Once again, real estate market watchers have pounced on a shred of seemingly positive news to proclaim that the long sought "bottom" is in sight. The routine is becoming extremely stale, but somehow the media never seems to tire of it. This time the "good" news was that the percentage declines in national home prices (according to Case Shiller) in July were not as large as they were in June.

Although the report contained many other negative data points, including increased inventories and a spike in foreclosure sales, it was the slowing declines that got the spotlight. Talk about grasping at straws.  The truth is that real estate has been grossly overvalued for years, and the adjustment process back to realistic pricing has only just begun. 

But the problem is this: Few "experts" seem to appreciate the magnitude of this adjustment and its implication for an economy dependant on inflated assets values.

By most accounts, the decade-long housing boom began in 1996 and finally went "poof" in mid-2006. In January 1996, the Case Shiller 10-city composite home price index stood at 76. By June 2006 it had tripled to 226 – by far, the largest increase in U.S. history. Since then, the index has pulled back by 20% to 180. For those who believed that home prices could never retreat nationally, this 20% correction is more than enough. In reality, it’s just the down payment.   

When real estate prices were expected to rise in perpetuity, the price of a house had two components – one part representing shelter and the other investment.   The shelter component was the actual utility and desirability of the house and the investment component was the expected future appreciation.   My guess is that at the peak of the real estate mania, a $500,000 house might have consisted of $250,000 for the shelter component and $250,000 for the investment component. 

In effect, the appreciation potential, and the ability of the homeowner to tap into it though refinancing and home equity loans, offset the real costs of home ownership, such as mortgage payments, taxes, insurance, and maintenance.  So the main reason a buyer would commit to a mortgage that would soak up 50% of his disposable income was that he expected to recover most of that outlay through future appreciation.  Absent the expectation of that windfall, buyers would not have been willing to pay such staggering prices for houses or commit to burdensome mortgage payments.

Lenders were caught up by the same delusion.  Since they, too, believed prices could only rise, lending standards were thrown out the window.  If the collateral (the house) were to always rise in value, what difference would it make if the buyer made the payments?  In effect, instead of relying on the borrower’s ability to pay to mitigate its risk, lenders merely relied on the house’s ability to appreciate.

However, now that real estate prices are falling, this has all changed: Lenders are beginning to rely solely on the borrower’s ability to pay.  As this trend continues, lending standards will tighten and mortgages will be brought back into line with the incomes of borrowers. 

In addition, down payments will be larger to reflect the greater likelihood of losses should loans end up in foreclosure.  When prices were rising the foreclosure risk was negligible.  However, now that foreclosures are soaring and recovery rates are less than 50 cents on the dollar, those risks are enormous.

So, with falling real estate prices, mortgages are much less appealing to both borrowers and lenders.  The only solution is for home prices to fall far enough to where they are cheap enough for buyers to afford the mortgage payments (both interest and principal), without relying on appreciation, teaser rates, or negative amortization, and save enough for a down payment that would protect a lender in the event of default. 

In addition, the collapse of the mortgage securitization market means houses must be cheap enough for our limited pool of domestic savings to supply the funding, as we will likely lose access to much of the foreign funding that fueled the bubble.  

Of course, we need to be honest about the winners and losers of this credit crunch.  Just because mortgage money becomes scarce, and lending standards tighten, does not mean people will not be able to buy houses – it simply means they will pay a lot less for them and that fewer new houses will be built.

Therefore it is sellers, builders and those holding or insuring existing mortgages who lose, while buyers win big.  There’s a reason for that: Despite higher interest rates and larger down payments, they end up borrowing a lot less money.  In the end they will become true homeowners, rather than indentured servants.  If home ownership is truly the American dream that so many realtors profess, then the ongoing collapse in home prices will actually be a dream come true.

Editor’s Note: Peter D. Schiff, Euro Pacific Capital Inc.’s president and chief global strategist, is a regular contributor to Money Morning, and most recently wrote about the gloomy "financial reality" that’s facing U.S. consumers and the looming spike in gold prices.]

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Troubling data on the U.S. housing industry released yesterday (Thursday) lends weight to iconic income investor Bill Gross’ theory that global financial firms will eventually see $1 trillion in total write-downs.

