Foreclosure, for Closure

Foreclosures have become a major political issue. Ever since December, Hillary Clinton has been making daily calls for a 90-day moratorium on foreclosures. The Bush administration has been inching toward an antiforeclosure policy. The Hope Now alliance was created in October as a voluntary industry effort to aid troubled borrowers. In December the White House and Treasury Secretary Henry Paulson encouraged Hope Now members to offer interest rate freezes and refinancing for certain qualified borrowers as part of an effort to avoid foreclosures. This week the administration rolled out Project Lifeline, which offers qualified borrowers the chance to freeze foreclosure proceedings for 30 days. (Coming next: Operation Desperation.)

All of these proposals are good ideas, and bad ideas, for the same economic reason: forestalling more foreclosure delays price discovery.

After a bubble pops, markets go through a painful process in which they try to agree on prices for formerly inflated assets. This is called "price discovery." When the bubble is in stocks, price discovery happens very quickly. A stock can go from $60 to $0 in a matter of days, if not hours, and sometimes did when the Internet bubble popped in 2000. From a macroeconomic perspective, such stock price discovery is painful but not necessarily devastating. The people who own bubbly stocks lose money. People who bought the stock on margin—i.e., they borrowed to buy it—lose a lot money. Banks who lent to high-flying firms frequently must write off loans. And companies that supply, or service, or depend on the afflicted firms may suffer as well. But, as when the tech bubble popped, stock price discovery usually doesn't lead to systemic failures.

By contrast, the process of price discovery in housing, and housing-related credit, has been much slower—and it has much more dire systemic implications. The housing market peaked in 2006, and it has been slowly slumping. But nationwide, according to the Case-Schiller index, housing prices have fallen only 8.4 percent in the past year. Home prices in some areas of the country may need to fall 30 percent in order to find bottom. That process is likely to take years rather than months.

The slope of the housing decline has been gentle because houses can't be flipped like stocks. People live in their homes, and there are big transaction costs associated with selling them. The market isn't very liquid. And there's another reason housing prices have been slow to fall: there are all kinds of incentives for everyone involved in the housing market to push off the day of reckoning, to delay the process of price discovery.

Start with the homeowner. Homes are highly leveraged purchases, whether it's 20 percent, 10 percent, or 0 percent down. Owners of existing homes are reluctant to mark down the value of their homes 20 percent overnight because, in many instances, it will wipe out their equity. Homebuilders and condo developers don't like to lower prices quickly because it makes those who bought in their development five months earlier feel like chumps. The banks don't want to concede that the houses they lent against are suddenly worth a great deal less than they were a few months ago. Investors who bought the bonds created by slicing and dicing mortgages—and then leveraged up their positions by borrowing money—get massacred when prices fall. The same holds true for bond insurers like Ambac and MBIA, which insured structured finance products created by lashing groups of mortgage-related securities together.