How the government can help

As many people may know, the Fed has changed its long-standing policy of being the lender of last resort only to regulated-commercial banks. This turn became apparent with the backed rescue of Bear Stearns two weeks ago. They have provided the credit market with liquidity and has done its job of making sure the credit markets don't completely collapse, along with any consumer confidence in the markets. But what of the housing market? Is there anything the government can do to facilitate the recovery of the housing market? We read of Hillary Clinton's call for the government to buy up sub-prime mortgages and Barack Obama's call for additional stimulus money (about $30 billion last I heard). Most approaches from the fiscal side embraces the idea of the state solving the problem. I propose that they not solve the problem per se, but do their part to allow the market to solve the problem itself. What I speak of is the real estate short sale and what the government can do to facilitate them.

A short sale is when a homeowner sells his or her house for less than what they owe on the house. This leaves a remainder for the houseowner to pay. In a short sale, the bank can agree to forgive the remaining debt on the mortgage basically in exchange for the home being sold. The down side of this deal is that the difference between the selling price and the mortgage debt is taxable income. In some markets, houses are losing hundreds of thousands of dollars in value. That is a lot of money to be added on someone's tax return as income. So much so in fact, that homeowners may still choose bankruptcy or foreclosure because they cannot afford this loss. This is where the government can help.

A well-regulated fiscal policy by the US government can forgive that loss through legislated tax policy. The government through its tax policy can facilitate short sales all over the country. If that loss is not counted as income, then this may lubricate the market better than any liquidity policy by the Federal Reserve.

This will revive the real estate market in several ways. First, it will allow buyers to enter the market again through short sales. Banks, needing better collateral to loan again, will have a lower price to loan a potential buyer. A lower price means a higher likelihood of having the 10-20% down on a new home. The mortgage market can move away from the fast-cash, no collateral, interest-only ways toward a more stable credit market with buyers with better credit. Second, this prevents the banks from taking on countless assets on their balance sheet through foreclosure, which will be sold at a loss anyway. Why not take that loss upfront, with someone not only still occupying the house, but still paying a mortgage? It may be less, but it is a lot more than if the bank was forced to bear the costs of foreclosure. Lastly, it will guide the housing market toward a more natural equilibrium. No one can argue that the housing market was inflated by the time of this downturn. A downward correction is needed, encouraging short sales will facilitate this correction.

If the government regulates these short sales to prevent misuse and fraud (and this is a big IF), then tax-forgiveness can be the lubrication the real estate market needs to move toward stability. A poorly regulated financial market, facilitated by the Fed's cheap money policy from 2001 to 2007 caused a white hot rise in real estate prices. They are coming down, and some argue they have further to fall. Now, this can be an absymal crash or it can be guided landing. The government has the fiscal authority to change tax law. Forgiving this mortgage debt is how the state can help. It is a minimal intervention, but it can have maximum effectiveness if it is done soon. The state will intervene at some point, let's just hope it is with the feather touch and not the iron fist. We may all lose in the end if that fist comes crashing down.
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On a Housing Crisis

I've read quite a bit about the recent credit crunch, and it usually leads me to contemplate the state of the US economy (I hear much of the same is happening in Western Europe, but I can only really account for what I see and know). I've studied the most on what is happening (on a macro scale) in the US housing market. Every time I see that the Federal Reserve lowers its discount rate to stave off some recession, I just have to shake my head. So much of what is happening now is a result of the unbridled growth in the Housing Market thanks to very cheap money.

What tinkering Central Banks seem to not realize is that the very things we are fighting to stop a recession were the result of low-cost money through low-interest and eventually unwise investing. Many forget that interest rates are the product of a free market, and that tinkering with that interest rate can have serious consequences. An interest rate is the bargaining equilibrium between savers and spenders. That rate represents the crossroads between future preferences versus present preferences. The savers (who have future preferences and must be paid to lend that money--interest rate.) and the spenders who pay that interest rate so that they may have their money now. When this interest rate is manipulated, mainly through Central Banks, this can throw a market off-balance to favor either the buyer or the seller.

We can see just why housing prices rose the way they did from the availabilty of many loans with little collateral to ensure a good investment loan. With different sorts of lending packages and investment vehicles, the last few years saw a very quick rise in house prices due to availability of money, cheap money that is. The interest-only loan, which only demand payments on the interest, not the principal, gambles that the price of the house will increase to profit from the purchase. For years, those housing prices increased with little abatement. Now that the credit machine of the United States (and a lot of Europe) has seized up, these homeowners can no longer count on a quick turnover of their investment. The problem with interest-only loans is that they mature and after a said amount of time demands payment of both interest and principal, something many homeowners cannot afford. This crowding up of sellers means now prices must fall.

As the Economist so adroitely pointed out, housing prices tend to be very sticky. Homeowners are not very quick to drop the price of their homes, many times because of stubbornness, but unfortunately also because they simply cannot afford to take the loss, that is if there is a buyer to sell to. We were able to sell our condo before this housing market went so sour. My wife and I had purchased a home, with no money down and with a nice mortgage payment from an interest-only loan. After a few months, we found we could no longer afford to live there presently, and we would certainly have foreclosed if our payment had included principal. We were lucky enough to sell our place and actually still made a nice profit. Many who are in the same circumstances now are not as lucky as my wife and me.

The Fed can lower interest rates, and there may be somewhat of a recovery, but that does not mask what has really happened: inflation in the housing market. When housing prices stop rising, there is less of an incentive to get an interest-only loan, so we should see less of those. As houses sit on the open market, a downward correction must occur to bring the housing market back to an equilibrium. Treasury can delay many loan maturities, but those loans have to mature sometime. What are we going to do then? These prices cannot stay this high and continuing to artificially inflate those prices, it just means that we have that much further to fall. A correction is needed, the longer it is delayed, the worse it will get. Let's wait and watch.
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