Money Morning’s Investment Director Keith Fitz-Gerald agrees. He’s been predicting an eventual $1 trillion total for mortgage-related write-downs since last year.

“I’ve long believed that there’s at least an additional $1 trillion of subprime slime out there – just waiting to rain havoc on investor portfolios,” Fitz-Gerald wrote in a column published in early November 2007.

The global financial industry has already taken $467.9 billion in losses and asset write-downs according to Bloomberg data, but Gross sees that figure doubling before it’s all over, eviscerating the balance sheets of the world’s financial firms.

“The problem with writing off $1 trillion from the finance industry’s cumulative balance sheet is that if not matched by capital raising, it necessitates a sale of assets, a reduction in lending or both that in turn begins to affect economic growth,” Gross wrote in a commentary posted on the Pacific Investment Management Co. LLC, better know as PIMCO, website, Bloomberg News reported.

The troubled housing market also is a serious drag on U.S. economic growth.

Sales of existing homes dropped 2.6% in June from May’s level, and sales are down 15.5% from the same period a year prior, according to data from the National Association of Realtors.

“A recent online survey of Realtors shows nearly a quarter of potential homebuyers are waiting on the sidelines,” said Richard F. Gaylord, president of the real estate agents group, Forbes reported.

Housing inventory, already at record levels, ticked up another 0.2% in June, as more first-time homebuyers opted to hold off on purchasing and incomes were squeezed by high food and fuel costs.

“About four in 10 homes are purchased by first-time buyers, which frees existing owners to trade up,” said Lawrence Yun, the Realtors’ chief economist.

But with more first-time buyers opting to hold off on making a purchase, the large number of available homes is putting downward pressure on housing prices.

The national median price for existing homes was $215,100 in June, according to NAR data, down 6.1% from $229,000 just one year ago. Yun, the NAR chief economist, said the price of homes is being pushed down due to the rising number of home foreclosures. One-third of homes currently for sale are due to foreclosures, he said.

Lower home prices in turn affect the credit-worthiness of home mortgages. Once a home’s value dips below the balance due on its outstanding loan balance, it becomes much more difficult for a homeowner to refinance or sell. With fewer options for homeowners struggling to grapple with high food and fuel costs and a weakening labor market, foreclosure rates rise.

At the same time, lower median home prices suggest that more properties will fall into the risky subprime asset class that kicked off the credit crisis, causing additional write-downs. Some 25 million U.S. homes are at risk for slipping into negative equity positions on their home loans, Gross said, which could easily lead to higher default rates and more asset write-downs.

The housing market must work through the existing level of home inventory before it can make a true recovery. One method would be for the government to purchase one million new or unoccupied homes, “blow them up, and then start all over again,” Gross wrote, Bloomberg News reported. And while that solution could work to boost housing prices, it’s certainly not feasible, making the proposed housing legislation “the best way to begin the long journey back to normalcy.”

The U.S. House of Representatives passed a bill on Wednesday that includes sweeping provisions to help bolster the U.S. housing market and potentially save struggling mortgage giants Freddie Mac (FRE) and Fannie Mae (FNM), which together secure almost half of the $12 trillion U.S. home mortgage market.
MarketWatch reported that the housing bill includes the following provisions:

• Allowing the government to insure up to $300 billion in refinanced mortgages.
• Establishing a tax break of as much as $7,500 for first-time homebuyers
• And creating a new regulator to oversee government-sponsored enterprises Fannie and Freddie.

The Senate is expected to vote on the bill before the end of this week.

News and Related Story Links:

• Bloomberg News:
  Mortgage Writedowns to Total $1 Trillion, Gross Says

• Forbes:
  U.S. Home Market Freezes In June

• MarketWatch:
  House approves housing aid, Fannie-Freddie plan

Housing starts made a sizeable 11.6% jump in June, the Commerce Department announced yesterday (Thursday). However the surprising surge was explained by a change in New York City code law, rather than a true turnaround in the troubled housing market.

"This report is much weaker than it looks," Ian Shepherdson, an economist at High Frequency Economics, a research firm, wrote in a note, The New York Times reported. "All the increase in headline starts and permits reflects a rush to begin multi-family construction projects ahead of a change in the N.Y.C. building code."

