On Housing, There Will Be More Lean Years Ahead
Expect another 10 years before US housing prices return to their 2006 highs

It is nearly five years since the peak of the housing bubble, and that highly leveraged sector, with its $11 trillion in residential mortgage debt, continues to struggle. Home values just posted their biggest quarterly decline since late 2008, largely due to a steady stream of foreclosures.

But if we consider that the housing bubble inflated from roughly 1999 to 2006, that made seven fat years. An ancient authority would suggest that seven lean years should follow. That would mean two more lean years to go--not a bad prediction.

Actually, what we experienced was a double bubble: one in housing and a parallel one in commercial real estate, which has mortgage debt of $2.4 trillion. Both of these sectors used the opening years of the new century to run up leverage and asset prices to an unsustainable 90% increase, with housing peaking in the second quarter of 2006, and commercial real estate in the fourth quarter of 2007.

The causes of the housing bubble--subprime mortgages, adjustable-rate mortgages, government-mandated loans, etc.--are well known. The role of traditional lending by the heavily regulated banking system in the commercial real-estate bubble has received less attention, yet its toll in subsequent bank failures is apparent.

The inevitable bust brought a national price drop of 32% from the peak for housing, and an even steeper 42% drop from the peak for commercial real estate. These erased trillions of dollars of illusory bubble "wealth." The combined drop in market values was greater than $8 trillion--that's more than the GDP of China last year.

Why did house prices fall proportionally less than commercial real-estate prices after they both inflated to the same extent? In part, at least, this reflects large government programs and subsidies to support house prices. But even with this support, the asset prices on which huge amounts of debt had been built shriveled, leaving the debt under water. As an old banker told me long ago, "Just remember this, young man: Assets shrink--liabilities never shrink!" The credit markets for housing and commercial real estate obviously did not remember this classic principle.

We all know too well the result: huge defaults, losses, TARP and more than 350 bank failures--not to mention the failures of government-sponsored enterprises Fannie Mae and Freddie Mac. Even this long after the peaks of the double bubble, much of the debt overhang--or better, hangover--remains to be worked through. The industrial sector has recovered and is growing, with strong profits, cash build-ups, and a bull market in stocks. But the huge real-estate debt hangover continues to weigh down overall economic performance.

Perhaps with some poetic justice, this is the inverse of the situation in the early 2000s, after the collapse of the tech-stock bubble. Then we had an industrial recession and the deflationary pressure from past euphoric overinvestment. Japanese-style deflation was feared and widely discussed. And an answer was found by the Federal Reserve: A housing boom could balance the effects of the industrial recession.

This was the Greenspan Gamble, which intentionally fostered a boom in housing in the 2000s to counter the drag in the aftermath of the 1990s equity bubble. Then-Fed Chairman Alan Greenspan explained to Congress in 2002 that the negative wealth effect from the losses in the stock market was being offset by the positive wealth effect of the rise in housing prices. So it was, at that point. But the desired housing boom grew into another massive bubble.

We now have the Bernanke Gamble to foster high prices for debt and equity securities, thus a positive wealth effect to offset the negative wealth effect of the huge losses in real estate and real-estate debt. Fed Chairman Ben Bernanke's gamble is being wagered on a long period of zero short-term interest rates and by the remarkable expansion of the Fed's own balance sheet, including the purchase of about $1 trillion in mortgage debt--making the Fed, in a sense, the largest savings and loan in the world.

Will it work? Perhaps. But large unrealized losses still need to be realized and swallowed. We will continue to move sluggishly through an extended period of negotiating how these losses will be distributed. Who will take the hit? Delinquent borrowers, banks, investors (domestic and foreign), the government and government-sponsored entities, and the strapped deposit insurance fund are all involved in these contentious negotiations.

The negotiations also involve the role of Fannie Mae and Freddie Mac, which although hopelessly insolvent and having their losses paid for by taxpayers, are nonetheless funding the majority of new mortgage loans with government-backed debt. Their supporters want to continue having them fund mortgages as big as $729,750 to help prop up high-end housing prices. Opponents like me point out that this prevents the necessary return of private capital to mortgage finance.

As the debt hangover works its way through the system, the outlook is for housing to continue along an extended rocky and bumpy bottom, generally moving sideways in nominal terms. Since we will have an overall inflationary regime, real house prices will be falling. After working through the concluding lean years, housing prices can reasonably be expected to regain their long-term trend of increasing a little over 3% per year in nominal terms.

This would take them back to their highs in 10 years or so. If this happens, it will be far better than the performance of Nasdaq stocks, which a decade later have never even remotely approached their bubble high.

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Alex J.
Pollock

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