Housing Crisis

The news media churns out tens of thousands of words each day covering what they have termed the “Housing Crisis,” but no one actually explains the true nature of the situation. The problem is simply that the price of homes becomes too high. This is not a new or unusual event. Those who work in the housing industry over time, see a housing bubble mature and burst about every ten years. The causes are well known and the bubble bursts are somewhat predictable and entirely inevitable. Reporters, investors, and politicians seem unable to grasp the simple truth that there is a price above which buyers cannot continue to buy. At the high point of the bubble, prices are so high that the only sensible reason for buying a house at all is the expectation that the buyer will be able to sell it for even more than he paid in a year or two. When that expectation proves invalid, the housing market fails.

That critical expectation becomes invalid when the price of the lowest tier of the housing market begins to exceed the financial capability of the first time buyers to qualify for a mortgage. First time buyers are people of modest income who buy older, smaller, modest homes. When the first time buyer can no longer buy, the second time buyer, who purchases newer, larger, less modest homes, cannot sell his first time home and therefore cannot buy either. When that happens, the third time buyer, who buys new, large, more opulent homes, cannot sell his second time home and so cannot buy. The market is now in full stall. The Developer of the new, large, opulent homes finds himself stuck with multimillions of debt tied up in homes that he cannot sell. He has no choice but to drop the price of his unsold new homes, hoping to unload them for enough to bail himself out.

But once the price of new homes begins to drop, the expectation becomes that the price will continue to drop. This is a self fulfilling expectation. Now, few if any of the three tiers is willing to buy because any purchase that he makes now may be worth less in a few weeks or months. And so the market continues in full stall with the price of all three tiers of homes dropping alarmingly, but still not selling. The banks and mortgage companies are now major contributors to the continuing stall because they are reluctant to take on mortgages for the same reason that the buyers are reluctant to buy. Eventually, the prices drop to the point that the first time buyer perceives that a bargain price has been reached and he can now easily qualify for a loan; historically this occurs at about 20% to 25% below the bubble bursting prices. With median prices at four or five hundred thousand dollars at peak, this is a value loss in the neighborhood of one hundred thousand dollars on each of millions of homes. Crisis.

While this is a much simplified analysis, it is essentially what happens every decade or so in the housing market, at least it has happened so over the past forty years. This time, however, it is an unusually severe “Crisis”. Several factors have made it more difficult. First of all, banks and savings and loans are no longer the only providers of mortgages. Many mortgages are now written by Mortgage Brokers who initiate the loans and then sell them to a secondary market such as Fannie Mae or Freddie Mac. The secondary market has expanded as well. Now, groups of mortgages are bundled together and sold as financial instruments similar to bonds. These mortgage backed investments, or securities, are bought by a variety of entities such as hedge funds, investment banks, and even individual investors. Thus, the formerly close relationship between buyer and lenders is broken. The broker who originated the mortgage is not that worried about either the buyer or the ultimate holder of the mortgage. His self interest is in making as many loans as he can sell to the secondary market. The result has been the financing of homes beyond the capacity of many buyers to sustain in the face of any economic slowdown. Secondly, all of this is compounded by the explosion of variable interest loans. Even if an economic slowdown is mild, an unaffordable increase in interest, therefore in mortgage payments, is often built into the so-called sub-prime loans.

Some politicians are calling for the government to bail out home owners who are overextended, in some way. This would be a fundamental mistake. The result would be the prolonging of the correction of the original problem, which is over priced housing. While we can sympathize with home owners who are losing equity in their homes, it should be realized that much of this equity is only on paper. Home owners who bought upscale (or refinanced to get cash out of their homes), were usually taking advantage of excessive appreciation of their former home. In the long run, the most important element of the housing market is that families should be able to buy a home at an affordable price that does not consume all their resources.

For this to happen there must always be an adequate supply of new homes for sale at reasonable prices. In order for this to be realized, developers must be able to buy land at reasonable prices and acquire the necessary permits in a timely manner. Cities and counties must find other ways to finance capital improvements rather than imposing all the costs on new housing. Developers must avoid offering more and more incentives to cities and counties in order to gain approval for their projects or to change zoning and permit home building in areas where it is not wanted. In the 1940’s and 50’s, the utility companies would often install water mains, power transmission poles and wiring, gas mains and other infrastructure in subdivisions at their own expense and recover the cost in the new business. Cities and counties would often construct sidewalks, curb and gutter, street paving, and storm drains in the expectation of recovering the cost in the property taxes of the new homes. Now, developers of new housing must pay all these costs, and many more, often at excessive prices. If a developer needs to move existing power poles for his project, the power company will often charge as much as ten thousand dollars per pole. Most of the utility companies charge excessive fees to developers of new housing.

No one actually has much incentive to resist higher and higher prices on new home construction. Developers know that they can jack up the prices of the new homes to cover the excessive costs. Cities and counties force the price of new homes up by requiring developers to pay for capital improvements often unrelated to the new homes and then levy taxes in accordance with the supposed value or selling price of the new homes. New home buyers offer little resistance to higher prices because they have made a killing on the excessive appreciation of their last home and they expect to do the same on the new home. The higher prices of new homes brings the price of existing homes along in lock step. And so the cycle goes until the next housing bubble burst.

Since it is unlikely that land owners, developers, cities, counties, utility companies, and new home buyers are going to change their ways anytime soon, the best the government can do is to mitigate the severity of the inevitable housing bubbles by restraining the secondary mortgage market. Perhaps regulations could require minimum standards for all mortgages that banks are now required to honor indirectly through banking regulations. Elimination of zero to fifteen percent down payment loans would help by restraining first time buyers until they are financially able to handle a mortgage through slow economic times. Outlawing mortgage insurance would help secondary lenders focus on the true value of the mortgage they are buying. Variable interest rate loans are especially pernicious. They entice unqualified buyers to overextend themselves by offering low initial payments. The enticement works because the buyer expects that his purchase will always appreciate so if the interest goes up too much, he can sell or refinance. Making mortgages harder to qualify for will indirectly restrain unwarranted appreciation and therefore prices as well.

All this flies in the face of the notion that, since everybody should be able to own their home, financing should be as liberal as possible, an idea blessed by conservatives as well as liberals. Possible, is the operative word. A proper goal would be: everyone should be able to buy a home at an affordable price as a place to live rather than as an investment. As long as everyone is speculating, landowners, developers, mortgage brokers, and new home buyers, the housing “crisis” will continue to occur periodically.