Even with the large number of condo and apartment starts the revised New York laws added to the report that caused the double-digit increase from May, June starts were 23.9% lower than the same period in 2007. Adding to the mixed message of the report, single-family housing starts, which some consider a better indicator for the health of the overall housing market, were down 3.5% from May.

"It is nice to see housing starts jump, but it would be better if it occurred across the country not just in New York," Joel Naroff, president and chief economist of Naroff Economic Advisors said in a note to clients after the housing starts release.

Once the atypical 250% increase in multi-family units in the Northeast is stripped out of the report, it becomes apparent that single-family home construction is at its weakest pace in over 17 years. Other U.S. regions all showed declines in housing starts and single-family starts were down nationwide.

"It’s still a very, very weak housing market around the country," Stuart Hoffman, chief economist at PNC Financial Services Group Inc. (PNC), told Bloomberg News. "Builders are coping with sharp oversupply, a big overhang of single-family homes that for the most part are still falling in prices."

The housing market remains week and this year seems destined to hit historic lows as the United States struggles through the worst housing depression in a generation.

Housing starts for 2008 will almost surely fall below the 1 million mark for the first time since World War II, Patrick Newport, an economist for Global Insight Inc., told MarketWatch.

Fannie and Freddie Troubles Put More Pressure on Housing Market

Any turnaround could be put off a bit longer as troubled lenders Fannie Mae (FNM) and Freddie Mac (FRE) cast doubts on any near-term recovery in the U.S. housing markets. Together, the two mortgage giants secure half of the $12 trillion U.S. home mortgage market.

"Fannie Mae and Freddie Mac play a central role in our housing finance system," Treasury Secretary Henry Paulson said this week. "Their support for the housing market is particularly important as we work through the current housing correction."

The two government-sponsored entities (GSEs) were originally created to help more Americans afford their own homes and that’s just what Fannie Mae and Freddie Mac do, by helping to keep lending costs low. But as the GSEs struggle to come up with the capital they need to remain solvent, and experts disagree on the best way to help, the cost of borrowing could very well go up.

Despite a low 2.0% Federal Funds rate, Fannie and Freddie might very well have to charge more for new loans if the two want to survive. And that’s going to make it even harder for consumers in the market for a new home to eat up some of the huge inventory of houses sitting on the market right now, some of which are there due to the rising rate of foreclosures.

"The foreclosure problem is getting worse and will stay with us well into the next decade," Mark Zandi, chief economist for Moody’s Economy.com (MCO) in West Chester, Pennsylvania, said in an interview with Bloomberg News. "The job market is eroding and homeowners have less equity. Lenders are much less willing to work with you if you’ve got negative equity, and you’re more likely to give up your house if you’re deeply underwater."

News and Related Story Links:

• Bloomberg News:
  U.S. Housing Starts Spurred by New York Code Change

• The New York Times:
  New York Anomaly Lifts Housing Starts

• MarketWatch:
  Single-family home starts drop to 17-year low

• Money Morning:
  As Treasury’s Paulson Prescribes Bailout for Fannie Mae and Freddie Mac, Guru Jim Rogers Predicts an "Unmitigated Disaster"

Another fresh round of economic data was released yesterday (Tuesday) with the prognosis looking dire for the U.S. economy.

Home prices as measured by the S&P/Case Shiller composite index of 20 metro areas fell 1.4% in April from March and slumped by a record 15.3% over the year. The group’s composite index of 10 metro areas dropped 1.6% in April, making for a record 16.3% annual drop.

According to the S&P, 13 of the top 20 metro areas are still posting record annual declines with price losses in the double digits for half of the areas.

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"The potential is a vicious cycle which we may already be experiencing. Falling home prices are leading to more foreclosures, which cause a further decline in prices," Richard DeKaser, chief economist at National City Corp. (NCC) in Cleveland, told Reuters.

The only bright spot to be found in the data was that the 20-city month-over-month decline was the smallest drop since the August-September 2007 period.

"If there is anywhere to look for possible improvement, it would be that the pace of monthly declines has slowed down for most of the markets," David Blitzer, chairman of the Index Committee at Standard & Poor’s, said in a statement.

Meanwhile a separate report from the Conference Board indicated consumer confidence had hit its lowest level in 16 years.

