Scared of the 800-lb. Gorilla?

Went to an interesting symposium on the economic crisis and the Obama policy response/spending bill yesterday. Two economists, Tom Campbell and Barry Eichengreen, gave their interpretations. What struck me was that nobody, especially nobody in politics, seems to want talk about the 800-lb. gorilla in the room. This beast is the pervasive uncertainty associated with price discovery roiling all markets and asset classes. This 800-lb. gorilla is partly psychological but also real, so perhaps we can talk about the big gorilla and his even bigger shadow.

Policymakers don't want to bring too much attention to the gorilla for fearing of scaring the public with his imposing shadow. But in so doing they seem to be pushing a form of denial that is also reflected in the proffered policies. Most of these policies seem targeted to further obscure prices or prop them up. Obama's proposal to throw another $275 BILLION at foreclosures in the housing market is a case in point.

The necessity of price discovery is crucial to clean up the banks and get credit flowing again. What do we think these toxic assets are? They're assets that nobody can agree how to value (most of them based on unrealistic housing prices). The market has depreciated these assets to 30-40 cents on the dollar, but the owners (banks) think they're worth more, but can't sell them and are hoping the government (i.e, sucker taxpayer) will buy them at par. At least that pig didn't fly. But if we don't discover prices on this toxic dump we can expect years of zombie banks in our midst. Expect some nationalizations and then break-ups.

True price discovery is also crucial to getting the housing market off the mat. Nobody is going to buy overpriced housing no matter how cheap and available credit is, and nobody is going to convince them that prices have stabilized by virtue of directives or hopeful words from Washington. What's a house worth anyway? The "bigger fool" strategy is history for now. Let's try a historical metric of cashflows off implicit rents or median incomes and we'll get an idea. A house that rents for $5000 a month is worth maybe $900K. Rents for $1500/mo. = $270K. But policymakers want to stabilize house prices based on inflated mortgages. Ain't gonna work. Just more wasted dollars...

But why? How are we helping things by encouraging people to buy or stay in overpriced homes they can't afford and then sticking them with the bill over the next 20-30 years? Are we searching for new ways to impoverish these people? How are they going to pay for the expenses of old age? Wonder how that's gonna work with our entitlement reform?

Bottom line is that nobody wants to adjust housing prices to the downside. But there's no other way out of this mess. Securitized mortgage money is gone...buying power is a fraction of what it was in 2006. Let's get real instead of throwing good money after bad. Indications are this is gonna take longer than we think.

Joe the Renter?

Date: February 6, 2009
Re: A memo from Joe the Renter

Dear Congresspersons, Senators and Mr. President,

We are in the midst of a serious economic correction and the causes are quite complex. As a prospective home buyer allow me to narrowly focus on the state of the housing market. There have been many calls from the Capitol to save home owners facing foreclosure – a moratorium on foreclosures, new government-subsidized fixed rate mortgages, loan renegotiations, and bailouts for lenders. (BTW, these owners underwater don't want to be saved and tethered to their bad investments - they want to be liberated.) But precious little has been focused on the people who can afford and wish to buy a home. Don’t we want buyers to re-enter the market?

For a home buyer, I have the desired qualifications: middle-aged, recently married, with a combined income that varies between $80-150K, zero debt, a credit score over 800 and roughly $300K cash that could be put toward equity. What matters most to me is the size of the mortgage and the prospects for price stability or, better yet, long-term appreciation. In the long-term it doesn’t matter that I might get a $7500 purchase tax credit or a low interest rate because these factors will just keep asking prices higher and increase the size of my mortgage principal owed. You could offer me limitless funds at 0%, but I still will not borrow to buy an asset that is overpriced based on cash flow fundamentals.

The problem in a nutshell is our national housing stock is overvalued by almost any economic measure we use, whether it be median incomes, imputed rents or national GDP. Currently we rent a 2200 sq. ft. home for $2800/mo. Comparable houses in the area of Los Angeles where we live have asking prices of $1.2-1.5 million. Buying just doesn’t compute. Because we live in a dense urban area of Southern California I know many other families in the same predicament – on the sidelines with cash waiting for a rational market to return. In the current environment we will all continue to rent and put our investments elsewhere.

You might think my take on this is self-interested, and I would wholeheartedly agree. But my actions have been financially prudent. I need to save money for retirement, not throw it away on overpriced housing. I did not “roll the dice” on subsidized housing with other peoples’ money. But the nation is in the same boat.

We made bad investments in an asset bubble. We need to correct these prices, not distort all the other prices in our economy. Otherwise we will be in a deeper hole when it comes to financing our retirements. We can make housing affordable in this country if we stop subsidizing it over other investment classes and let it return to true market value. The political challenge will be how to manage the losses this will incur to those who were not so prudent – buyers, lenders, banks and investors. I suggest you leave us taxpayers out of it as much as possible.

Sincerely, Joe the Renter

P.S. While I am an average citizen and home buyer, perhaps I am not the typical voter. I’m a macroeconomist, finance MBA and political scientist. I hold doctoral, masters and bachelor degrees in these three disciplines, all from top-ranked schools. Thus, I am one of the so-called “experts” you often consult for policy advice. Please take it into consideration.