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Dream to Nightmare: Who Should Pay for the Housing Disaster?

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.)

Author of the article
Peggy Crawford, PhD, Professor of Finance
Peggy Crawford, PhD, Professor of Finance
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