There was an article last week in the New York Times about economists calling for the government to simply allow house prices fall and reach their bottom, an idea which is gathering more and more support. I think this is a bad idea because the real costs falling home prices are obvious, likely, and severe, while the benefits are vague and speculative.

For starters, as the following chart from Calculated Risk shows, in Q1 2010 there were millions of homeowners who are in a negative equity position. If prices fall another 5%, each of these bars will shift to the left one position. If prices drop 10%, they will shift two.

Lets make the conservative assumption that there are as many people right now in the 0% to +5%, +5% to + 10%, and +10% to +15% bins as there are in the -5% to 0% bin. This means we’ll get another 1.8 million borrowers underwater for each 5% fall in prices. If they fall 15%, that means 5.4 million more.

As you can see though, the numbers of homeowners in each category get larger as they approach zero, going from 1.1, to 1.3, to 1.5, to 1.8 million in the last 4 bins. So it’s likely we’ll actually get upwards of 6 million more homeowners underwater.

In addition, a fall of 15% would push around 1.9 million more homeowners into 50% or more of negative equity, driving this number up to around 6 million. These large increases in total negative equity will drive a wave of foreclosures. The best evidence indicates that foreclosures, in turn, will decrease nearby home values by 1% to 2%, which could exacerbate the foreclosure blights many neighborhoods are already facing.

Why are these foreclosures a problem? Most economically literate readers will be familiar with Bernanke’s famous paper on non-monetary causes of the Great Depression, where he makes the case that an increase in the cost of credit intermediation worsened the Great Depression. In contrast to the argument for how bad things can get when banks fail, few seem to focus on aspect of Bernanke’s paper that focused on defaults and bankruptcies as a mechanism for deepening the depression. In fact Bernanke even discusses the drying up of credit for homeowners as one of the important channels through which the credit system was failing:

Home mortgage lending was another important area of credit activity. In this sphere, private lenders were even more cautious after 1933 than in business lending. They had a reason for conservativism; while business failures fell quite a bit during the recovery, real estate defaults and foreclosures continued high through 1935….

To the extent that the home mortgage market did function in the years immediately following 1933, it was largely due to the direct involvement of the federal government.

Removing the existing government supports for the housing market now will allow this important channel of credit to dry up. As Bernanke recognized, this could worsen and lengthen our recession.

Another problem is that when a buyer defaults they lose a real asset: their credit. As near as I can tell from Googling around, credit scoring agencies have not adjusted their models to decrease the damage that a foreclosures does to your credit score. This seems puzzling to me as economists seem to agree that the huge fall in house prices was largely unpredictable when many of these mortgages were made. Defaulting on a mortgage in 2010, one would think, is not nearly as much of an indicator of lacking creditworthiness as defaulting on a mortgage in, say, 2005.

In any case, when defaults happen a real asset which gives borrowers access to credit goes away and the cumulative creditworthiness of U.S. households falls. In a recession, when borrowing and investing are important means of driving economic activity, this is not a good thing.

I believe the reason that falling home prices are getting support is what Karl calls The Pain Bias. Somehow, falling prices feel like tough love, and it feels like borrowers will be more confident. And it may be the case that another 15% fall in prices will convince people that prices are at a bottom. But along the way to that bottom real economic damage will be done. If that damage is great enough, and hurts economic growth, those rock bottom prices may fall even further.

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