The Conference Board said its overall monthly index tumbled to 50.4 this month, its lowest point since hitting 47.3 in February 1992. The index measured a revised 58.1 in May.

Most analysts agree that consumer spending has held up relatively well in recent months, but that is easily attributable to the $50 million in economic stimulus payments the U.S. government sent out in May. Also, annual tax refunds have been coming in after the April tax season.

"Getting both [checks] at this time of year has led to an increase in household spending, but I expect this to be temporary. I’m looking for spending to trail off in the latter part of the summer," Bernard Baumohl, an economist at the Economic Outlook Group, told CNNMoney. "If consumers are not spending, then the economy is in serious trouble. I think we’re in a recession right now."

News and Related Story Links:

• CNNMoney:
  Consumer confidence tumbles to 16-year low

• Reuters:
   Home prices extend record slide in April: S&P

U.S. home prices suffered their worst decline on record, skidding 1.7% in the first quarter, the Office of Federal Housing Enterprise Oversight (OFHEO) announced yesterday (Thursday).

That drop-off from the fourth quarter to the first quarter in the OFHEO’s "purchase-only index" exceeded the 1.4% decline between the third and fourth quarters of last year, and was the biggest decrease in the 17-year history of the index. On a year-over-year basis, home prices have fallen 3.1% since the first quarter of 2007.

All the figures were reported on a seasonally adjusted basis.

"For homeowners and financial market observers, these declines spell further erosion in home equity levels and potentially more trouble for mortgage markets," James Lockhart, OFHEO’s director, said in a statement.

However, Lockhart also noted that the decline in prices could be good news for some.

"To prospective home buyers who have been shut out of homeownership because of affordability constraints, these declines may be welcome news," he added.

The size of the first-quarter decline is yet another signal that the housing recession is still weighing heavily on the home market.

The steepest declines were in areas that experienced overbuilding, such as California and Nevada, where home prices dropped as much as 8% in the quarter, the OFHEO reported.

The drop in housing prices only serves to exacerbate the ongoing subprime crisis.

"It’s a dismal picture, there’s no way around it," Paul Kasriel, chief economist at Northern Trust Corp. (NTRS) in Chicago, told Bloomberg News. "A complicating factor is the fact that so many homeowners owe more on their mortgages than their houses are worth. This is a financial crisis. You can’t put lipstick on this pig."

As home prices drop, overextended owners are unable to sell for a price high enough to cover the outstanding balance on their mortgages. The result has been a large upswing in the number of home foreclosures.

Foreclosure filings have hit an all-time high, with a 65% year-over-year increase in April and a 4% increase from March, RealtyTrac reported earlier this month.

Almost two-thirds of U.S. banks have raised standards for mortgages, even to their most creditworthy borrowers, Bloomberg reported. For those with limited or bad credit history, so-called subprime borrowers, three-fourths of banks have raised lending requirements, according to a U.S. Federal Reserve survey of senior loan officers published May 5.

At the same time that consumers are finding it hard to obtain needed financing, the high level of housing inventory, currently at an 11-month supply, is making it very difficult for distressed homeowners to sell. The glut of homes currently on the market is putting downward pressure on home prices.

"The large overhang of real estate inventory awaiting sale continues to force price declines in many areas, but particularly in places that had seen very sharp appreciation in previous periods," said Patrick Lawler, OFHEO chief economist.

News and Related Story Links:

• MarketWatch:
  U.S. home prices down 1.7% in first quarter: OFHEO

• Bloomberg News:
  First Quarter U.S. Home Prices Fall 3.1%, OFHEO Says

• Reuters:
  U.S. 1st-qtr home price declines at record – OFHEO

• Money Morning:
  Home Foreclosures Continue to Rise, But Biggest Jump Still to Come

By Jennifer Yousfi
Managing Editor

Foreclosure filings hit an all-time high with a 65% year-over-year increase in April and a 4% increase from March, RealtyTrac reported yesterday (Wednesday).

RealtyTrac Chief Executive James J. Saccacio said the 243,353 foreclosure filings last month was the highest since his firm began tracking the data in January 2005, The Wall Street Journal reported.

"Although only about 2% of households nationwide are in foreclosure, these properties contribute to already bloated inventories of homes for sale, and put downward pressure on home values," Saccacio noted.

Nationwide, one in every 519 households received a foreclosure notice.

