The decline in residential real estate prices over the past several years has inflicted severe damage to the U.S. economy and housing markets. The damage is well documented; lost household wealth, a flood of foreclosures, a credit crisis and the deepest economic and housing contractions since the Great Depression, to name a few. Policymakers have made serious attempts to stem the tide of plummeting home values, but to date, no government program has been meaningfully successful.
Until home prices stabilize, it is difficult to imagine a housing sector in recovery. Some, like Robert Shiller, say that in some cities home values need to decline further before they can be in a healthy situation; and he may be right. But I would also claim that some markets are not behaving rationally, resulting in a spiraling downward of home values.
The Case-Shiller 20-city home price index fell 18.7 percent in March compared to a year earlier. All of the 20 cities reported annual rates of decline. Measured from its mid-2006 peak, the index has tumbled 31 percent through March of this year. Such cities as Las Vegas, Miami and San Francisco have been hit particularly hard, experiencing price declines of 50, 47, and 46 percent, respectively from their 2006 peaks.
Home price deterioration is not just limited to 20 major cities. According to other recent housing reports, home price declines are broad-based. The Federal Housing Finance Administration, FHFA, purchase-only home price index, which covers the entire nation, declined 7.3 percent in March compared to a year earlier. Further, the median price of total existing homes sold in April declined 15.4 percent from a year earlier.
In practice, there are two obvious ways to stabilize home values-stimulate housing demand and reduce housing supply; the government has tried both. An $8,000 tax credit (effective until November 2009) and keeping mortgage rates near historic lows are current examples of the government’s efforts to lift housing demand. Both have had a marginal impact on home sales, at best.
Reducing housing supply has become a preoccupation for the government over the past year-its mantra: decrease the number of foreclosures. Foreclosure mitigation programs such as Hope for Homeowners and FHA Secure have been attempted over the past two years but to no avail. Its most recent program, Making Home Affordable, helps borrowers in trouble through either loan modifications or refinancings. To date, this program has shown some success but is very slow to implement. For example, Fannie Mae has received over 233,000 eligible refinance applications, but has only closed 2,150.
While we wait for foreclosure mitigation programs to slowly reduce the pace of foreclosures, delinquency rates elevate and foreclosure filings continue to mount in the marketplace. According to the Mortgage Bankers Association, mortgage delinquency rates surged 124 basis points (approximately 1.25%) to a record high 9.12 percent of total mortgage loans in the first quarter compared to the fourth quarter of last year. Similarly, mortgages that entered foreclosure in the first quarter were up 29 basis points to 1.37 percent of total mortgage loans compared to the fourth quarter. And according to RealtyTrac, foreclosure filings were reported on a record 342,038 properties during April, an increase of 1 percent from the previous month and an increase of 32 percent from April 2008.
Government efforts aside; more is needed to slow the pace of home price deterioration in the U.S. housing markets. Looking at the regions that are experiencing the greatest price declines- like Florida, California, Nevada, and Arizona, may shed some needed light on the problem and offer a solution.
Common to these regions is a glut of vacant homes created by an overflow of foreclosures. The glut was created by speculative investors who bought at the peak of the boom and have chosen foreclosure rather than holding on to a property that is generating a large negative cash flow; and by families, who because of lax underwriting, purchased homes they could not afford that end up in foreclosure. And there are more foreclosures in the pipeline because more and more households are having a difficult time meeting their mortgage payments due to higher mortgage rate resets.
As a result, many local markets in these regions are getting worse, not better and are generating inefficient market outcomes. Picture a local market with an overflow of foreclosures (mostly vacant) properties. The owners of these properties are usually banks and government agencies, like Fannie Mae, Freddie Mac and the FDIC. On the demand side, there are not enough households to purchase these properties because many households no longer qualify for a mortgage loan since they were recently involved in a foreclosure. In many cases, these families are low-to-moderate income households of which a significant percentage of them are minorities.
Local market conditions continue to deteriorate because banks and government agencies continue to dump new foreclosed properties into a marketplace already replete with an alarming number of vacant properties; this is like adding gas to a fire. In some cases, these vacant properties are sold to speculative investors at deep discounts and in many cases, these properties just sit on the market unsold; both sending home values lower.
Current government policy is focused on assembling programs that eventually reduce the number of new foreclosures so that less of these properties are added to the housing fire pit. However, a simpler and more direct solution would be to not sell the homes at all. Why are banks and government agencies selling foreclosed properties in a market already overflowing with vacant properties when they know that it will only depress home values further? Why not rent these properties rather than sell them? We already know there is greater demand for renting than owning since a large number of households in these markets no longer qualifies for financing to own.
The answer is that banks and government agencies feel pressured to dump their non-performing assets quickly due to the fact that today’s regulations do not permit them to be in the landlord business. As a consequence, banks like Wells Fargo and Bank of America are making nonsensical business decisions by retaining real estate agents to sell their foreclosed properties at deep discounts to speculative investors for say, $45,000, when the replacement cost of that property is $110,000!
It seems reasonable to modify a rule that may correct a severe market problem then to abide by a rule that is contributing to the problem. One possibility is for regulators to permit banks to convert their non-performing assets into performing assets and to keep these assets on their balance sheets for a specified period of time, say 3 to 5 years; hopefully giving the market enough time to recover. This could be accomplished by allowing banks to retain property management companies to rent and manage their foreclosed properties. This is a true win/win for the marketplace. Banks would be better off because they would now have assets that generate positive net cash flows (net of property management fees). They would also be eliminating the carrying costs of vacant properties. In addition, they would significantly reduce realized losses by eventually selling these properties for a higher price (hopefully) 3 to 5 years from now compared to the price they would have obtained. The real estate markets win because this would ease downward pressure on home values, permitting local markets to recover sooner. Every one wins when the local market recovers.
Another possibility is to direct banks to sell their foreclosures in bulk to investors that commit to manage and rent the properties for a specified period of time (3 to 5 years). This gets the non-performing assets off banks’ balance sheets and lets an investor assume the responsibilities of ownership and property management. Because these properties are rented for a given period of time, the inventory of homes available for sale in the local marketplace shrinks considerably.
The private marketplace is already creating programs designed to help banks rent and manage their distressed properties. The Chang Group, a real estate brokerage and property management company located in Ft. Myers, Florida, offers an innovative option/lease program called Fresh Start. In the program, families are renting (leasing) with an option to own contract and up to 75 percent of the rent paid every month goes towards a down payment. The monthly payments as well as payments for utilities are reported to a credit agency, allowing families to raise their credit score. In many cases, the option price is close to the replacement cost of the property, establishing a floor for home values in that market. The objective is for these families to become homeowners within 12 to 24 months.
Programs like Fresh Start offer a win/win/win for the real estate markets. Banks win because their non-performing assets are converted into performing assets which eventually sell at a price higher than a distressed price. The marketplace wins because the program establishes a floor on home values. And families win because they are offered an opportunity to re-live the dream of homeownership.