Market Report: July 2009

Bubble World

The Great Recession has re-priced real estate but there are other fundamental changes ahead for this beleaguered economic sector. Many financial experts, both in and out of the Administration, believe the recurring boom-and-bust cycles based on inflated asset values does more harm than good. They argue that much of the prosperity of the past decade was ephemeral and false; we did not create the recent veneer of prosperity through work or enterprise. The overpaid army of creative financial engineers moving handfuls of debt, paper, and money from one pocket to another did not make for lasting national wealth. Lax governmental supervision of this greedy mob added to the severity of the eventual correction. The inevitable backlash will lead to political and economic changes that will have serious implications for residential real estate.

In the global era credit flowed easily to Americans who used borrowed money to bid up the price of real estate. The lending industry enabled this behavior and after years of binging on fat fees generated by originating questionable loans, banks are now behaving like reformed addicts, becoming zealous converts to their new religion. Prudence is their stated mantra but unreasonable risk-avoidance is the reality. Lenders want to make only home loans they can re-sell in the secondary mortgage market and are understandably reluctant to make portfolio loans. Not surprisingly, sales of lower-priced homes are flourishing in San Diego. Anyone who has been trying to buy a property under $450,000 knows that in the lower reaches of the price continuum it is a seller's market.

These mortgage underwriting practices make price points the main determinant of who wins and loses in real estate. One segment of the market is overheated and another languishes by bank fiat. Credit for homes priced above $700,000 has been so restricted that this contraction could fuel a future crisis in higher-priced homes. Foreclosure filings on upper-strata houses are increasing and will continue until a reasonable flow of credit is restored. Banks are not recognizing the consequences of their collective timidity, the link between red-lining and future mortgage failures. Also of equal concern is that these craven and misguided policies are also being applied to commercial real estate, laying the groundwork for future foreclosures, which the economy can ill-afford.

The Obama administration, frustrated with a still-restricted credit supply, just introduced a sweeping plan to re-regulate the country's financial system. Cooler heads in the financial services game know the rules are going to change and that re-regulation is coming in spite of the ranting cabal at Fox News. The finance industry is going to the woodshed in the hope to avoid the more draconian options now being debated in Washington. Lenders see themselves as caught between two near-immovable objects: maintaining banking capital requirements (easily done by not lending money and buying Treasuries with their bail-out money) and the political imperative to provide credit to revive the economy. The 11.5% unemployment rate in California and the continued contraction of the Gross Domestic Product are cautionary signs to this crowd; today's well-secured loan could easily become a foreclosure tomorrow. I think this caution is not completely justified. This business cycle appears to have a U-shaped bottom and all markets are bumping along the lengthy trough. The worst of it is over even though there is still risk going forward.

Housing should be stabilized within 24 months, albeit re-priced and transformed in character. Homes will be owned as shelter and not as speculative commodities. Appreciation will be steady but modest. The nation's homebuyers will lack the economic capacity to engage in another buying orgy. The recent cycle of unsustainable asset bubbles fueled by cheap money may be a thing of the past. The President and the Fed will attempt to control the formation of any asset bubble; as a result housing is going to gradually lose some of its favored political and economic status. The team running our economy, like the President himself, wants to enact fundamental changes to our economy. There are those in the Administration who argue that changing the rules of the financial system will lessen the extremes of the business cycle and prevent another collapse. Ward Cleaver trumps Gordon Gekko, maybe.

Americans may be better off economically if real estate becomes boring and safe, like it was when Ike was President. The extremes of the business cycle and the Age of Globalism may be a toxic duo that we cannot afford in the future considering the size of the national debt. America cannot control our global competitors but can make far better domestic economic decisions. The lessons of the past decade are clear and if prices of real estate assets in the future begin to inflate too rapidly, you can be assured the Fed will take immediate action and sharply restrict the flow of credit to housing. Prices of real estate will go up from this bottom but the party will not get out of hand and that is good news. This regulated approach is not a new idea but its return should serve the country better over the long run. America cannot easily withstand another colossal meltdown. Were this to happen again too soon, our country would become an economic ward of the creditor states. It is not outside the realm of possibility, just read some modern British history.

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