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California, Florida, Nevada and Arizona were the hardest-hit states. California had the highest number of total filings with 64,683 properties falling into foreclosure while Nevada had the highest foreclosure rate, with one in every 146 households filing for foreclosure.

And while current foreclosure levels are at record highs, Saccacio expects the situation to get worse. The credit markets remain tight, making it difficult for overextended homeowners to obtain refinancing that might help them to avoid foreclosure.

"Loan modification isn’t working," Ira Rheingold, executive director of the National Association of Consumer Advocates in Washington, told Bloomberg News. "It’s extremely difficult for a homeowner to talk to a servicer and even if they do, it’s hard to get the servicer to change the terms. You get voice-mail hell, they don’t return calls, you can’t get a live person on the phone."

At the same time that consumers are finding it hard to obtain needed financing, the high level of housing inventory, currently at an 11-month supply, is making it very difficult for distressed homeowners to sell.

Saccacio stated that he expects foreclosure filing levels to "remain high and even increase" through the end of the year, particularly "given the number of loans due to reset through the middle of 2008 and the continuing weakness in home sales."

In fact, banks will continue to seize about 60,000 properties a month through December, Bloomberg reported. At that rate, about 1 million U.S. homes, or 25% of all homes for sale, could be bank-owned, Rick Sharga, RealtyTrac’s executive vice president of marketing, said in an interview.

News and Related Story Links:

• The Wall Street Journal:
  April Foreclosures Hit New High

• Bloomberg News:
  Foreclosures Climb 65% as Loan Workouts Fall Short

• Digital Journal:
  Foreclosure Heading Towards The Seventy-Five Percent Mark For American Homeowners

Just a few months ago, the world’s biggest property fund manager, ING Real Estate (ING), announced plans to spend another $700 million on Chinese real estate. That was on top of the $350 million raised for residential development in China in 2006.

Now, investment firms and sovereign wealth funds around the world are scrambling to catch up.

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"On the one hand you see part of the world slowing down, triggered by the credit crunch," ING Real Estate Chairman and Chief Executive, told Reuters. "And then you see another part of the world -China, Japan, and even Australia -where there are lots of opportunities."

India has been one of the primary beneficiaries of foreign real estate investment so far. With tight lending practices and a thriving market, a rapid influx of foreign cash -much of it retreating from the U.S. market -has begun to pour in.

Lehman Brothers Holdings Inc. (LEH), for instance, has already deployed about $2 billion in India and is reportedly preparing to raise its first India fund this year.

"It will be for real estate, and a companion to our Global Real Estate Fund," Tarun Jotwani, chairman and chief executive of Lehman Brothers India, told the Mint paper.

The fund "will be large enough to give us significant firepower in a sector that is experiencing a capital crunch but is small enough and flexible enough to allow us to build a top quality portfolio," Jotwani added.

Citigroup Inc. (C) and Morgan Stanley (MS) have also invested in Indian real estate and many analysts believe that Goldman Sachs Group Inc. (GS) and HSBC Holdings PLC (HBC) will soon join them.

Most recently, Philippines-based Ayala Corporation and its affiliate, Arch Capital Management, announced plans to invest $100 million in the Indian property market over the next two years.

India isn’t the only country enjoying fresh inflows for foreign cash either. In fact, Vietnam currently attracts more overseas investment than India does.

For Vietnam, 2007 was a banner year for foreign direct investment (FDI), which brought a record $20.3 billion into the country.  

In 2005, FDI was recorded at $ 5.8 billion, and in 2006 it reached $10.2 billion, before virtually doubling in 2007. Over the last 20 years Vietnam has amassed $98 billion in FDI for over 9,500 projects, and a great deal of that money has been finding its way into the real estate market, Arabian Business reported.

Last week, Qatar Investment Authority bought a 27% stake in Dragon Capital, a Vietnamese property fund, which will buy into offices and serviced apartments in Ho Chi Min City, Bloomberg News reported.

In February that same Qatar Investment Authority bought a 15% stake in an Indian office complex being built at the Bandra Kurla complex in Mumbai.

The fund has $60 billion to play with and one of its managers said earlier this week that more emerging market real estate investment is in the works.

