Cincinnatus BLOG *** Political Commentary - Social Commentary

On average home prices have fallen 32.2% since they hit their peak in the second quarter of 2006. In super housing bubble markets like Phoenix and Las Vegas home prices have plummeted by 50% from their all time highs. At the risk of being labeled a cock-eyed optimist I will predict  - The end is near!

What makes me so optimistic? Traditionally home prices have tracked inflation. In fact, in the last 50 years home prices have appreciated approximately 1% faster than inflation. There is an internal logic to this trend. If housing prices appreciate at a rate that is appreciably faster than income, within a decade we would be unable to purchase our own homes. And that is exactly what has happened.

Fueled by political pressure from the left and right to either help those who were struggling to own a home or to create an “ownership society”, homeownership rates were driven up from a sustainable 64% to an unsustainable 69%.  With the very willing help of an “innovative” Wall Street, mortgage and securitization products were created to implement this questionable strategy. No longer was it necessary to study, get an education, work hard, save or even have an income to own a home. Just breath for a few more minutes, Mr. Smith, and your mortgage will be ready. We could hardly build them fast enough. And prices - We’re all housing millionaires! And then the bubble burst.

When did it all begin, 1997, that’s the year that the increase in home prices began to grow at rate that was a multiple of inflation. In 1997 the Consumer price index (CPI) increased 1.7% and the price of an average home escalated by nearly 5.9%. This trend continued for nearly a decade until the second quarter of 2006 when average price reached a level that was completely out of reach of the average buyer.

Speculation was rampant, mortgages were being written for buyers who couldn’t even make the first payment, Wall Street sliced and diced and pooled this mortgage detritus into AAA rated Mortgage Backed Securities (MBS) and Collateralized Debt Obligations (CDO) and sold them off to presumably sophisticated buyers around the world. Insurance giants like AIG insured these assets with a “non-insurance” insurance product called Credit Default Swaps (CDS). And when the housing fever broke, the chill could be felt from Wall Street to Main Street.

Where were the financial professionals! Surely they couldn’t believe that house prices could rise at an annual rate of 6% ad nauseam, as their models projected, when the CPI was only growing at 2% per annum? The regulators and the rating agencies seemed mesmerized by this incomprehensible new math. Worse still, politicians like Barney Frank were screaming like banshees that not enough was being done to help the poor achieve the American dream of homeownership.

In the end all the government programs to keep people who couldn’t afford their homes in the first place, in their homes, are doomed to failure. A conservative projection is that between 65% and 75% of modified subprime loans will fall delinquent by 60 days or more within 12 months of having been modified. Even loans where the principal has been reduced by as much as 20% are redefaulting in a range of 30% to 40% after 12 months.

There is only one fundamental solution to the housing problem, the market - Let the price of the average house fall to the affordable level it would have reached if prices had merely kept up with inflation between 1997 and 2006. That price is approximately 35% below the 2006 peak. We are nearly there hence, the rationale for my optimism. One word or caution, there will be a long period of recuperation from our recent bout of housing fever. Assuming that the Obama spending spree does not cause rampant inflation, it will take a decade for the nominal price of an average house to return to its 2006 level.

The good news is that the next generation of buyers, those who studied, worked hard and saved will be able to buy that first house at a very affordable price. This is what will return stability to the housing market in the next few years.

For those who think I am too pessimistic about home price recovery I will remind you that the NASDAQ was over 5,000 in March of 2000 and today it is still under 2,000. When bubbles burst they don’t reinflate.