Monday, February 9, 2009

Safe as Houses?

For centuries the British have used the expression "safe as houses," to denote a general sense of security and well-being. Needless to say, that saying is probably headed to extinction as a centuries-old obsession with homeownership inflicts massive financial harm on the English-speaking people of Europe and the United States.
This blog entry will argue that U.S. home prices have much further to fall, and will probably remain in descent for the next 5-10 years -- longer than any of the "experts" are predicting. This threatens to leave an open wound across much of the country and decimate wealth, turning the post-war American dream into into a 21st-century nightmare. I will conclude with three specific proposals that need to be considered by anyone seriously interested in fixing the problem.
Bank of America economist Mickey Levy was recently on Bloomberg Radio. Asked whether home prices will stop falling soon, he responded with a long "noooo...."
"The reason I can say that -- unfortunately emphatically --is we still have this yawning gap between supply and demand in housing. That is, we have a huge inventory of unsold homes, and until we close that gap, either by increasing demand or by reducing supply there's going to be downward pressure on home prices."

Levy also observes how the declines have ac.celerated recently and adds that overall home prices will be "materially lower than now" by mid-2009.

One of the troubling things about the current discouse in the general financial media is that everyone just assumes house prices are going to just magically stop falling. But, no one explains how or why this will happen. I for one am going on the record and predicting home prices will continue to drop for years and that much more significant action is needed.

The first reason is the curse of the bubble. A price bubble occurs when the price of some kind of asset goes up for a prolonged period of time based on speculation rather than underlying supply and demand. Price bubbles defy the naysayers by proving them wrong. In the process skeptics are turned into believers and join the stampede. In the process, everyone comes to trust that the bubble asset can never lose value and is inherently safe. ("Safe as houses?")

Another aspect of bubbles is that prices keep going up despite new supply of the asset in question. In the housing boom, for instance, home construction surged and inventories started piling up unsold for about a year before prices started falling.

Bubbles often result from easy credit for the asset in question, or from some kind of government endorsement. For instance, the 1920s stock market bubble resulted from aggressive margin lending by banks. The 1990s bubble resulted in many ways from the rise of 401(k) plans, which gave people a tax incentive to buy stocks.

The housing bubble had both: a reckless and aggressive lending environment, plus countless government programs to encourage homeownership and real-estate development. I will discuss these later. For now, I just want to demonstrate we're dealing with a classic bubble phenomenon.

The key thing about bubbles is that once they break, the asset in question becomes worthless and stays that way for a long time. For instance, Japanese stocks continued to fall for 13 years after the bubble broke in 1990, and now stand 80% below their highs. The Nasdaq only approached 60% of its previous bubble-peak in late 2007 before the latest bear market struck. Other bubble assets, such as the 1970s' darlings gold and oil, fell by similar amounts in the 1980s and 1990s.

Just as the bubble drives prices up to utterly "irrational" levels, they then fall to equally irrational levels after it breaks. Just as people are conditioned to buy the bubble asset on dips on the way up, they then learn to sell it on any kind of rally after it's broken. While home prices don't "rally" like stocks, as soon as the market firms up, loads of houses will be listed for sale by people who have been waiting for a better market.

Just as a cuckholded man might despise his unfaithful wife, love also turns to hate in the world of finance when people feel betrayed. They stop trusting the bubble asset.

George Packer, a reporter for New Yorker magazine, recently appeared on the radio program On Point to discuss an article he'd written about subdivisions near Tampa, FL:

"The slums of the future are visible in some of the driveways and houses in some of these places...
Lehigh Acres was a very good and successful working class and lower middle class development

.. and now alot of driveways have weeds growing up in the pavement and the yards are unkempt and it doesnt look like the kind of place where new familes would want to relocate to."

The New York Times apparently piggy-backed on Packer's work in this article over the weekend.

The prospect of slumification is the most worrisome thing facing American suburbs. I grew up near Bridgeport, CT, and was amazed at how the former paper and tool making city had devolved into one of the the most violent and crime-ridden places in the country by the early 1990s.

It really sunk in when I went to college and wound up surrounded by fellow white kids from Westchester County, suburban Chicago, Philadelphia, St. Louis or Birmingham. I realized I had more in common with those kids than I did with poor blacks who'd grown up less than 20 miles from me. It became clear to me that a new kind of sectionalism had swept our land, the division between city and suburb (or exurb). This has been an obsession to me ever since and I have researched it extensively.