"We are focusing on prime cities in India, China, Singapore, Korea, Vietnam and Malaysia, cities around the world where there is strong GDP growth and fundamental unmet demand for high quality real estate," Navid Chamdia, head of real estate at Qatar Investment, told Bloomberg at a wealth funds conference in Abu Dhabi. "About 40% of our real-estate investments will be in Asia."

In addition to taking a harder look at Asia the fund may start looking for some bargains in the U.S. market.

"We anticipate several opportunities in the U.S. for mezzanine financing, and individual distressed assets," Chamdia said. "We are looking at a number of these opportunities with several partners."

Sovereign wealth funds like these will be fixtures in real estate for years to come. Fueled by a commodities boom and large currency reserves Morgan Stanley estimates sovereign fund assets could reach a total of $12 trillion by 2015.

News and Related Story Links:

• Bloomberg:
  Qatar’s Fund to Invest in Asian Property, U.S. Assets

• Arabian Business:
  Record US$ 20.3 billion FDI drives Vietnam real estate

• LiveMint.com:
  Battered in the US, Lehman bets on India

• Money Morning:
  ING Plows an Additional $700 Million Into Chinese Real Estate

In much of the discussion about the collapse of the U.S. housing market, commentators have assumed that the massive run-up in property prices that preceded the subprime-mortgage meltdown were simply the result of a speculative frenzy that became a full-fledged market bubble.

But that’s not the case at all.

You see, the bubble and subsequent crash were inevitable under the current system of housing finance. Fundamental changes must be made.

Standard and Poor’s recently projected the likely future loss rate on the $650 billion of subprime-mortgage-backed securities that are still out in the marketplace. From that we can estimate the losses S&P is projecting on the actual mortgages themselves.

According to S&P, senior AAA-rated bonds will pay out about 60% of principal, junior AAA-rated bonds about 35%, AA-rated bonds about 5% and lower-rated bonds nothing at all. Since about 75% of subprime mortgage-backed securities were AAA rated, we can calculate that S&P thinks subprime mortgages will eventually return about 40% on the original principal amount.

That’s a startling number.

Losses Still to Come

If you had a portfolio consisting entirely of 100% loan-to-value mortgages, on which the appraisals were accurate but a large percentage of the borrowers had poor credit, and house prices were destined to drop between 20% and 25% over the next few years, you’d expect to lose 25% – or perhaps 30% – of principal, but still manage to keep 70% to 75% of your money.

When you had a foreclosure, there would be costs involved that increased your loss. On the other hand, some of the borrowers would be able to make their mortgage payments, leaving you with no loss at all. Thus, if subprime mortgages are expected to return only 40%, almost half of them must have had some fraud involved, either by the borrower, the mortgage broker or the appraiser.

Let’s now turn to actual housing prices. The S&P/Case-Shiller Home Price Indices of home prices in the Top 20 urban markets dropped a bigger-than-anticipated 12.7% in the 12 months that ended in February – the worst showing since the index debuted in 1991. What’s even more alarming, however, is that the decline is accelerating. In February alone, prices dropped 2.7%  – the equivalent of a 28% decline if this rate persisted for the entire year.

That should have alarmed both homeowners with large mortgages and mortgage market participants – if prices were to drop 30% to 40%, instead of the generally expected 15% to 20%, even prime home mortgages would get in trouble and the losses would be appalling – in the range of multiple trillions of dollars.

Since the first-quarter vacancy rate in U.S. housing – owner-occupied and rental – increased to 2.9%, the highest level in 50 years, we may indeed be approaching such a bearish scenario.

However, when you look at factors like the ratio of house prices to incomes, it becomes obvious that the problem is not the current drop, but the previous rise. Since World War II, the average house price was 3.2 times the average income. By 2006, however, the average house price had jumped to 4.5 times the average income. With house prices outrunning incomes in that way, mortgage financing was bound to become more and more risky, and a substantial drop was eventually inevitable – to take prices from 4.5 times income to 3.2 times would require housing prices to plunge 29%. And that doesn’t even consider the possibility that prices might overshoot on the downside. 

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The principal reason for the excessive rise in house prices and the high level of fraud was the housing finance system. In the modern system, the originator of a home mortgage loan is paid a fee on the origination, and never has to worry again about the credit risk on that loan, which is passed off to investors through a process known as "securitization."

