Housing Crisis: Prices are Dropping and Should Drop

by  D. Cupples | A record-high 900,000 people are facing losing their houses to mortgage foreclosures. (CNN)  That's about 2.04% of all mortgages.

Some commentators seem to think that plummeting housing prices are the enemy.  But weren't plummeting prices (i.e., a market correction) inevitable and necessary? 

Starting in 2001-02, U.S. housing prices began to artificially inflate, like stock prices did during the tech-stock bubble.  Eventually (unless people's salaries go up at the same rate as housing prices,  which they haven't), the housing bubble had to start deflating because the economy can't sustain artificially high prices forever.

I'm not an economist, but it seems to me that the Fed's keeping interest rates artificially low for too long is what caused housing prices to artificially skyrocket.   

In my North Florida town, for example, a house that might have sold for around $175,000 in the year 2000 ended up selling for $250,000 or more in 2004-05.

Most people's salaries did not go up that fast.  The only reason many people could afford a $250,000 house is that interest rates were so low, enabling them to make the monthly payments if they stretched the mortgage out 30 years.

Those who got fixed interest rates probably still can afford their monthlies.  Those who got  Adjustable Rate Mortgates (ARMs) could afford the payments until the interest rates started adjusting upward (i.e., back to a normal level).

To give you an idea of how interest rates affect monthly house payments, I've constructed the table below (based on a Wachovia mortgage calculator for a 30-year mortgage on a house in Florida that's actually worth $200,000).

Loan              Interest Rate         Monthly Payment

$200,000             4.5%                     $1,013

$200,000             5.5%                      $1,135

$200,000             6.5%                      $1,264

$200,000             8.0%                      $1,467

People who can afford the monthly payments for a 5.5% mortgage might not be able to afford the payments on an 8% mortgage.

From about January 2001 - June 2003, the Fed cut interest rates 13 times, partly in response to the dot-com bubble and the 9/11 attacks.  The initial cuts might have been good for our economy, but keeping interest rates low for so long drove up housing prices beyond reason (i.e., beyond what most people could afford while paying a more natural interest rate).

My fear, assuming that I understand the situation correctly, is that policy makers might opt for going back to cutting interest rates for the long term.  l

If mortgages become cheaper again (and for a long time), then won't housing prices simply remain artificially inflated or become even more so?

If that happens -- unless most American's salaries inflate similarly, which I wouldn't bank on -- most Americans won't be able to afford houses down the road. 

That might be nice for people who bought houses at artificially inflated prices, but what about everyone else?  And how would that affect the building industry and other connected industries -- along with the many jobs attached thereto?

Memeorandum has other commentary.

Comments

[Adam]

In fairness, regular folks who downsized (empty nesters, folks moving away from expensive neighborhoods, et cetera) were also winners as a result of the real estate bubble. And of course, the builders, agents, and banks who won during the bubble are getting killed right now. (On the other hand, I bet there's some speculators out there who sold short on the pre-bubble market and made a killing.)

We are in a "market correction", and anything that forestalls that correction - either cutting lending rates or freezing forclosures - is simply delaying the inevitable. Even worse, offering relief to those who speculate and lose simply encourages people to invest recklessly (for another example of this, look at the S&L crisis of the late 80s).

Obviously this situation sucks and I'm not without sympathy. I know people who have put $50k into a house and are still upside-down (i.e. they owe more on their house than the current value of the home). This sucks for them, but they made terrible financial decisions. Signing a mortgage that you know you won't be able to afford down the road unless your house appreciates is just crazy.

The government is not going to be able to keep everybody in their new $400k 6k sq. foot houses in the suburb development that they bought with a tiny down payment and a big subprime loan. People are going to have to declare bankruptcy, banks are going to have to write off a ton of debt and take big losses, and with some luck the real estate market won't see such irrational exhuberance for a long time. The government should provide assistance to poor families who are put out of their homes, and can slow the process somewhat, but they can't and shouldn't stop it.

[D. Cupples]

Adam,

We DO agree on stuff. I edited the piece since putting it up (took out the short para re: some of the people who benefited).

I think you're so right about harms coming from delaying the inevitable. You put it perfectly ($400 K, 6K sq ft house).

I also agree with what you said re: a bail out's encouraging bad behavior (like the S&L scandal).

What do you think our "leaders" will end up doing?

[Adam]

Inaction is something this government is reasonably good at. I think that the current administration is going to avoid doing anything too dramatic, and by the time the next one is in, we will be pretty close to the end of the correction.

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[San Diego Lasik - Betty]

Good post! As a tie-in, I came across another post that reported that Moody's Investor Services recently issued a report showing that 40% of mortgages re-worded in 2007 are now again in default! The full post is at http://www.brokerforyou.com/brokerforyou/ The site has a very good 7-17-08 post on the coming next wave of foreclosures. Thanks for the read .... Keep up the good work!

[D. Cupples]

Betty,

Thanks for the info