New Thinking Needed to Rebuild the Housing Market

by: Larry Doyle

Traders, strategists, analysts, economists and politicians will always review models of past behaviors in an attempt to forecast future developments. In the process, the models become only as robust as the inputs. Many of the aforementioned individuals will become overly dependent on models. The risk in that process is that the models ‘work until they don’t work,’ and, as a result, programs, policies, and procedures are implemented that perhaps exacerbate rather than amend a situation. I believe this scenario is playing out in our housing market.

The breakdown in Washington’s housing model revolves around the newly developed phenomena known as “strategic mortgage defaults.” I highlighted this topic a few weeks back and now we see more evidence of this new extension on our housing model in a report released by Reuters:

The Center for Responsible Lending says foreclosures are on track to wipe out $502 billion in property values this year.

That spillover effect from foreclosures is one reason why Celia Chen of Moody’s says nationwide home prices won’t regain the peak levels they reached in 2006 until 2020.

In states hardest-hit by the housing bust, like Florida and California, the rebound will take until 2030, Chen predicted.

“The default rates, the delinquency rates, are still rising,” Chen told Reuters. “Rising joblessness combined with a large degree of negative equity are going to cause foreclosures to increase,” she added.

Anyone doubting that the recovery in U.S. real estate prices will be long and hard should take a look at Japan, Chen said.

Prices there are still off about 50 percent from the peak they hit 15 years ago.

The pressure from homes currently in foreclosure only further depresses home values which lead to an increase in strategic mortgage defaults.

Kudos once again to our friends at 12th Street Capital for leading us down new highways and byways along our economic landscape. On Thursday, 12th Street highlighted a riveting report produced by Paola Sapienza (Kellogg School of Management at Northwestern University), Luigi Zingales (University of Chicago Booth School of Business) and Luigi Guiso (European University Institute) for International Communications Research:

Using data collected from surveys conducted within the last six months as part of the Financial Trust Index, this paper is the first to examine the economic and moral implications of strategic default in the current recession. The finding of a strategic motivation to default contrasts with an earlier study of the Boston housing market during the 1990-91 recession in which homes devalued by approximately 10%. In that study, which Sapienza, Zingales and Guiso believe is the basis for the Obama’s administration’s current housing policy, found that very few homeowners who could afford their mortgage chose to walk away from their homes.

“Housing policy under the current administration has focused on reducing households’ cash flow problems in response to the housing crisis, but no one has addressed the negative equity issue as part of public policy regarding housing,” said Sapienza. “We’re in a completely different economic environment today, where for the first time since the Great Depression millions of Americans have mortgage loans that exceed the value of their home.”

While the administration swims upstream on this issue, bank policies focused on tight credit and restrictive lending only further exacerbate the housing problem. Make no mistake, though, banks are tightening credit at the behest of regulators who know the level of losses in the banking system and are trying to preserve the industry as a whole.

I like a rallying equity market as much as anybody but I wouldn’t spend any paper gains just yet. Why? The new housing model is displaying that,

“As defaults become more common, the social stigma attached with defaulting will likely be reduced, especially if there continues to be few repercussions for people who walk away from their loans,” concluded Sapienza. “This has an adverse effect on homeowners who do pay their mortgages, and the after-effects of more defaults and more price collapse could be economic catastrophe.”

This model needs some quick-dry crazy glue, which can only be applied in the form of a serious principal reduction program. Banks would take immediate and massive hits to capital which they clearly won't accept.

Thoughts and color from your local markets always appreciated.

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