THE ROAD TO RECOVERY
By: Daniel Encell
March 12, 2009

The Problem
Throughout our country, residential real estate values have suffered unprecedented declines. The Standard & Poor’s Case-Schiller Index shows a continuous decrease in values since 2006 for the 20 largest U.S. metropolitan real estate markets. Declining home values, combined with irresponsible lending practices have lead to unprecedented negative equity nationwide. The reduction in values has been so severe that a recent estimate shows 20% (1 in 5) of U.S. households owe more on their home than the present market value of the property (in California, this figure is about 27% and in Nevada, over 50%). Homeowners are defaulting on their loans in record number. The resulting foreclosures force home values down. The problem magnifies as more foreclosures force home values down further, creating more economic distress, which leads to more foreclosures…

The Solution
Currently, many forms of economic stimulus are being proposed and implemented to ease the financial crisis that is gripping our country, and the rest of the world. Unfortunately, most, if not all of them involve enormous costs to taxpayers and none will be as effective or immediate to stabilize the housing market as this proposal. By substantially lowering interest rates to homebuyers who legitimately qualify for loans, the federal government has the direct and immediate ability to stabilize the housing market. Although the proposal submitted here is not a cure-all, it does provide an important step towards stabilizing the crumbling residential real estate market throughout our country.

In 2008, the federal government seized control of leading giants Freddie Mac and Fannie Mae after both agencies ran into trouble for irresponsible lending practices (i.e. making loans to borrowers who never had the ability to pay the loans back). Although I am generally not a proponent of government intervention into private sector business, as long as there is already such intervention, some very positive results can be achieved. These two institutions originate or guarantee over half of the residential mortgages in this country.

By making loans readily available and attractive to homebuyers, the government has the immediate ability to stop the downward spiral of real estate values. The government can instantly lower interest rates on loans originated through Freddie Mac and Fannie Mae to the point where the desired homebuyer demand level is achieved (i.e. home values stabilize). Lower mortgage interest rates can achieve the same necessary increase in homebuyer demand as lower home prices (without all the negative consequences of declining values).

As demand for homes increases, prices will stabilize. As prices stabilize, foreclosure levels will subside. As prices stabilize and foreclosures subside, the risk to lenders decreases. As the risk to lenders decreases, institutions besides Freddie Mac and Fannie Mae will be willing to return to making competitive residential loans. Once other lenders feel comfortable with the reduced risks associated with residential loans, they will begin to compete for loans by lowering interest rates to the same or similar levels as Freddie Mac and Fannie Mae.

Unfortunately, we have already seen that the government’s indirect efforts to stimulate residential lending have been ineffective. The billions of dollars that the government has provided to institutional lenders has not made its way to homebuyers in any meaningful way. Because the market has not yet stabilized, lenders are reluctant to make loans. It’s hard to fault the lenders because it is a very risky business decision to loan into a declining market.

Similarly, efforts by the Homeowner Affordability and Stability Act to assist existing homeowners who are in default, or are at risk for default, are cumbersome and incomplete. They do little, if anything, towards stabilizing home values. Instead, they are merely band-aids, aimed at covering up financial wounds instead of preventing them. By contrast, the proposal to boost demand through lower interest rates both absorbs existing inventory of unsold homes and helps prevent future defaults and foreclosures by stabilizing values.

Tax credits for homebuyers won’t help enough either. They simply do not provide enough financial incentive to create the increased number of homebuyers necessary to adequately address the problem.

In addition to the immediate and direct benefits associated with lower mortgage rates, there are also substantial indirect benefits. As the real estate market stabilizes and the corresponding risks associate with residential lending decline, interest rates for all mortgages will decrease. Homeowners will have the opportunity to refinance existing loans at lower interest rates, creating more disposable income. More disposable income will allow more consumer spending.

The banking industry will also benefit from this proposal. Lower interest rates will lead to increased Buyer demand, thus speeding up the absorption of existing R.E.O.’s. This combined with a healthier lending environment will lead to improved balance sheets for banks eventually allowing them to competitively offer residential loans without federal assistance.

President Obama, if this message reaches you, seize this opportunity to act. Show the American people your commitment to helping our economy regain stability. Freddie Mac and Fannie Mae have the unprecedented ability to stabilize the real estate market quickly and efficiently. Put them to work for the American people.

Daniel Encell graduated with high honors from the University of California, Santa Barbara with a degree in business economics. He has consistently ranked among the top residential real estate agents in the country, and has written articles for both the UCSB and California Economic Forecasts.