Stopping Foreclosures Will Not Stop Price Declines

There is a common misperception that foreclosures are pushing home prices down. I see this all the time in quotes like "Stemming the number of foreclosures will go a long way to stabilizing the market" which was part of an otherwise solid article at Inman.com. I actually made this mistake myself for quite a while until I watched home sales pick up as REO inventories increased - a feat that flies in the face of basic laws of supply and demand. Then it hit me: People simply don't buy homes based on price, they buy based on payment.

When loan products change, the price a buyer can afford also changes. 100% of the price correction to date can be perfectly correlated to the change in available lending products and has little, if anything, to do with foreclosures.

Sales sucked in 2007 because people couldn't afford the homes at those prices given the available financing. As prices have come down to meet available financing sales have risen. I actually said at one point that foreclosures were bringing back affordability to CA. But that was incorrect - the return to traditional financing has pushed prices down, not foreclosures.

Those of us who sat through econ 101, and look to past housing cycles get fooled into thinking the current price declines have something to do with too much supply. And we, therefore, believe that stopping foreclosures and limiting supply will stop price declines or even bring prices back up.But outweighing supply and demand is the simple ability to pay. Turns out this is what is driving prices down. And it turns out we still have strong demand at prices people can afford to pay (sales have risen each month as prices have declined here in CA).

The important takeaway is that by focusing on stopping foreclosures we take our eye off what could be a more serious problem - rising interest rates. Interest rates are up this week. That will directly correlate to either slower sales at current prices or lower prices. Why? Buyers buy based on payment, not on price, and higher interest rates lower the price they can afford. As homes become less affordable, less sell.

I see only two things that can return prices to their peak levels, neither of which is terribly exciting:

1. Taxpayer-backed home loans in the 2-3% interest rate range. At least in CA, that is what it takes to make these loans affordable at peak prices. And, one could argue, that is essentially what is happening now with the bailout. Countrywide, for example, is currently doing 5 year, 2%, interest only, loan mods.

2. Wage inflation. To get house prices back to their peak levels with traditional financing we could dramatically inflate everything else to catch up with peak home prices. Think 15%/year inflation for 5 years.

The best bet is to at least ensure that traditional financing remains available so that we can put a floor on the losses. The federal government has already taken extreme steps to shore up home financing with the takeover of Freddie and Fannie. Yet they will need to attract capital to continue buying these mortgages or rates will rocket upwards, and prices downwards - foreclosures or not.