Continuing Vicious Cycle of Pain
At the heart of the near-panic rocking Fannie Mae and Freddie Mac is a vicious cycle gripping the U.S. housing market.
It starts with the oversupply of homes, which is causing prices to plummet. Falling prices are leading to more foreclosures, as homeowners have difficulty refinancing their mortgages or selling their houses. Banks are reluctant to lend freely at a time when home values keep sinking and defaults keep rising. That is crimping housing demand further and leading to more price drops and defaults.
This phenomenon — which some economists call a “negative feedback loop” — began with subprime borrowers but has gone well beyond the small segment of borrowers with poor credit. It is now spreading to the much-larger market of prime borrowers, which forms the bread and butter of Fannie’s and Freddie’s mortgage assets.
Actual credit-related losses at Fannie and Freddie have been relatively small when compared with their huge size. In the first quarter, for example, Fannie Mae reported $3.2 billion of credit-related expenses, mostly provisions for expected losses on mortgage defaults. That is a small fraction of the $3 trillion of mortgages Fannie currently owns or guarantees.
But the companies have been suffering a crisis of confidence because it isn’t clear how big credit-related losses will eventually become. Much of that could depend on how far home prices continue to slide.
“House-price declines are at the root of all our economic and financial problems,” says Mark Zandi, chief economist at Moody’s Economy.com and author of “Financial Shock,” a new book about the collapse of the subprime-mortgage market. “Investors can’t tell where the bottom is or how far mortgage-related assets have to be written down. That’s shaking even blue-chip institutions like Fannie and Freddie.”
One problem with trying to assess when home prices will stop falling is that the typical measures economists use to determine signs of a recovery may not be as useful in this downturn. For example, when measuring the relationship between house prices and household incomes, it would seem they are returning to a healthy balance. During the housing boom, loose lending standards and speculative buying pushed house-price inflation way above the sluggish rise in household incomes. But in the second quarter, Mr. Zandi estimates, the ratio of home prices to annual incomes has come down to near its 17-year average of 1.88 from a recent peak of 2.39.
Also coming into balance, though not there quite yet, is the ratio of home prices to rents. The lower the ratio, the more people are likely to buy a home than rent one. Mr. Zandi estimates that this ratio dropped to 20.02 in the second quarter from a high of 24.90 during the boom. The average ratio from 1985 to 2002 was 14.44. “If you just look at affordability indices, we would say we are probably close to a bottom,” says Ivy Zelman, a housing and homebuilding analyst. “But these are not normal times.”
For sure. During the previous housing downturn, prices fell 2.8% nationwide in the period 1990 to 1991, according to the Fiserv Case Shiller national home-price index. (In the hard-hit state of California, prices fell 16.7% over about five years before bottoming in 1995.)
Those levels have already been exceeded this time around. As of the first quarter, the S&P/Case-Shiller national home-price index had fallen about 16% from its peak in the second quarter of 2006. Prices in California were down about 29% during that same time period.
Better indicators for assessing when conditions might improve for the housing market can be found in the foreclosure numbers. Right now, it is the overhang of foreclosure inventory that is helping to drive the staggering home price declines.
The number of homes in the foreclosure process — as of the end of June, there were 681,000 homeowners with first mortgages that were in default, which is up from 313,000 a year ago — is such a problem that banks are slashing prices on those homes in an effort to sell them quickly. That is partly because they fear prices will keep falling. But the banks are also being nudged by the rising costs of holding onto vacant homes — insurance, lawn care and fines from cities and towns if the property falls into disrepair.
In the Sacramento, Calif., area, where 65% of the sales by Realtors in May involved bank-owned houses, the median home price fell to $230,250, down 34% from a year ago.
The banks are taking hits on all price ranges and house styles. For example. a three-bedroom home in Scottsdale, Ariz., featuring granite countertops and views of Pinnacle Peak, sold in March for $855,000, down from the $1.65 million it fetched in February 2007. A two-bedroom home recently sold in Cape Coral, Fla., for $267,500. That home had sold for $535,000 in March 2006 to buyers who financed 100% of the cost.
Banks also feel pressure to sell because the rate of new foreclosures continues to rise rapidly. The Mortgage Bankers Association reports that more than 500,000 foreclosures were started in the first quarter of this year alone. “The inflow [of homes into bank ownership] is outpacing the outflow,” says Chad Neel, president of Loan Portfolio Solutions, Denver, which manages the sale of foreclosed homes on behalf of banks. But he says, “Properties will sell if they’re priced right.”
What is right for banks, though, can be wrong for neighboring homeowners. As foreclosed sales drive down neighborhood home values, “people are now finding that their current mortgage balance is 30% higher than the value of their home,” says Thomas Lawler, a housing economist based in Leesburg, Va.
In addition, the time it takes to clear out the inventory of foreclosed homes may vary greatly by state. In California, foreclosures are typically resolved through a nonjudicial process, which may be helping lenders take possession of the houses and get them sold relatively quickly. In Florida, on the other hand, lenders have to pursue foreclosures through the local court systems, which is leading to backups in some markets, Mr. Lawler says.
The delay means that large price drops could hit some Florida markets when these foreclosed homes finally work their way through the system. “There are some markets where the disposition wave hasn’t fully hit,” he says. That process could take many more months, prolonging housing’s downward spiral.
The government can help stem the slide, but don’t expect a perfect fix. “The government can’t stop falling prices,” says David Kotok, chairman and chief investment officer at Cumberland Advisors in Vineland, N.J. “When you have falling sentiment and buyers who can defer decisions, they will defer until they think prices have hit bottom basement. I don’t think the government can do anything to alter that psychology.”
What government can do, says Mr. Kotok, is repair the credit markets so that there is more faith and credibility in the nation’s financial system.