Wednesday, February 17, 2010

Pullback Of Government Support For Housing Could Cause Tailspin

Moses Kim argues that as government stimulus programs for the housing market begin to end, it is extremely likely we will enter the second leg of a double-dip recession, starting with housing and expanding to reach the entire economy. As government ends purchases of mortgage-backed securities, we can expect to see a significant rise in interest rates and as a result, declining demand. See the following post from Expected Returns.

People will be wise to prepare for the coming double dip in housing and in the broader economy. What we experienced was merely a reprieve from the secular downturn in housing. As the government eases away from its stimulus programs, the effect on housing should be substantial. From the New York Times, U.S. Housing Aid Winds Down, and Cities Worry:
Over the next six months, the federal government plans to wind down many of its emergency programs for housing. Then it will become clear if the market can function on its own.

People here are pretty sure the answer will be no.

President Obama has traveled twice to this beleaguered manufacturing city to spotlight the government’s economic stimulus program. The employment picture here has indeed begun to improve over the last nine months.

But Elkhart also symbolizes the failure of federal efforts to turn around the housing slump at the heart of the economic crisis. Housing in this community has become almost entirely dependent on a string of federal support programs, which are nonetheless failing to prevent a fall in prices and a rise in mortgage delinquencies.
It's pretty clear now that the much-hyped stimulus efforts of the government have been largely ineffective. Without the constant propaganda of "green shoots" propagated by our government, most people would not even entertain the thought of an economic recovery.

The Stimulus-Led Housing Recovery Flatlining

To the extent that the real estate market is functioning at all, people here say, it is doing so only because of the emergency programs, which have pushed down interest rates on mortgages and offered buyers a substantial tax credit.

Equally important is an expanded mortgage insurance program run by the Federal Housing Administration, which encourages private lenders to accept borrowers with small down payments. The government takes the risk of default.
I don't think people appreciate the magnitude of the government's programs to support housing. The government will eventually own $1.25 trillion dollars in agency debt. In effect, they have been the only buyer of these "toxic securities."

Given the massive input of stimulus, the "output", as reflected by housing prices, has been disappointing. If the Fed follows through on its plan to end MBS purchases, how will that affect housing?

Tax Credit Distortions

The government programs, however crucial, are distorting the market. The tax credit produced sales last fall, but some lenders here say it has troubling implications.

“People are buying to get that tax credit, to get some reserve money. They’re saying, ‘If something happens, I will have a little bit of money to fall back on,’ ” said Denny Davis of Horizon Bank in Elkhart. That’s not healthy.”

The programs favor first-time buyers, who have the fewest resources to bring to a deal. Heather Stevens, a 23-year-old nurse here, is closing on a three-bedroom house this week. Since her loan was insured by the Federal Housing Administration, she had to put down only 3.5 percent of the $74,900 purchase price.

“It was a breeze to get approved,” she said.

The sellers are covering her closing costs, which agents say is often the case here. That meant Ms. Stevens had to come up with only the $2,600 down payment, which still took all her savings.

But the best part is the $7,500 tax credit. She will use that to remodel the kitchen. “If it wasn’t for the credit, we would have waited to buy,” said Ms. Stevens, who is getting married this year
The key point to take away from this account is that this young couple would not have bought a home without the homebuyer tax credit and favorable FHA loan terms. This is just the type of government intervention (read: community reinvestment act, artificially low Fed Funds rates) that got us in this mess in the first place. I expect the consequences of government stupidity to be a prolonged depression.

Unwinding Stimulus

“There has been all kinds of help for housing. I’m not unappreciative,” said Barb Swartley, president of the Elkhart County Board of Realtors. “But you can’t turn real estate into a government-sponsored operation forever.”

Many in Washington agree. With worries about the deficit intensifying, the government is eager to start withdrawing some of its support programs.

The first step could happen as early as next month, when the Federal Reserve has said it will end its trillion-dollar program to buy up mortgage securities. That program has driven mortgage interest rates to lows not seen since the 1950s.

Yet it is uncertain whether the government can really pull back without sending housing markets into another tailspin. “A rise in rates would kill us all by itself,” Ms. Swartley said.
The most visible effect of the Fed's direct MBS purchases has been on mortgage rates. With mortgage rates still hovering near historic lows, prospective home buyers have bought homes at favorable terms. Throw in a tax credit and subprime level FHA loans, and you start seeing the government's hand everywhere.

Starting in March, when the Fed is ostensibly eliminating MBS purchases, mortgage rates will likely rise. As mortgage rates rise, consumers will be more hesitant to invest, and bankers will increasingly balk at lending. As people in the banking industry know, the servicing costs of 30-year fixed loans increase substantially with even a small rise in interest rates.

The synergy of tighter FHA loan standards, rising mortgage rates, and expiring tax credits will be enormous in an economy where people still aren't finding jobs. The likely drop in home prices nationally will further depress the net worths of individuals who are banking on a housing recovery to remain solvent. Baby Boomers are the demographic that concern me, as the majority were not prepared for retirement even at the peak of the housing bubble. Boomers don't have the luxury of waiting out this storm, which means distressed sales will increase and defaults will rise.

The prevent this scenario from unfolding, the government is now looking abroad for support to the MBS market. But as most of you know, the rest of the world is mired in economic crises of their own. When our agency debt is "unexpectedly" shunned by foreigners, expect the government to step in with another round of massive stimulus programs. The consequence? Levels of inflation we haven't seen in some time.

This post has been republished from Moses Kim's blog, Expected Returns.
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