Step One: Deflate the Housing Bubble

The Wall Street bailout doesn’t address the core problem facing the US economy: house prices that are continuing to fall…

The U.S. financial system will remain in tatters even if the bailout succeeds beyond anyone’s wildest dreams. The core problem is the large and growing volume of bad loans, which currently exceeds $700 billion by most estimates.

While this has usually been identified as a subprime crisis, it is really a larger problem of bad mortgage debt. Subprime loans are over-represented because by definition these were the most risky loans to the most vulnerable segment of the population. However, the default and foreclosure rate on all housing loans has soared far beyond the normal range.

The reason for surging default rates is simply the collapse of the housing bubble. House prices nationwide have fallen by almost 20 percent since their peak in the summer of 2006. In some cities the decline has been more than 30 percent. As a result, tens of million of homeowners are now under water, owing more than the value of their home.

The loss of home equity is also leading to higher default rates on credit card debt, car loans, and all other types of consumer loans. People who could have drawn on home equity to pay other debts no longer have this option.

While the drop in house prices has led to the recession and the financial crisis, the fact that prices are continuing to fall worsens both problems. At this point, the bubble is only about 60 percent deflated. House prices still have another 10 to 15 percent to fall, and considerably more in many markets that are still seriously inflated.

This pattern of declining house prices worsens the economic situation because banks will be very reluctant to make loans in markets with declining house prices. A 10 percent down payment provides little security to lenders in markets where price declines will leave the homebuyer with no equity after a year.

Whether or not the country faced a credit crunch, it takes a very foolish banker to make mortgage loans in markets with sharply declining house prices, without very large down payments. Earlier this decade, Greenspan and others became irrationally obsessed with the risk from small rates of deflation. It does little obvious harm to the economy if prices overall drop by 0.5 percent annually. However, it can do great harm to the economy if house prices are falling at the rate of 10-15 percent annually.

Some analysts have foolishly proposed house price support systems to end the fall. House prices supports makes no more sense than farm price supports and are considerably less workable. However, there is a better way to stop house prices from falling: bring them down.

If house prices can quickly be brought down to their trend levels, then prices can stabilize. This would allow for banks to resume normal lending in the mortgage market. If house prices stabilize at their trend level, it would also allow homeowners to make plans based on the true value of the equity in their home.

This rapid price reduction could be brought about through policy actions. The key factor is simply information. It is possible to produce rough estimates of the trend level of house prices based on past movements in house prices, rents, and long-term relationships between sale prices and rents. Dan Alpert, of Westwood Capital, used this information to calculate the extent to which house prices can be expected to fall in each of the 20 cities in the Case-Shiller house price index.

This information can be publicized to quickly bring prices back down to their trend levels. For example, Federal Reserve Board chairman Ben Bernanke can use this information to highlight the problem of a continuing housing bubble in his testimonies before Congress and other public appearances.

He can stress the fact that banks who continue to make loans to purchase bubble-inflated properties can expect to see large losses, unless they require extraordinary down payments. He could also point out that buyers who purchase homes at prices that are still inflated can expect to see substantial losses on their houses. Such comments would help to quickly bring house prices back to their trend level where they could stabilize.

Better yet, President Bush, who threatened the country with the prospect of another Great Depression if Congress didn’t pass his bailout bill, could instead use his bully pulpit to warn of over-valued house prices. This would be done with the supporting charts and data so that everyone could evaluate the evidence.

It might be hard for President Bush to explicitly act to deflate the bubble after he allowed it to grow unchecked and reach such dangerous proportions. However, quickly deflating the bubble would be the best thing to do for the country and the economy. Perhaps a President who has shown so little courage and integrity during his eight years in office will finally be able to rise to the occasion in his last months in the White House.

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