Dream to Nightmare: Who Should Pay for the Housing Disaster?
Monday, April 7th, 2008
This is a guest post by Peggy Crawford, PhD, Professor of Finance, and Terry Young, PhD, Professor of Economics
The housing saga continues. The hope of “owning a piece of the American dream” is becoming a nightmare for some home buyers. While optimists argue that the “worst” is over as they cling to any sign of positive news, such as the slight upturn in sales of existing homes in February, others call for the government to come to our rescue and save homeowners by declaring a moratorium on foreclosures or “encouraging” financial institutions to renegotiate loan terms. Meanwhile, the Federal Reserve continues to cut interest rates (sometimes dramatically) hoping to ease the pain for some as interest rates reset on their mortgages and to spur activity in the sagging economy.
Have housing prices stopped plummeting? The experts disagree, but Business Week states that home prices could decline by another 25 percent over the next 2 or 3 years, returning the values to their 2000 levels in inflation-adjusted terms.
What can we expect? Like any market, the housing market is based on economic fundamentals of demand and supply. In general, housing prices are inversely related to interest rates. Now, both interest rates and housing prices are falling at the same time.
So, why aren’t sales increasing? Things have changed.
First, lenders are scrutinizing borrowers more carefully. No/low down payments are disappearing and no documented income is a thing of the past—at least for the time being. And second, potential buyers hear the news and are waiting for prices to fall further. On the other hand, some potential sellers are still in denial that the value of their property is decreasing not increasing.
This slows clearing in the market and increases the inventory of unsold homes. The wait and see attitude of buyers may be a self-fulfilling hypothesis as sellers/builders come to the realization that prices must fall—even further.
How far will it fall?
Housing prices spiraled upward more quickly than wages. Loans were approved with historically high ratios of home price to wages based on low mortgage rates—often low teaser rates which would eventually adjust upward. This artificially made home ownership possible for subprime borrowers. These borrowers stayed ahead of the game as long as interest rates were low and prices were increasing. They continued to refinance—often again at low teaser rates—and frequently pulled cash out of their home increasing the size of the mortgage.
But, interest rates begin to rise and borrowers lost the ability to refinance. Foreclosures begin to rise increasing the inventory of unsold homes. Builders, who had been throwing up homes in every conceivable spot, found that sales began to dry up. The oversupply of new homes increased the inventory of unsold homes.
So, housing prices have more room to fall, but the fall will not be a broad based. Housing prices that increased the most will probably fall the most. Over the past five years, house prices have more than doubled in California, Nevada, and Florida. These areas are already seeing the biggest drops.
How far will the housing woes spread?
The housing slump is impacting the economy in several ways.
First, homeowners felt “rich” when the price of their home was increasing and they shopped. Consumers have been the engine of growth. A key risk to the economy is decreasing consumer expenditures. Now that credit has been tightened; and the wealth effect eroded, will consumers stay home?
Second, the housing boom created jobs in construction, real estate, mortgage banking, and other support areas. When jobs were plentiful and income was growing, weakness in the housing market was muted. Now the jobs are disappearing in these areas and many of the jobs now available offer lower salaries. Will unemployment or lower wages decrease consumer spending?
Last, the misery in the housing market spread throughout financial markets affecting a large number of financial institutions. The credit crunch limited borrowing , mortgage defaults spread to credit cards and other types of loans, assets on the books of institutions lost value, profits of some firms are down, and equity markets have trended downward. Will the vicious cycle continue?
Do reckless mortgage borrowers deserve to be rescued?
Much of the political discourse centers on saving homes from foreclosures. Subprime borrowers were often poorer and frequently bought toward the top of the boom. Lax lending standards, easy credit, and creative mortgage instruments provided by lenders allowed borrowers to take out loans that they could not afford.
No doubt there are many hard working borrowers who did not understand what they were doing. But the question is who should pay for this?
Lenders who mislead borrowers should pay.
Wall Street bankers, who misrepresented high risk mortgage-backed securities, should pay.