As I studied the division of urban and exurban, I came to realize that it resulted from a series of long-term factors, most of which dated back to the 1930s, if not earlier. Urban decay involved several self-reinforcing processes that formed a vicious cycle of job loss, property price declines, lost tax revenue, worsening schools and rising crime.

In many ways, much of the economic growth enjoyed in the post-WWII period was little more than a transfer of wealth from cities such as Bridgeport, which had teemed with life for more than a century, to towns like Trumbull and Westport, which barely existed 60 years prior. The same story played out on a national scale as factories sprawled across old farmland while plants shut down in cities like Pittsburgh and Erie, PA.

I will now sum up the major factors that fueled this process. For more details, see this lengthy article from my college days as an Anthropology student in London. The key takeaway from all of this is that most of these processes have now either halted or are reversing themselves.
The rise of the automobile: No secret here. For decades, suburbia grew as America remade itself to accomodate motor vehicles. Americans bought cars like crazy, and run up huge debts in the process. Automobiles are the ultimate consumer discretionary item. I believe that going forward, people will drive less and come to favor communities that don't require frequent use of cars. As I explain in this blog posting, owning a car makes little sense financially, environmentally or health-wise. Why must people commit themselves to $100-300 a month in car payments and another $30-200 in insurance payments just to get around? Why must a 150-pound person transport 10x their weight in steel and fiberglass just to go to the store? Why must Americans spend 1-2 hours a day behind the wheel, getting fat and listening to the radio when they could be working out, spending time with family or improving their skills? I know it sounds very abstract, but these are real quality of life issues I hear from people now. Furthermore, consumer credit to buy cars is not going to just magically reappear on the other side of this financial crisis. Even if it did, I think millions of Americans have been so burned by debt that they'll be much less willing to take on car payments.

Home price speculation: Houses were never just a place to live. Even when prices were going up very modestly, they were always an investment. As I explained with the post-bubble phenomenon above, the belief home prices always go up is broken forever. (Or at least for a generation or two.)

Education: The quality of schools has always been a key factor determining property values. City schools lagged for years as their tax bases dropped. That is going to change going forward as suburban municipalities grapple with plunging property values and mounting foreclosures. Cities now appear to be on the vanguard of change for education.
A recent report showed huge improvements on Advanced Placement test scores for New York public school students. Most importantly, minority groups that previously struggled showed the biggest gains. Here's a graphic from the New York Post article:

So far a handful of cities like New York and Washington have implemented free-market reforms. Because they have lots of kids and lots of schools in one place, it's a perfect environment for competition between schools. Even if it's not the model for the future, cities are going to close the education gap with suburbia, which will attract families and give them fewer reasons to chose a life at the end of a cul-de-sac. This will be a direct threat to the attractiveness and relative value of the suburban life.

Racial exclusion: People in suburbs never liked to admit it, but they benefited from a de facto system of apartheid. Many of them were liberals who supported the Civil Rights Movement. When they sought "a better life" on Long Island or in Westchester in the 1960s or 70s, they implicitly diverted resources and jobs from blacks who had recently migrated to the old industrial centers. The flow of educated white people away from cities channeled more money and purchasing power into suburban real estate. Now that line of distinction is fading as many middle-class families move to cities while suburbs attract more minorities with relatively low levels of education and income. The money is no longer moving in just one direction, which will be a negative for suburban home prices.

Mortgage lending: For years, Washington pushed home loans. The Federal Housing Administation was founded in 1934 to guarantee mortgages, followed by Fannie Mae in 1938. These companies got banks to make 30 year loans, when previously they would only lend for periods of about five years. Their goal was to expand lending, but they were too successful. (The federal government also enforced racial segregation using the FHA until 1968.)

Home loans peaked at a ridiculous level not very long ago. Now much of the U.S. banking system is insolvent as a result and the economy faces what could prove to be something like another Great Depression. The chart above says it all. (It's interesting that by trying to make something like homeownership "normal," the government has destroyed it. There's a lot to think about in that, especially for proponents of nationalized healthcare.)

Crime: As property values fall and homes become empty, crime will inevitably spread. Insurance rates will rise, cars will get broken into and people will move away. This is what happened in countless inner cities across the country, and now it's starting to happen in suburbia.

