Why Falling Home Prices is Good News

Reported today in the Wall Street Journal were the new numbers for the housing market:

Demand for existing homes climbed in February above expectations, driven by foreclosure sales that are sending prices plunging.

Home resales rose 5.1% to a 4.72 million annual rate from 4.49 million in January, the National Association of Realtors said Monday. About 45% were foreclosure and short sales.

The large number of these distressed property sales is driving prices lower. The median price for an existing home fell 15.5% last month to $165,400. Falling prices depress demand, contributing to the high inventory that is a factor keeping prices down. Inventories of previously owned homes rose 5.2% at the end of February to 3.8 million available for sale, which represented a supply of 9.7 months at the current sales pace.

“As long as inventories stay very high and a high proportion of sales are distressed, prices will continue to decline,” Insight Economics analyst Steven Wood said. “In addition, because of tighter mortgage-lending standards, a sustained recovery in the housing market is unlikely, at least while home prices are continuing to fall.”

The February resales level of 4.72 million reported Monday by NAR was above Wall Street expectations of a 4.48 million sales rate for previously owned homes. The 5.1% increase was the largest since 5.6% in July 2003.

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Famous Austrian economist Joseph Schumpeter called this part of the capitalistic process “creative destruction.” Basically what he meant was that the market corrects its own mistakes, unlike politicians.

In my opinion the whole crux of our Great Recession was and is overpriced housing. The whole credit bubble that caused the crash was based on inflated housing prices. The mortgage and housing boom was driven by cheap money. The housing affordability index got way out of alignment. Who could afford houses at the ridiculous prices they were selling for? Well, it turns out a large part of the market was based on speculation (estimates range up to 24% of homes were owned by non-owner occupied speculators).

All of the mortgages that were sold to or guaranteed by Fannie and Freddie, or securitized as subprime paper, were overvalued. Rising housing prices spurred equity borrowing to fund a massive consumer spending binge. That in turn created a huge slug of credit card, auto, and student loan debt, much of which was securitized and sold to investors.

Everyone prospered until it went bust.

How do you recover from this? The free market economists say you have to let all this debt be paid back or let the makers and holders go bankrupt. Tough medicine as they say. It means deflation: prices going down. It requires that inflated assets find their true value in the market. What “true value” means is the price that results from a transaction between a willing buyer and a willing seller. That’s what’s happening now in the markets. As a result buyers are starting to come back into the housing market.

The government, as this blog has consistently and noisily pointed out, can’t stop the process. If they try it will only slow things down and keep the economy depressed. As in Japan.

Creative destruction is not a pretty process. But it’s quick. The sooner prices find their level, the sooner we’ll recover. Then new savings (not spending) will restore depleted capital, and we’ll take off again. Financial institutions will take the hit and either go broke or recover. If they go broke there are many players that will jump into the void. Until then, everyone believes prices will continue to fall, and they remain uncommitted because they don’t know what the government will do next.

The key to the whole thing is housing supply. We are now seeing a trend that shows inventory dropping. This also means prices are dropping as opportunistic buyers bid at foreclosures and at auction for bargains. Supply has been in the 11 month range, but appears to be slowly dropping–a 9.7 month supply. Once supply reverts back to the norm, say a 4 to 6 months supply, the economy will start its turnaround. Don’t look for home prices to surge for years to come; people have been burned.

Don’t expect underwater financial institutions to recover quickly either; they will continue to go into FDIC receivership or bankruptcy. Once debt has been liquidated and balance sheets restored, then we’ll have a healthy economy. The one big “X” factor? Actions the government will take to prevent all this from happening. We don’t know what they’ll do next. Whatever they do, it will delay recovery.