Because securitization separates the mortgage originator and the actual investor, the investors – often foreigners – have no idea of the actual underlying quality of the loans that they’re purchasing.

The mortgage broker’s incentive is to maximize loan volume – pretty much regardless of whether or not the borrower can afford the loan. Falsification of documents, suborning of appraisers, and other similarly reprehensible machinations becomes a normal course of action in such a situation, as does turbo-charging the housing market to valuation and sales levels it cannot sustain. A system in which prices are forced up to unsustainable levels and fraud is rampant is broken, and needs to be replaced with something better.

It (Once) Was a Wonderful Life

Years ago, the United States had a superior home-financing system; it was extolled in the 1946 Jimmy Stewart movie, "It’s a Wonderful Life." Home-mortgage loans were made by local institutions to borrowers whom they knew personally. The system had some inefficiencies. For example, if the housing needs in a particular area expanded rapidly, there might be a shortage of funds, so that mortgages would be unavailable. However, banking is mostly national today, so local funds shortages would be less important, although there would probably be a corresponding decline in personal knowledge of the borrowers.

It’s not true that the Jimmy Stewart system of financing home mortgages was less efficient than today’s: That’s a myth put out by Wall Street, which has been one of the chief beneficiaries of the recent shenanigans. (Riddle me this: Do you think that "George Bailey" – Jimmy Stewart – ever got a million-dollar bonus?).

If you look at the U.S. Federal Reserve statistics on U.S. interest rates (which started recording home mortgage rates in 1972), you will discover that in 1972-78 – when the Jimmy Stewart home financing system was still mostly in place – 20-year Treasury bonds yielded an average of 7.41%, while 30-year fixed rate home mortgages yielded 8.49%, a differential of 1.08%. In 2000-06, an equivalent period that predates the recent worries about credit risk, 20-year Treasuries yielded an average of 5.28%, while home mortgages yielded 6.50%  – a differential of 1.22%. 

Thus, the "spread" of home mortgage interest costs over Treasury bond yields, the most appropriate measure of home mortgage costs, has widened by 0.14%. That may not sound like much until you realize that it’s an effective cost increase of 13%. Where did that increase go?

While some lawyers made money, too – what did you expect – it’s largely Wall Street that would rather you didn’t think about that question.

Two Key Changes

We can move back a long way toward the Jimmy Stewart system, but to do so two things must be changed:

• First, we need to close down Fannie Mae (FNM) and Freddie Mac (FRE), the government-sponsored enterprises that guarantee most home mortgages. By putting a quasi-government guarantee on the mortgages – they’re not quite government-guaranteed, but close (another worry for the taxpayers of America) – you take away the local credit risk and make them easy to pass around the money pits of Wall Street. Most countries don’t have the government-guarantee home mortgages; it’s entirely unnecessary as good home mortgages are fine credit risks on their own.

• Second, you need to enact some kind of small transfer tax on paper shuffling that makes securitization of mortgages expensive. The British have a 0.5% stamp duty on share dealing; even a 0.1% duty per transfer would probably be enough, here. It would make packaging the mortgages and turning them into mortgage bonds just a little less competitive, compared to the other alternative of having local banks or bank branches lend directly.

Once the financial incentives had been tilted against securitization, and the foolish government guarantees had been removed from the mortgage market, home-mortgage lending could revert to the Jimmy Stewart model.  (You might want to leave a small loophole for low-income housing, on which mortgages – otherwise non-creditworthy – still could be guaranteed by Ginnie Mae, part of the U.S. Department of Housing and Urban Development; it seems voters want the government to subsidise housing for the poor and help them get mortgages).

Overall, under the new model, home mortgages would be a little cheaper, you would go to a proper bank – and not a salesman – to get them, and housing prices would remain reasonable.

Of course, thousands of rich Wall Streeters would be thrown out of work. There’s a pity.

News and Related Story Links:

• Money Morning News:
  Housing Slump Continues.

• Wikipedia:
  Securitization.

• Wikipedia:
  It’s a Wonderful Life.

Housing prices continue to fall in 20 major metropolitan areas, according to the S&P/Case-Shiller home-price index released yesterday (Tuesday).

