[NYTr] Booming Economy: The Housing Bubble Pops

[All the News That Doesn't Fit]

The Nation - Oct 1, 2007 issue
http://www.thenation.com/docprint.mhtml?i=20071001&s=baker

The Housing Bubble Pops

by DEAN BAKER

The housing market is in its worst downturn since the Great
Depression--and it's taking the rest of the economy down with it. Most
forecasters insist there won't be a recession, although the August job
losses forced even optimists to acknowledge that the meltdown is
causing serious economic problems. (When it comes to recessions, the
professionals seem to be the last to find out: On the eve of the last
downturn, in the fall of 2000, all the Blue Chip 50 forecasters
predicted solid growth for the following year.)

The downturn should not have been a surprise. House prices rose at an
unprecedented rate over the past dozen years. For a hundred years, from
1895 to 1995, house prices nationwide increased at the same pace as the
overall inflation rate. Since 1995 inflation-adjusted house prices have
risen by more than 70 percent. It should have been clear to economists
that this run-up was being driven by a speculative bubble. There was no
change in the fundamentals of supply or demand that could have
explained the rise.

Like Japan's in the 1980s, the US housing bubble coincided with its
stock bubble. While the two bubbles burst simultaneously in Japan, in
the United States the stock collapse actually fueled the growth of the
housing bubble. Investors, after losing much of their wealth in the
stock crash, viewed housing as safe. The housing bubble in turn fueled
the recovery of the US economy from the stock crash recession of 2001.

Soaring home prices pushed construction and home sales to record
levels. Even more important, the run-up in home prices created more
than $8 trillion in housing bubble wealth. This wealth fueled a
consumption boom, as homeowners withdrew equity from their homes almost
as it was created. The savings rate plummeted to near zero in 2005 and
'06. People used their homes as ATMs, borrowing to take trips, buy cars
or just to meet expenses.

This pattern of growth could not be sustained. Record house prices were
supported by a tidal wave of speculation, as millions of people
suddenly became interested in investment properties. As prices soared,
financing arrangements became ever more questionable. Down payments
went out of style. Adjustable-rate mortgages and interest-only loans,
even negative amortization loans (in which mortgage debt grows month by
month), became common.

The worst of the speculative financing was in the subprime market,
where moderate-income home buyers were persuaded to take out
adjustable-rate mortgages, which generally feature very low "teaser
rates," typically reset after three years, often to levels that are
five or six percentage points higher. Millions of families who could
afford the teaser rates cannot possibly afford the higher rates. This
is leading to a huge wave of defaults and foreclosures--which is just
beginning, as homeowners who took out mortgages in 2004 are now hitting
their three-year mark.

The subprime scandal would not have happened if the mortgage market had
not been transformed over the past quarter-century. Banks used to hold
the mortgages they issued, which gave them a strong incentive to be
careful (often too careful) not to issue a mortgage the borrower could
not pay. In the current market, the mortgage issuer typically sells it
off in the secondary market, where it becomes the basis for
mortgage-backed securities that are then sold throughout the world.
This is why the subprime crisis is leading to failures of banks and
funds in France, Germany, Australia and elsewhere.

Mortgage credit has frozen up for all but the safest loans. This showed
up starkly in a 12.2 percent drop in the July pending sales index,
which measures the number of sales contracts signed each month. While
this is an extraordinary decline, the reality is almost certainly much
worse than the data show, since many of these contracts will fall
through because buyers can't get mortgages.

The price data also scream trouble. Formerly supercharged markets like
Las Vegas, Miami and San Diego are experiencing double-digit price
declines, while the slightly less bubbly markets of New York, Boston
and Washington are seeing declines in the single digits. With record
numbers of unsold and vacant homes, it is difficult to see how prices
will stop falling anytime soon.

The basic story is a downward spiral as the housing sector interacts
with the rest of the economy: lower house prices, more foreclosures,
fewer jobs in housing and less consumption, a weaker economy and less
demand for housing. Throw into the mix declining state and local tax
revenues due to the loss of construction fees and property taxes, and
you have a further source of bad economic news.

There will be no quick fixes. As former Federal Reserve chairman Alan
Greenspan discovered in 2002, it is not easy to boost the economy out
of a recession caused by a burst financial bubble. Since housing wealth
is far more evenly distributed among households than stock, it will be
even harder to recover from the housing crash than the stock crash. But
we can implement policies to get the economy on the right track.

First, it is important to protect the subprime home buyers who were
tricked into taking out mortgages they could not afford. President Bush
has proposed measures that would encourage lenders to renegotiate
mortgage terms to allow people to stay in their homes and would provide
additional support from the Federal Housing Authority. These are steps
in the right direction, but they will not help the vast majority of the
subprime homeowners at risk of losing their homes. The simplest and
quickest way to help them is to adopt the "own to rent" policy, by
which subprime homeowners facing foreclosure are allowed to remain in
their homes indefinitely as renters paying the fair market rent. This
assures them a roof over their head, with no new bureaucracy and no tax
dollars (for more information see cepr.net).

Tax cuts directed at low- and moderate-income families are a good way
to jump-start the economy, as would be government investment aimed at
neglected infrastructure needs, such as rebuilding New Orleans and
preventing the collapse of more bridges. Pushing down the value of the
dollar should also be a top priority. There is no way to correct our
trade imbalance with an overvalued dollar providing a massive subsidy
for imports and imposing a tariff on US exports. A lower dollar will
make US manufactured goods far more competitive in the world economy,
and will thus create a large number of relatively high-paying jobs. One
benefit of the housing meltdown is that it should be much easier to get
our trading partners to go along with a lower dollar now that we can
show them how much money they lost by investing in US financial assets
that have gone bad.

Finally, we must get people on the Federal Reserve Board who take
financial bubbles seriously. Greenspan recently asserted that "the
human race has never found a way to confront bubbles." But it is
possible for the Fed to do so, most obviously by repeatedly and
publicly warning against stock, housing or other market bubbles as they
arise. This would educate even the stupidest hedge fund managers, or at
the very least make them fear personal liability for mismanaging
billions of dollars. Clearly, Greenspan was not up to the job. We will
need more qualified people running the Fed in the future.