Foreclosure, for Closure

And so, since the bubble popped and home prices ceased to rise, desperate players in the market have taken a series of actions intended to delay price discovery in housing. Rather than cut prices, sellers began to throw in free cars or other inducements to buyers who paid the asking price. Brokers reduced their commissions. Builders started including all sorts of extras (fancy kitchens, pools, etc.) for no additional price. Every link in the chain sacrificed margins and profits rather than cut prices. The Wall Street Journal reported last year that homebuilders were funneling large cash payments to buyers through third-party marketers, in effect reducing the price buyers had to pay while publicly reporting that sales prices remained buoyant.

Such measures were like throwing sandbags at a rising river. And it hasn't worked. The carnage in subprime loans has led to a spate of foreclosures. When banks or investors take over properties, they recoup whatever they can by placing them on the market quickly and accepting any reasonable offer. When foreclosed properties are dumped onto the market and sold at fire-sale prices, they establish new comparable sales on a given street or neighborhood. It might take a solvent home-seller 18 months to mark down the price of his house by 20 percent. A bank will do it in 18 days.

Foreclosure also has the effect of hastening price discovery on the mortgages on those homes, and on the bonds backing them. Here, again, the impact can be devastating to those who bought the assets with a great deal of leverage. Hedge funds and other institutions sitting on the depreciating debt either had to put up more collateral to maintain their leveraged positions or dump the assets to raise cash. Bond insurers must increase reserves to prepare for defaults of the bonds they insured. And if the bond insurers fail, the financial firms that purchased insurance from them will have to take their own write-downs. The potential for massive systemic problems is the reason there's been so much discussion between financial institutions and government regulators about trying to orchestrate some sort of bailout for the bond insurers.

In general, cleaning up quickly after popped bubbles is good for the economy, because it enables everybody to move on. Over the years the American economic system has proved to be quite adept at doing so. And as Japan's experience in recent years shows, refusing to deal with the overhang of bad debt can condemn an economy to a lengthy period of slow growth. But I doubt there's the political will to allow the fast price discovery allowed by foreclosures to continue. While it would certainly bring long-term economic benefits, the short-term social, financial, and political consequences of a rapid clearing of the housing mess are too much to bear. As the year goes on, expect presidential candidates and government officials to keep throwing lifelines and buckets full of hope at the housing market.

© 2008