Bailout, house prices and recession

http://calculatedrisk.blogspot.com/2008/09/housing-its-about-prices.html

The above link has some very good information on house prices. Includes real prices (inflation adjusted), price-to-rent ratio, and price-to-income ratio. This would show where house prices should/could revert back to based on statistical norms and also based on past (conservative) loan standards. The bail-out of the GSE's should help to free up liquidity and also may reduce interest rates a bit, but it doesn't solve the problem of asset prices being unsustainable under "normal" loan standards and risk models.

In my opinion, what the bailout does primarily is provide a very solid support to the housing market once it reaches bottom based on these models. A return to statistical norm. The risk was that with a failure in the GSE's (90% of all current loans), the market would completely collapse and we would overshoot on the correction. This is typically what would happen in a "free-market" correction. A large bubble is followed by an equally large and statistically proportionate drop below norm. Banks generally would not want to come in and provide loans until a true bottom had been revealed (the banks that survive that is). The fear of catching a falling knife. Therefore, generally the correction would overshoot and that would be catastrophic. A return to norm will be painful enough...an overshoot would have been a disaster.

The problem is, a return to statistical norm will still cause a massive deflationary event and there is still a tremendous amount of leverage built into the system that will continue to unwind along with house prices. Those charts should give you a good idea where house prices need to return to until the bottom is reached. There is still a long way to go. Fannie and Freddie will not be loosening their loan requirements under this bailout. If anything, they will become stricter. What won't happen is that someone who qualifies for a loan, would have trouble getting access to capital. That was a risk under the previous scenario.

What most people aren't touching on is that the primary driver of asset prices (in particular houses) is income. Factors such as interest rates have a much smaller impact on home prices under normal loan standards. The problem with this bubble was the primary factor in home prices was driven by "lowered standards". No doc loans and option-ARM loans allowed families making $60k to buy houses worth $800k with zero down. Those types of loans are gone forever (or for atleast a generation). There really is no market that can fill the void left by an almost 3-6 times income decrease in purchasing power by consumers.

If median income was $70k, then the "affordability" of homes was closer to $600k to $700k. Now we are looking at $210k to $280k for the same income level. That's a massive discrepancy in the purchasing power of consumers. That will be the primary driver of home prices. The only group really able to fill the void are investors and they will be looking squarely at the price to rent ratio before they get back in the game. There is ALOT of capital just waiting to get back into the game, but not until asset prices are attractive again. The government would love to try and artificially inflate house prices, because they know the impact it has on foreclosures, federal and state incomes, etc... The reality is they can't maintain these inflated values UNLESS they subsidize loans to people who wouldn't qualify for them in the first place. That would be a return to the lax loan standards of the last 8-10 years. I can't imagine any scenario where the american public and foreign governments would allow that to happen. Asia and the Middle East would be crazy to continue funding our current account deficit at these low rates if that were the case. You would see a spike in Treasury rates and that would convert to higher costs on ALL debt across that board. By explicitly linking mortgage debt to treasury debt, the government has in essence dropped the one method for hiding those losses and providing a lack of transparency. As in most ponzi schemes (and this fundamentally has been one for the last 5 years), eventually the game is up. One of the only reasons that foreclosures did not begin spiking 3-5 years ago was that people who were technically in default on their loans were able to refinance or sell there houses. That exit strategy is gone now and the ponzi scheme of rolling the debt over evaporates. Same thing is starting to happen with credit cards, autos, corporate debt, etc... Corporate debt is generally a lagging indicator. It's already showing signs of stress and in a recession, typically we would have 8-10 times the level of default that we have now. In my opinion (and based on past recessions) that will start kicking in heavily within the next year or two. There have already been some significant corporate bankruptcies this year because of heavily leveraged buyouts. The LBO debt in the corporate bond market is extremely high and is a house of cards during this credit contraction.

You may think I'm all doom and gloom and negative, but the reality is, we will be in a much much better place as far as our country is concerned if we flush out all the malinvestment. Recessions in my opinion are a necessary event to help eliminate the bad business models and to provide a mechanism in place that deters malinvestment. You cannot continue to socialize losses and subsidize bad models without major repercussions. Greenspan when he lowered rates to avoid a recession in early 2000 in some ways didn't anticipate the massive bubble he would blow in real estate. The combination of historically low interest rates and an unproven securitization model was explosive. Warren Buffet realized that and commented on derivatives. "The real weapons of mass destruction". He also subsequently sold off his massive stake in the GSE's. He once owned almost 10% of both companies. He liquidated long ago when he saw the model and transparency changing. It didn't take a genius to understand the model was flawed, just somebody who cared and had a stake in the outcome.

If the government is to step in and help stop an over-correction in the markets I'm all for that. They must, however, wipe out the investments that were made under the knowledge that they were "investments". They must also make sure that the models and transparency that are put in place are fundamentally sound based on KNOWN economic models. Not assumption and financial wizadry that has no proven track record. You can't burden the tax payer with losses that should have been sustained by a knowledged investor and at the same time continue to support the business model that failed initially. In some cases, asset prices must decline to get back to sustainable models. The government CANNOT and SHOULD NOT try to subsidize prices. They should only provide adequate liquidity and capital to allow the market to function efficiently under a viable and sustainable model.