But, should the borrowers take responsibility for their decisions? Or should taxpayers who may have accepted loans with higher interest rates, but less risk, pay for a bailout?
We have an opinion. What’s yours?
Let us know in the comments and we’ll get back to you soon with our thoughts.
Related in the Graziadio Business Report
Will the Sub-Prime Meltdown Burst the Housing Bubble? by Peggy J. Crawford, PhD, and Terry Young, PhD
Is the Real Estate Market a House of Cards? by Peggy J. Crawford, PhD, and Terry Young, PhD
Facing Up to the Possibility of Deflation by Donald M. Atwater, PhD (From 2003: An early prediction of how the housing market could spark a deflation event in the U.S.)
Topic: America's Financial Crisis, Economics, Finance, In the News, Real Estate
Tags: bubble, deflation, housing, Real Estate, sub-prime
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Comments
Eric Hundin
April 7, 2008 at 5:16 AM
I found your blog on MSN Search. Nice writing. I will check back to read more.
Eric Hundin
Glenn
April 7, 2008 at 7:51 AM
An excellent article. No one really has a crystal ball that can tell us when the prices will bottom out. Yes, we look for positive signs within the real estate cycle for hope that the market will turn around. However, a real estate market is a long turn around, it is dissimilar to the equity or commodity markets that can have a quick turn around.
My thought is that price declines will be dependent upon the timeline for the rapid price increases. The longer the timeline the greater the fall. If the price appreciation was over a longer timeline the price drop will be less severe.
I like the fact that you kind of re-engineered the loan cycle to state that lenders and Wall Street bankers should be the first to pay, since they were the last to profit from the cycle.
Off the topic, I would really like to hear your thoughts about the socio-economic responsibility of business in today’s business world.
unlawflcombatnt
May 1, 2008 at 12:43 PM
”
Lenders who mislead borrowers should pay.
Wall Street bankers, who misrepresented high risk mortgage-backed securities, should pay.”
Amen. I completely agree.
In regards to your question:
“should taxpayers who may have accepted loans with higher interest rates, but less risk, pay for a bailout?”
No, absolutely not.
Also, I wanted to comment on the current disconnect between interest rates and home prices.
Interest rates aren’t having the predicted affect on housing because it’s not interest rates themselves that directly affect housing demand or prices.prices. Interest rates are largely a surrogate marker of borrowing ease & lender willingness to make loans.
It’s the relative ease of obtaining loans that directly affects home prices. Rising interest rates normally parallel reduced loan availability and reduced lender willingness to make loans. In contrast, declining interest rates normally parallel increased loan availability and increased lender willingness to make loans.
The current situation, however, marks a shift from the apparent connection between interest rates and loan availability. Despite lower interest rates, mortgage originators are less willing to make loans. Instead of just raising the interest rates to compensate for the increased default risk of less credit-worthy borrowers, lenders are simply screening out less credit-worthy borrowers to begin with. Instead of loaning money at higher interest rates to credit-challenged borrowers, lenders aren’t issuing them loans at all.
Thus, current mortgage interest rates are under-stating loan availability. A 5.8% rate today may represent the same loan availability that 6.8% represented several years ago.
unlawflcombatnt
May 1, 2008 at 12:45 PM
”
Lenders who mislead borrowers should pay.
Wall Street bankers, who misrepresented high risk mortgage-backed securities, should pay.”
Amen. I completely agree.
In regards to your question:
“should taxpayers who may have accepted loans with higher interest rates, but less risk, pay for a bailout?”
No, absolutely not.
Also, I wanted to comment on the current disconnect between interest rates and home prices.
Interest rates aren’t having the predicted affect on housing because it’s not interest rates themselves that directly affect housing prices (or demand). Interest rates are largely a surrogate marker of borrowing ease & lender willingness to make loans.
It’s the relative ease of obtaining loans that directly affects home prices. Rising interest rates normally parallel reduced loan availability and reduced lender willingness to make loans. In contrast, declining interest rates normally parallel increased loan availability and increased lender willingness to make loans.
