Why there is little Hope for Homeowners

Why there is no real solution for the housing market…

There is no quick fix for the housing market for two reasons. First, the investment/speculative demand created over the past decade for homes and mortgage notes caused a massive oversupply of homes which has resulted in their being simply more homes than there are people to live in them. Second, since homes are an extremely durable good, it will be several decades if not generations before the excess supply is worked off.

What caused the excessive demand which led to the excessive supply of houses?

To understand how it all happened, we have to start with a discussion of the two drivers of demand. The most commonly known and studied driver of demand is consumption based demand. The second type which is rarely studied is investment or speculative demand. (Speculative demand is simply highly charged investment demand.)

Investment/Speculative demand is not well understood and rarely studied in business schools because it does not fit economic models and is difficult to put into mathematical terms. Investment demand is created by the human emotion of greed and there is no room in economic models for greed or any sort of irrational behavior. The science of Economics assumes that everybody acts rationally and all decisions are based on an individuals desire to maximize his own gain.

The relationship between consumption supply and demand and its determination of price is fairly straight forward. Assuming constant supply, as prices increase, demand goes down. Conversely, if demand goes up, then prices go up. The direction of the relationship is absolute according to economics – an increase in demand will always lead to an increase in price assuming supply is constant. Conversely, a decrease in demand will always lead to a decrease in price assuming constant supply.

The dynamic between investment demand and price (i.e. valuation), however, is very different. The impact that an investment’s price has on demand is not a one-way relationship. At times, an increase in the price of an investment leads to an increase in demand as investors don’t want to miss out on an appreciating asset. However, there are other times when an increase in price decreases demand as investors take profits and you run out of buyers.

The most recent issue of the Economist (12/6/08 – 12/12/08) says the following regarding the difference between consumer and investment demand, “If savers treated financial assets as they do other goods, they would sell them when they are expensive and buy them when they are cheap. Actually, they do the opposite.”

The price of an investment bottoms because demand for it is at its absolute low-point – what Sir John Templeton referred to as “maximum pessimism”. Everyone who will ever sell has sold and nobody is buying. When an investment demand peaks, such as dot.com stocks in 2000 or homes in 2006, it is because demand is at an absolute peak – what has been referred to as “irrational exuberance”. At this point, every single person who will ever buy the financial asset has done so exhausting the supply of potential bidders. When there is a limited supply of the good in demand, it causes a speculative bubble.

Inevitably, investment/speculative demand will lead to the creation of artificial supply. The problem is that as investment demand is destroyed, the excess supply that it was responsible for remains. In this speculative bubble, the result is there are too many homes for too few people. Currently, the supply of homes exceeds the natural demand for homes therefore prices will need to continue to fall until supply and demand reach equilibrium.

What caused the excessive investment demand leading to speculation in housing which led to excessive supply?

The simple answer is government. While economies will always get out of whack on their own, it takes government to really screw things up. For the last 70 years, the government has created various incentives to artificially stimulate the demand for homes but in the last five plus years, they took extremely irresponsibly steps to stimulate the housing market pushing it into a bubble. One of the primary drivers of real estate speculation was the complete void of regulation in the industry. In addition, the government took three proactive steps which generated tremendous amounts of artificial demand for not only houses but also for mortgage debt.

1. The Fed dropping interest rates to 1%: By dropping interest rates to 1%, the Fed provided an incentive for consumers to take on more debt. Refinancing homes at 4-5% resulted in the credit market becoming seriously over leveraged. Real estate is one of the most leverage sensitive markets since few real estate transactions can take place without leverage. With too much leverage, too many real estate deals are done. Furthermore, dropping rates to 1%, caused a massive wave of refinancing as cheap credit motivated homeowners to withdrawal equity from their homes.
2. Excessive leverage at Fannie Mae and Freddie Mac: The private/public partnerships known as Fannie Mae and Freddie Mac were allowed to maintain recklessly large amounts of leverage. At their breaking point, FNM and FRE were leveraged up 60:1 which means if the value of their assets fell by more than 2%, they were insolvent. And guess what? The value of their assets did fall by more than 2% - much more! By allowing FNM and FRE to become so seriously overleveraged, it drove the prices up for mortgage debt which created more investment demand for these securities.
3. US Treasury quit offering 30 year treasury bonds: In 2002, the US Treasury quit selling 30 year treasury bonds creating even more demand for collateralized mortgage obligations (CMOs). Investment pools such as pension plans who were obligated to buy 30 year debt had only place to turn to meet the demand for these long-term instruments. Practically, the only other 30 year bond available for them other than treasury debt was mortgages. The demand for mortgage debt by pension funds and insurance companies without a viable alternative drove up the demand for mortgage securities even further. Prices increased substantially which attracted the attention of foreign investors. Because the demand was so strong, banks were provided the incentive to create as much mortgage debt as possibly regardless of the homeowners ability to meet long-term obligations.

Today we realize that the entire cycle fed on itself causing possibly the largest bubble in the history of capital markets. The government juiced the demand for mortgages at both ends – by the consumer and the investor. Rating agencies turned a blind eye to the growing risks of mortgage default as they were nicely compensated for AAA ratings on impaired paper. Investment banks who were no longer hindered by the Glass Steagall Acts, minted profits from churning out securitized mortgage products. The entire mess kept snowballing until it created an avalanche that cannot be stopped.

Why has the excessive supply of homes created by excessive speculative demand created an insolvable problem?

The real problem with the housing bubble which makes it unmanageable is the fact that housing is an extremely durable good. In past consumer product bubbles from tulips in the 1670’s to pork bellies in the early 1980’s, time was the solution. Once the tulip bubble burst, people quit growing tulips. When the commodity bubble of the late 70’s burst, people quit drilling for oil, growing soybeans, raising pigs, ect and eventually the excess supply was worked off.

Since houses are extremely durable goods, the excessive supply will not be worked off for an extremely long-time. My aunt lives in a home built in the 1700’s. I live in a house built in the mid-1950’s. Time will not work off the excessive supply of homes so for the foreseeable future, there will continue to be more homes than homeowners. The result will be that prices will continue to fall until the market reaches equilibrium. Unfortunately, price equilibrium will likely be below where it would have been prior to the bubble because supply is far greater than if the bubble had never existed.

What is the solution?

In short, there isn’t one. The government is largely responsible for the housing bubble so we can assume that we cannot count on them to solve it. In fact, they are likely to make it worse. The market will eventually find a way to figure it out but market solutions to excesses are usually painful. Loan modifications are certainly a start. It will allow home owners to stay in their home by making the mortgage more affordable to the homeowner and slowdown the rate of foreclosures. But a significant issue is homeowners who have no incentive to keep their home because their mortgage is so far “underwater”. In these situations, we should start seeing the market correct itself when banks agree to workout upside down mortgages.