For decades, the factors above supported the value of suburban real estate relative to urban. Now they're all reversing and cities are going to enjoy a renewal after decades of decline.

Given that suburbia benefited from this systemic pattern for more than 50 years , it's seems reasonable to expect the process to go in reverse for at least 10-20 years.

One more thing: The USA is going to attract fewer immigrants in the future as the economy generates fewer jobs. Population growth will slow, also reducing demand for houses.

As suburban areas and houses decay, they will bring down everyone's net worth and cause large geographical parts of the country to become slums. (Suburbs cover many more square miles than did the old inner cities.)

I see three immediate courses of action the government should pursue to manage this problem:

1-Organize a concerted effort to halt foreclosures. Foreclosures are devastating to home prices. It's a bizarre irony that local authorities are using their own laws to screw over their own citizens and taxpayers. Given that foreclosures are legal proceedings carried out by a local sheriff, I don't see why governors, the Federal Reserve and FDIC can't somehow reach an agreement to stop home seizures. Now that the government is taking ownership of the banks and their vast holdings of "toxic mortgages," does it make any sense to foreclose on anyone? There have been isolated instances of local officials halting foreclosures, so it can be done.

(I see this as a truly exceptional event, and should be done under a program with a clear expiration date. Under "normal" circumstances with a functioning resale market, foreclosures are fine. In a situation like we have now, they hurt borrower and lender alike.)

2-Dismantle houses: Do a national study of the worst-affected areas and hire unemployed construction workers to dismantle entire subdivisions. Leave the roads, sewers and maybe slab foundations. If they could uproot entire neighborhoods to build the Cross Bronx Expressway, they can do it in the suburbs too.

This would help reduce house inventories. More importantly, it would prevent suburbs from turning into dilapidated, crime-ridden slums that will haunt the country for years to come.

It might sound like this isn't a productive use of human labor, but it's common for companis to spend billions of dollars in "restructuring charges" to exit a bad business. Freeing oneself from a debilitating legacy is an investment in the future. The company winds up with lower costs and can focus on more profitable activities. In the long run, it's often a good thing for a company's stock price.

The same logic should apply to fixing housing. If something's a problem that's only going to haunt you, it's best to take your lumps and move on. Otherwise, you live in crisis for years. It's a bit like cutting off an infected limb to prevent dying of blood poisoning. We have seen slums take shape before. It's a process we understand and need to prevent.

3-Encourage investors to take over houses. For 70-80 years the government has encouraged home-ownership. That means owner-occupancy.
Generally, when the government wants to "encourage" something, it means the activity in question is economically unfeasible. I say that if homeownership wasn't already a common thing, there was probably a good reason for it. (I think some of that is now becoming obvious. A certain percentage of the population is simply not suited for owning and caring for a structure costing $200-400k, or more.)

We should make a new legal system so that investors can buy houses and convert the current owners into tenants. There could be some kind of rule about allowing the tenant to live their guaranteed for 5-10 years, or perpetuity, etc. The homeowner might lose their downpayment and the bank would probably have to take a haircut, but it would reestablish an economically viable ownership model.

Mickey Levy of Bank of America, cited above, called for a new tax credit for home purchases, saying it will put a floor under home prices. I think this is essentially right in theory, but still misses the point I am making. Many people shouldn't own homes. We need to stop thinking that home ownership is an a priori, unquestioned good thing. People have rented residences for millenia (like in ancient Rome) because it often makes more sense. We need to cast aside the notion that home ownership is always the right thing.

Many aspects of the lending rules and other laws also discriminate against landlords. We need to rethink all of this.

One more idea, which is geared to the financial side: We need to encourage private investors to get back into the market for mortgage-backed securities. I think the government should outline a new series of standards for the bonds and buy them at a certain spreads. This will make private investors more willing to purchase them. There could also be tax benefits to buying distressed assets.
If the government gave people a complete tax holiday for buying these assets, it might seem like a big tax giveaway. (After all, many of these yield 20-30%.) But, they are currently on the books of banks, which are suffering huge losses. Those banks are now costing the taxpayers money already, so they will never pay tax on the income. So, in my view, making them tax-free instruments would cost the government nothing. And, it would help get them off bank balance sheets.

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