The current situation, however, marks a shift from the apparent connection between interest rates and loan availability. Despite lower interest rates, mortgage originators are less willing to make loans. Instead of just raising the interest rates to compensate for the increased default risk of less credit-worthy borrowers, lenders are simply screening out less credit-worthy borrowers to begin with. Instead of loaning money at higher interest rates to credit-challenged borrowers, lenders aren’t issuing them loans at all.
Thus, current mortgage interest rates are under-stating loan availability. A 5.8% rate today may represent the same loan availability that 6.8% represented several years ago.
Danielle L. Scott
May 2, 2008 at 10:49 AM
Several people have commented on this post on digg.com. Go to http://digg.com/business_finance/Who_Should_Pay_for_the_Housing_Disaster to read them! And while you’re there, don’t forget to digg it!
Charles
June 12, 2008 at 7:07 PM
Prices have stopped falling in Las Vegas and in some areas have started going back up. There are still a lot of short sales and foreclosures so the worse part isn’t over yet. I think it helps that a lot of foreign investors are buying property here. Who knows, it may just be a bump in road.
First Time Home Buyer
July 13, 2008 at 3:38 PM
Real estate became a gigantic bubble. Excessive demand was created due to mortgage lenders providing financing to hundreds of thousands of people who shouldn’t have qualified for a mortgage loan.
Wall Street was all to eager to package those loans and sell them as investment quality. Now Wall Street gets bailouts by the billions and the average American suffers due to the falling value of the US currency.
I don’t forsee a bottom in the real estate market until late 2009 at the earliest.
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Think Money
September 4, 2008 at 8:06 AM
Some might say the goverment should lend a hand.
Al
September 22, 2008 at 8:10 AM
I found this blog on Google. After reading it i have yet another reason why to invest in the Middle Eastern real estate market. There are no signs of that market slowing down for at least another 5 years
Atlanta Foreclosure Real Estate Agent
December 7, 2008 at 8:31 PM
Great article! I expect values to continue to fall as the number of foreclosures continues. In the first quarter of 2009 we may see an explosion in foreclosures due to the current Fannie and Freddie moratorium on foreclosures ends. On the flip side it seems that anytime a market experiences a sharp fluctuation the rebound is just as sharp. Prices and mortgage interest rates could fall so low that many consumers may become real estate investors, including foreigners, and those seeking shelter from the volatility of the stock market.
Lease Purchase Agreement
February 13, 2009 at 10:37 AM
Taxpayers that go to work every day (if they still have a job) and follow the rules will ultimately for this mess, as they have every other mess. The only money the government has is the taxpayer’s.
LueMarie
February 17, 2009 at 2:43 AM
Great Post! I am loving it. Will come back again – taking your feeds also.
Kandra Hamric
April 14, 2009 at 5:36 AM
Taxpayers will have to pay the bill again! I really can’t wait for this real estate nightmare to be over.
San diego property management
May 21, 2009 at 7:31 AM
This is an excellent blog post. It clearly lays out the implications of the current housing downturn. I’m curious about your contention that lenders should pay, however.
It seems to me, that everyone was at the trough and everyone was benefiting. The investors, the lenders, the mortgage brokers, the real estate agents and brokers, the sellers… the list goes on.
Everyone knew on some level that they were getting something for nothing…
And this is besides the point. The fact is, the US tax payer will incur the cost.
Just for context, I write a blog on San Diego Property Management.
Prahova Imobiliare
September 30, 2009 at 1:34 PM
Very insightful. Hope this will be over soon…
Nicole Arsenault
February 18, 2011 at 12:01 PM
It is always interesting to read perspective on the market, years after it was posted. I am glad the market is beginning to show signs of life. I enjoyed your post! You can find my blog onHuntsville AL Real Estate here.
Dallas Homes
August 30, 2011 at 10:32 AM
The market has been fairly strong here in the Dallas Texas market, but some of our re locators are having challenges in buying due to not being able to sell in other markets. This will all pass soon
thanks for the great post
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