The index dropped 12.7% in February from a year ago, a bigger drop than was anticipated and the largest decline since the index’s inception in 2001. The index has had back-to-back monthly declines since January 2007 as the United States has suffered through the worst national housing slump in a generation.

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“This is just one more strain for consumers, in addition to high energy prices and tight credit,” Michelle Meyer, an economist at Lehman Brothers Holdings Inc. (LEH) in New York, told Bloomberg News. “Prices are going to continue to fall, probably through the end of next year.”

With an estimated 900,000 vacant homes, representing an 11-month supply, on the market, it’s unlikely the housing market will see a rebound any time soon.

And the trouble is widespread with 19 of the 20 cities in the index registering year-over- year price declines for February, with homes in Las Vegas (down 23%) and Miami (down 22%) suffering the most. Charlotte was the only bright spot, registering a price increase of 1.5% for the month.

With the family home representing many Americans’ largest asset, the steady decline in price has led to waning consumer confidence about the state of the U.S. economy. As home equity values dwindle, both consumer spending and financial optimism have been curbed.

"We think it very likely that the plunge in home prices is a key driver of the collapse in consumers’ confidence," wrote Ian Shepherdson, chief U.S. economist for High Frequency Economics, MarketWatch reported.

The gloomy housing market will weigh heavy on the minds of Federal Open Market Committee members, who will vote later today (Wednesday) on whether or not to cut the Fed funds rate. It is expected the FOMC will make a 25-basis point cut.

U.S. Federal Reserve Chairman Ben S. Bernanke has moved to slash the central bank’s key interest rate six times since mid-September, but homeowners with adjustable rate mortgages are still feeling the pinch as banks continue to tighten lending standards and remain skittish about refinancing subprime loans.

News and Related Story Links:

• Bloomberg News:
  S&P/Case-Shiller U.S. Home-Price Index Fell 12.7%

• MarketWatch:
  Home prices plunge at faster pace in February

Existing home sales in the United States unexpectedly rose in February, breaking a six-month streak of declines and signaling a turnaround for the browbeaten housing market and U.S. economy.

Purchases climbed 2.9% to an annual rate of 5.03 million, the National Association of Realtors (NAR) reported. Existing home prices continued their decline, with the average home price falling from $213,500 in February 2007 to $195,900, an 8.2% drop and the largest monthly decline since 1968.

However, nearly half of metropolitan areas reported price increases, with healthy gains in Oklahoma City and Trenton, N.J.

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"In other areas such as Sacramento, a rapid price decline has induced buyers to come into the market and sales are now rising," Lawrence Yun, NAR chief economist, said in a statement. "The relationship between home prices, interest rates and income has improved to the point where buyers are more serious about making offers."

The news gave the markets a nice bump in morning trading. And while Yun is pleased with the improved statistics, he said not to read too much into one month’s data.

"We’re not expecting a notable gain in existing-home sales until the second half of this year, but the improvement is another sign that the market is stabilizing," he said. "As inventories are drawn down, prices in many markets should go positive later this year."

Joel Naroff, president and chief economist of Naroff Economic Advisors, agrees, saying he expects prices to continue falling. As that happens, home sales will continue inching up.  

"Let’s face it, housing is not a bright light in this economy. And it is not likely to be that for quite some time," Naroff said. "But as I have been saying for over a month now, it appears that the housing market may be trying to make a bottom." 

Regional Statistics

In the Northeast, existing home sales jumped 11.3% to an annual pace of 890,000 in February. However, that figure is 26.4% below that of February 2007. The median home price in the region went up 0.4% to $264,800.

In the Midwest, existing home sales rose 2.5% in February to a level of 1.24 million, and that is 19.5% below a year ago. The median price in the Midwest was $143,900, which is 7.1% lower than February 2007. 

In the South, existing home sales increased 2.1% to an annual rate of 1.99 million in February, 22% below February 2007. The median price in the South was $163,400, down 8.6% from a year ago. 

In the West, existing home fell 1.1% to an annual rate of 920,000 in February, 29.2% below a year ago. The median price in the West was $290,400, down 13.4 percent from February 2007.

Overall housing inventory fell 3% to 4.03 million homes available, which represents a 9.6-month supply, down from 10.2-month supply in January.

News and Related Story Links:

• National Association of Realtors:
  Existing Home Sales Rise In February