Economics of the Bailout

The scope / implications of the real estate meltdown underway in San Diego and soon spreading to the rest of California, yes - including Los Angeles, and San Francisco are surprising me. I really can't think of any better example of George Soros' reflexive framework used to analyze boom / bust cycles than the real estate cycle we have experienced from 2001-2002 to present.

Initially long term interest rates at half of normal averages allowed buyers to bid home prices up to twice the previous level based on approximately the same mortgage payment they were making previously. After the initial doubling of prices, loan underwriting guidelines were essentially eliminated in order to grant loans to anyone with a pulse. Traditional methods of gauging borrower's ability to pay back loans such as audits of assets and income were no longer expected to be needed based on the tremendous amounts of "equity" in the homes that were being lent on. This produced another 50% increase in price at put prices throughout San Diego at a minimum of 3 times the previous price just 3-4 years earlier.

The common viewpoint among the public and EVEN the professionals - re: bankers, realtors, etc. - was quite typical of human hubris - that is - the home prices increases were a testament to our own greatness. Asset price inflation made us all "wealthier" and allowed a further development of the "ownership" society - and I use that term loosely. ;)

Which brings us to present day San Diego. Foreclosures and REOS are hitting historic highs and we are only six months into the bust. Home prices in several areas (think Chula Vista) are already down 20-30% from peak 2005 pricing. The ability of any sub-prime borrowers to refinance their option ARMS has basically been eliminated due to the disappearance of any "equity" they had in the property as well the inability to make a fully amortizing mortgage payment anyways.

The new lending guidelines released by the Government basically require all ARMs to be underwritten based on a borrower's ability to make the loan payment AFTER the loan adjusts. This takes even more propsective buyers off of the market. How far will prices drop during this bust? I am guessing a minimum of 50% from 2005 peak numbers in nominal values. That would still leave us with a 50% increase in price from the beginning of the cycle in 2000-2001. As the $200K home would essentially be worth $300K up 50% but down 50% from the $600K peak.

So the above statement will probably be controversial to a lot of people, but lets just take it as an assumption for argument's sake. A price drop of that magnitude over the next 2-3 years is going to require multiple government bailouts. Not because those bailouts will actually "fix" the problem, but the Government for political reasons needs to make it clear that they are trying to help out the little guy.

Additional tax deductions are not likely to be helpful as there is no gain when the properties would be sold. A tax CREDIT would be interesting as it could basically allow the government to GIVE directly to homeowners an additional say $3K-10K a year back in their pockets. Again this will not "fix" anything - but it has to be seen in the context of what Government will do to try and stabilize the issue.

I think another probable measure will be some relaxation of the rules for discharge of indebtedness income when it relates to your principal residence. Mainly the current rule may be changed so that if your home is sold for less than you owe on the property and the difference when charged off could be attributed to you as ordinary income / discharge of indebtedness income those charges could be eliminated if you can prove that the property was your primary residence. This would allow people to quickly move out of their home either through foreclosure or short sale, beginning renting, and then transition back into home ownership when the finances were more appropriate.

How ironic is it, that in attempt to make homeownership available to everyone through the enormous tax subsidies of mortgage interest deduction on principal up to $1M, exclusion of up to $500K tax on sale of home, and additional mortgage interest deduction for home equity up to 100K - the Government has instead created a huge economic incentive for speculation.

The dream of home ownership has been put so far out of reach of the "average joe" that they essentially have to borrow such huge amounts of money to invest in housing that the housing related expenditures may reach higher than 50% of disposal income. If the potential of home price appreciation disappeared would homeowners see things the same way?

I guess Im just saying that if the end goal is "affordable housing" - why should we provide subsidies to homeowners that will likely inflate housing prices? I guess in some ways it is the short term versus long term issue. Over the short term the subsidies decrease the cost for a homeowner but for another prospective buyers - and national welfare as a whole - the subsidies drive up the prices for citizens as a whole.

On that note - look at who is writing this piece - a non-homeowner. :)

Before this cycle is done, I'm guessing five years or more till we reach the boom in "real" terms of decline, we should see an actual aversion to both housing and debt levels re-assert itself among the American public. This will initially kill economic growth as we know it which is so dependent on our own internal consumption growth / expectations. Still this adjustment will be important because it will allow the country to rebuild our domestic savings levels in an attempt to make investments increasing welfare over long term and not just going to fund current consumption preferences.

Let's just pray that the Federal Reserve and Government do not attempt to cut rates to 1% again in order to attempt to restart the consumption engine of growth. This time around I don't fear for a reinflation of real estate prices or even stock prices. I fear a destruction of the value of our currency and a hyperinflation.

Ill leave off with that and maybe if time next weekend I will discuss a bit "The paradox of inflation." I read about this concept in Marc Faber's book "Tomorrow's Gold" and I found it very useful / interesting for identifying undervalued investment opportunities.

-BG