Wednesday, May 16, 2007 | The speculative housing bubble that launched San Diego home prices so high is now in the process of deflating. Prices have been on the decline for over a year, but they remain well above the levels that would be justified by the economic fundamentals now that the bubble-era forces of rampant buyer optimism and unsustainably lax lending are disappearing before our eyes.
Using the analytical framework described above, and considering the precedents set by past boom/bust cycles in the San Diego housing market, it sure seems that the most likely outcome is for San Diego home prices to continue declining for some time to come. But nothing is ever for certain in the financial markets, so today I’d like to discuss the following question: what could prevent a serious decline in home prices?
As I see it, there are two potential factors that could help out the housing market.
The first is economic growth. If home prices are too high in comparison to rents, incomes, and other fundamentals, then it’s at least possible that those fundamental factors could rise to meet home prices rather than the other way around.
The problem is that this just isn’t very likely. Home prices are so out of line with rents and incomes that, given the current pace of their growth, it would take many years for rents and incomes to catch up. Meanwhile, the oversupply of inventory (especially that of the must-sell variety) would be exerting downward pressure on prices the entire time.
The only way that economic growth could single-handedly bail out the housing market would be for regional economic activity, employment, and incomes to grow in great excess to their current levels. Such a gold-rush style boom is certainly within the realm of possibility, but it’s not an outcome that I would consider likely.
The second factor that could aid housing market is government intervention.
We don’t have to look back very far to spot a potential blueprint for the federal government’s reaction to a housing-led slowdown. In the aftermath of the 2001 recession that followed the bursting of the stock market bubble, the Federal Reserve slashed short-term rates to levels not seen since the 1950s. Such ultra-low rates encouraged consumer borrowing that, in combination with rampant federal deficit spending, helped to keep overall demand aloft and to end the recession in fairly short order.
Of course, this technique had some unintended consequences (a housing bubble, record-shattering debt levels, and a structurally weak U.S. dollar come to mind). But I don’t expect such nitpicking to stop the folks in Washington from using the same playbook again should the housing-related pain become too uncomfortable for their constituents to bear. Let’s look at the actions of the Federal Reserve and Congress in turn.
The Federal Reserve will want to lower their short-term federal funds rate. In the case of a housing bust, lower short-term rate would be of key importance to the hordes of adjustable-rate mortgage holders who are facing higher payments once their loans reset. Jamming short-term rates back down to 2003 levels would certainly prevent a lot of foreclosures.
If things got bad enough and lowering the fed funds rates didn’t do the trick, Federal Reserve chairman Ben Bernanke could even implement some of the more radical policy suggestions he made in his seminal 2002 “helicopter drop” speech, such as setting long-term as well as short-term rates and directly intervening in the mortgage market.
It all sounds easy enough, but the truth is that the Fed can’t lower rates (let alone enact any of Bernanke’s proposed pull-out-the-stops policies) with impunity. Lowering short rates tends to cause the dollar to fall and inflation to rise. Here in 2007, the dollar is a lot weaker and inflation notably higher than in 2003 when the short-term rates plumbed their lowest depths. It’s doubtful that the Fed could do anything as drastic as they did after the stock market bust, but it’s still likely that they will lower rates to the extent that they are able.
For its part, the people in Congress can continue to do what they do best: spend money that they don’t have. There have been few repercussions to such an approach so far, and until there are, the government can be expected to keep on spending — especially if times get tougher. In general, borrowing from the future to spend in the present tends to provide a short-term stimulus to the economy. Given that “short-term” is the typical politician’s favorite timeframe, this approach is a crowd favorite.
A housing bust would provide even further temptation to spend money directly on attempts to address the market itself. Some of our more eagerly opportunistic leaders are already scrambling to throw taxpayer money at the subprime mortgage problem, but the list of potential opportunities for federal largesse is nearly endless. Our leaders could stoke housing demand by offering tax breaks or direct subsidies to potential home buyers. They could help out struggling homeowners by increasing the already generous tax breaks that owners are granted. They could force lenders to extend mortgage teaser-rate periods or allow lower monthly payments for troubled owners. They could put a moratorium on foreclosures (an early variation on this theme is already taking place in Massachusetts, where the state is demanding that lenders delay the foreclosure process by up to two months for any borrower that files a complaint with state bank regulators). They could direct government-sponsored mortgage purchasers Fannie Mae and Freddie Mac to loosen their standards to keep mortgage credit freely available. And if too many private lenders got into trouble, the government could affect an industry bailout as they did with the savings and loan industry in the late 1980s. The list goes on.
Keeping rates excessively low and increasing deficit spending could work for a more fundamental reason. Both activities tend to result in more money being created and spent into the economy. To the extent that there are more dollars chasing the same amount of goods, each dollar becomes worth less in comparison to those goods. This reduction in dollar purchasing power is more commonly known as “inflation.”
If the government’s tactics were to cause inflation to pick up the pace, incomes and rents might quickly rise in dollar terms. This could allow the fundamentals to catch up to home prices without the latter falling too steeply. It’s not that great to own a home whose price is stagnating while the price of everything else is rising, but it’s probably better than owning a home whose price is falling outright. (Of course, higher inflation would tend to increase interest rates, but as described above, various legislators and Fed chairman Bernanke have already pitched the idea of forcefully keeping mortgage rates low.)
The potential interventions are many, varied, and complex. And unlike an explosion of local economic growth, at least some degree of monetary easing and housing-oriented deficit spending will be almost inevitable if things get bad enough in the real estate market.
What effect the interventions will have is another question. Meddling with the market rarely works out exactly the way it was intended, as witnessed by the housing bubble and the other economic distortions caused by the government’s stimulative efforts from 2001-2003. And as we’ve seen with the subprime debacle, the government rarely reacts to something until after it’s a crisis, so there could be some issues of closing of metaphorical barn doors vis-à-vis the whereabouts of certain metaphorical horses.
We have a long way to go before home prices once again meet up with their fundamentals, and there’s no way of knowing exactly what path will be followed to that destination. The point is that while there will likely be tremendous downward pressure on home prices, it’s important to acknowledge that there could be some forces putting pretty serious pressure in the other direction.