Market Report: January 2009

Mr. Bernanke Gets It

Like doctors trying to identify unknown bacteria plaguing a sick person, Mr. Bernanke and Mr. Paulson have been trying all manner of treatments to save our troubled economy. Their initial game plan was to toss billions around and hope that this federal largesse would stabilize the financial system and revive the flow of credit. This was probably the best idea they had at the time given the unusual economic circumstances and their own ideological limitations. Thus far, the patient is alive but still bed-ridden and could possibly get sicker next year. Recognizing his error, Mr. Bernanke has brought in a new bold program. For his part, Mr. Paulson is the dead man walking.

After wasting months of valuable time and billions of your dollars, this duo finally realized that they have been stabbed in the back by their pals at the banks. Mr. Paulson has been given his walking papers although I thought the President-elect would be wise to keep him on board for a lengthy transition period. The Secretary’s mistaken belief that banks would act just a little bit in the national interest sealed his fate. Mr. Bernanke and the Federal Reserve Board, on the other hand, acted boldly once it was clear the initial plan failed. The Fed created a semi-nationalized shadow banking system that will flush the economy with credit. Who says the Fed doesn’t read the election returns.

This is clearly an affront and challenge to financial institutions accustomed to lucrative monopolies, cheap borrowing at the discount window and manifold privileges granted by law. Since a temporary nationalization of the banks, a step I think deserves more than passing consideration, is out of the question this is a clever gambit. It should serve Mr. Bernanke’s larger goal; to get banks to dip into their (Federal supplied) hoards of cash and unfreeze credit to both the consumer and business market. This will be a key part of the effort to neutralize a major threat to our country, deflation.

Curtailing deflation is important because it is well known that there will be another round of mortgage difficulties in 2009 and 2010 similar to the sub prime-driven crisis of 2007 and 2008. This second group of adjustable mortgages is due to begin resetting with higher interest rates and of course higher payments. The betting is that fifty percent or more of these borrowers will lose their homes. Just as the wave of last year’s mortgage defaults sparked the financial crisis of 2008, the second wave could have a far more deleterious effect on an already weakened economy. If all asset classes continue to deflate there will be little incentive to make payments on a property that is worth far less than the debt—or more importantly the expectation that the value will continue to deflate over the medium term.

I think both Mr. Bernanke and the new Administration are firmly committed to preventing such an occurrence. The real question to ask is: can they? Will three or four percent 30-year fixed rate mortgages arrest the slide in home prices? I think we will see these loans this year but I am not convinced that it will be enough to stabilize residential real estate prices. If the second wave of foreclosures does descend upon us, and I see nothing yet enacted to halt that occurrence, interest rates approaching zero will not necessarily save housing or the rest of the economy. As long as there is a belief in the inevitability of lower prices tomorrow, no interest rate will motivate enough consumers to save the market.

The real solution lies in jobs and population. A combination of crushing rents, job growth and cheap money will eventually save housing. Sooner or later, consumers in enough numbers will be forced by demographics and cheap credit to move into the housing market. This will absorb the distressed inventory, now representing about half of all transfers, and clear the way for more market rate transactions. The problem is the personal carnage that occurs along the way even though the new administration seems bent on ameliorating the worst parts of that.

Our world has not collapsed but that our economic system is constantly punishing and rewarding people for their economic choices. A new cohort of homeowners, previously priced out the marketplace, have benefited greatly from the misery of the over-extended class. Housing does not disappear when foreclosure occurs, only a new set of neighbors moves in. Sooner or later, the combination of low prices and cheap money will restart the familiar cycle. Sometimes there are more losers than winners and that has certainly been the case as of late. The Fed, however, stands ready to shower plenty of cash and credit upon us to help us slay the dragon of deflation. This determination, free of past restraints, is what gives me hope.

This is not to discredit the game efforts of Mr. Paulson at Treasury or Mr. Bernanke at the Fed. The former is hampered by an intellectual distaste of anything that hints of nationalism and chose a course that proved to be futile. The latter realized the dismal result and radically changed courses in the days before Christmas.

Click here to see Jim's past Market Reports.

> Send me complementary, custom MLS listings
> Contact Jim Scott for more information or with comments at jimscott@sqre.com