Housing Finance After the Bubble | Credit Union Business

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By Alex J. Pollock

Twelve years into the 21^st century, the dominant financial and economic fact is that we are still living in the wake of the vast housing and mortgage bubble, which peaked in mid-2006, almost six years ago. ?Then came the peak in commercial real estate, making a real estate double bubble, and then the European sovereign debt bubble, all together making a great? 21^st century? compound bubble?a financial adventure of truly memorable proportions and pain. (Whether it actually will be remembered by the future investors, bankers, credit union managers and politicians of coming generations is highly doubtful.)

The dominant problem with being in the wake of every bubble is that no one can escape Pollock?s Law of Finance, which states: Loans that cannot be repaid will not be repaid. Since they will not be paid, they will default and impose losses. In the wake of a bubble, the losses are unavoidably massive. Because this iron law and its implications are highly unpleasant, financial actors and politicians strive mightily to escape them, in spite of the fact that they cannot, with scheme after scheme. All to no avail, of course.? The massive losses must ultimately be taken. After that, normal financial life can go on.

So the real questions are not: Will the loans default? Or will the losses be huge? They will. The real questions in the wake of a bubble are: What form will the defaults take? Who will take the losses? And when will the losses be recognized by those who are forced to take them?

Naturally, each party would prefer that losses be moved to someone else. Of course, one notable move is from unwise or unlucky lenders, investors and borrowers?by way of the government?to taxpayers, as has happened and is still happening with the losses of Fannie Mae and Freddie Mac. The foreign and domestic bondholders of Fannie and Freddie will all get 100 cents on the dollar of all principal and interest, on time, experiencing not one penny of credit loss, while the taxpayers take a trimming of $160 billion or so.? If you are collecting coupons on Fannie or Freddie obligations, give a little appreciation to your taxpaying fellow citizens.

Another crucial movement of losses is from borrowers and lenders to savers and depositors, thanks to the monetary actions of the Federal Reserve. Of course, government guarantees cover the nominal value of deposits, but counting in real, rather than nominal, terms, savings and deposits are being expropriated by the government?s attempts to address the effects of the bubble.

To try to help mortgage debtors, restore financial institution profits, make it cheap to carry leveraged financial positions, induce higher prices of stocks and bonds, reduce the cost of financing the government?s deficits, and encourage investment?in the name of trying to do all these things?short-term interest rates, as we all know only too well, have been reduced to about zero.

We have by now gotten used to this remarkable situation, although in all previous times we would have said it was impossible. What is this helping of borrowers and leveraged investors doing to savers and depositors? Obviously, it is crushing them, especially if they are retired. Conservative savers are getting perhaps a 0.3 percent yield, and have to pay taxes even on this meager amount. The Consumer Price Index increased in 2011 by 3 percent, so your reward for saving was to be about 2.75 percent poorer at the end of the year than at the beginning. This is how losses from the bubble are being transferred to savers.

Among the implications is that the best way to save at this point is to pay off your mortgage loan, if you have one. It its interest rate is 5 percent, paying it off is effectively making a risk-free investment of 5 percent?an opportunity you will not find elsewhere.? In general, it would be good for America to rediscover and once again stress the virtue of actually paying off your mortgage to become a real home owner.

It is not fun to be in the wake of the bubble, but the good news, relatively speaking, is that we are probably approaching the bottom. Graph 1 shows the American housing bubble, as measured by the Case-Shiller national house price index. After their intoxicating inflation to the 2006 peak, average U.S. house prices fell dizzyingly by about a third, representing the disappearance of about $7 trillion in housing assets people thought they had. (Of course, a large part of that perceived wealth was an illusion created by the bubble.) Since 2009, average prices have moved broadly sideways, but weakened again in 2011. Now they are at about the same nominal level as in 2003, and have crossed their trend line, as shown on the graph.

By the middle of 2012, it will be six years since the peak. The average duration of the housing busts, which inevitably follow housing bubbles, considered across history and numerous countries, is six years. This is according to Reinhart and Rogoff in their grand tour of financial cycles, ?This Time is Different.?? The regional housing bust of Boston in the 1980s bottomed after a little more than six years, and that of southern California in the early 1990s in approximately six years. That we are approaching the bottom is also consistent with observed rising rents, falling mortgage delinquency rates, and high housing affordability calculations.

Graph 2 shows the double bubble of residential and commercial real estate prices. The similarity of the shape of these curves, their inflation and collapse, is obvious and remarkable. Average commercial real estate prices did fall further than residential prices, but they too are now moving broadly sideways, having returned to the nominal levels of almost a decade ago.

Of course in any statistical distribution, some things are worse than average. If our post-bubble housing bust lasts a year longer than average, that would be seven years and a bottom in 2013. In other words, the 21^st century bubble cycle would have the Biblical seven good years (2000-2006), followed by seven bad years (2007-2013). While the bad years seem like they will last forever, they won?t.
Alex J. Pollock is a resident fellow at the American Enterprise Institute in Washington DC.? He is the author of Boom and Bust, a study of financial cycles.

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Source: http://www.creditunionbusiness.com/2012/03/29/housing-finance-after-the-bubble/

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