Are No Savior- A 1% Fed funds rate for over a year may have started the epic bubble, but this go round lower rates will do practically nothing to stop its slide. That’s because try as they may, it’s now impossible to re-inflate the bubble, no matter how low rates go.

The reason? Lower prices now and in the future make today the worst to time to be entering the housing market-no matter what your realtor may tell you. In fact, according to a recent report by Goldman Sachs, home prices will likely decline by 15 percent nationwide from their peak. But if the United States enters a recession — which Goldman expects the economy to narrowly escape — home prices could fall as much as 30 percent nationwide. Those aren’t exactly the types of declines that will be luring buyers off the sidelines anytime soon–even if rates continue to drop. Falling knife anyone?

Moreover, price declines approaching 20% will completely wipe out the second mortgage market. And when that happens the mortgage market will be changed in ways that lower rates will never be able to compensate for. Higher mortgage insurance and heftier down payment requirements as a result will further limit the ability to qualify.

4. Tougher Lending Standards- Back in the day when anyone and everyone could qualify for a loan, keeping home prices down was nearly impossible. Because when lending standards became as loose as they did, anyone and everyone that wanted to buy home did. And using a mix of option ARMs, interest -only loans, sub prime teasers, and liars loans, borrowers flooded the markets with a level of demand that will never be seen again-the result was a doubling of home values.

But as the absolute foolishness of those days has been exposed, lenders have gone completely in the opposite direction, turning back the mortgage clock a good ten years. That has made borrowing money considerably tougher, even for "good" borrowers.

In fact, according to a recent study by the Federal Reserve, banks are now raising their credit standards for mortgages, consumer loans and commercial real estate loans at a pace never seen in the 17-year history of the Fed’s quarterly survey of senior bank loan officers. That means that an entire level of would-be borrowers has been locked out of the market for good, further weakening demand.

Simply put, people that can’t borrow money don’t buy homes.

5. Massive Oversupply- When home price appreciation was at its peak demand was so great that on average there was a 4 month supply of homes on the market. That skinny supply scenario helped to push the market into another level.

But with demand having peaked in 2005, not even good economic times could stop or slow down the build up of inventory nationwide. In fact, according to recently released data, the supply of new homes has now grown to a glut of 9.6 months supply, while existing homes have grown to a 10.1 month supply. Those are figures that will continue to grow as demand shrinks and mounting foreclosures pour onto the markets.

In fact, according to a recently released report, the number of foreclosures soared in 2007, with 405,000 households losing their home,. That’s up 51 percent from the 268,532 homes that were repossessed in 2006. That will push prices lower in the years to come as the laws of supply and demand continue to work in reverse.

6. The Affordability Gap- When liar’s loans and outright fraud disconnected a person’s ability to borrow from their income, chasing home prices beyond real affordability was easy. But now that a persons ability to actually make their payments has suddenly become the rage again (go figure), home prices will return to their traditional anchor-income.

The result will be lower values across the board. That’s because historically, median home prices and median income have always shared a pretty consistent relationship. In fact, from the 1970’s until 2001 the historical ratio between median home prices and median income was between 2.6 and 3.0.

So where are we today? Well with the median home price at $208,400 and median income at about $49,000 that leaves us at a ratio of 4.25–more than 30% beyond the historical norm. That means that in order to return to a historical level of affordability either incomes have to rise significantly or values have to fall by as much as 30% on average nationwide.

That’s a gap that’s hard to finesse. Here’s a bet on falling values rather than rising incomes.

So while one politician after another panders to the mortgage moms, and the Federal Reserve cuts rates to near zero, it will all fail to live up to its hype.

This is one bust that can’t be stopped-even though politicians will try to convince us otherwise.

Wishing you happiness, health and wealth,

Steve Christ, Editor