My Proposal to Stabilize Home Prices

Stabilizing Home Values

There are a great many ideas floating around about how to stabilize the market price of homes and prevent foreclosures. In this post I will add a new one to the list.

Economics 101 tells us that, in any market, an increase in the supply of a good or service will reduce the price without a proportionate increase in demand. This is the situation in the U.S. housing market. The supply of homes has increased substantially, due in large part to foreclosure sales, while demand has declined. As supply increases, prices decline leading to more foreclosures. More foreclosures increases supply causing more price declines and more foreclosures. And on and on and on. It is a cycle that will continue until the market has purged itself of all or most of the sub-prime-alt-a-low-doc-no-doc-liar loans.

I have a proposal for Mr. Paulson & Co. that could slow, or possibly reverse, the downward spiral.

The concept is quite simple: remove a significant amount of the housing supply by encouraging or mandating banks, or other mortgagees, to stop selling real estate owned (REO) for a certain period of time. In exchange for holding the real estate, the Treasury would purchase a 50% interest in each REO from the banks. The purchase by Treasury would give the banks some liquidity with which to lend. But also, by retaining a material interest in the REO's the banks would have an incentive to maintain the properties and seek top dollar for their sale when it is once again allowed.

The obvious problems with this proposal are:

1. The REO's could depreciate/deteriorate rapidly due to lack of use.
2. Administration of the program would be labor intensive and difficult.
3. The tax payers could lose money on the eventual sale of the REO's.
4. There would be significant cash outflows required of Treasury.
5. More government intervention in private markets might be inappropriate.

I am sure there are many more problems but I am merely trying developing the concept.

With regard to problem number 1, we could have a moratorium on REO sales for a short period of time, 2-3 months. After which only a percentage, say 10%, of the REO's in the program could be for sale at a given point in time. In this way, there would be a continual stream of REO's being sold so that they are not sitting unoccupied for long periods of time. The program would serve to 'bottleneck' the supply of homes.

I'm not sure there are solutions to problems 2 and 3.

Problem 4 could be limited by capping the funding appropriated to the program to $100 billion.

Problem 5 is a matter of personal ideology.

The Benefits

The National Association of Realtors reports that the median home price in the U.S. for the 3rd quarter of 2008 was $200,500. Given $100 billion for the program, if the Treasury paid $100,250 (half of the median home price) on average, for each 50% interest, nearly 1 million homes could be removed from the housing inventory. I couldn't find reliable data on the number of REO's currently for sale but I assume there are less 1 million of them; meaning, a $100 billion program would cover the entire inventory of REO's.

According the the National Association of Realtors, there are currently 4.6 million new and existing homes for sale. My proposal would reduce that number to 3.6 million, a 22% decrease. We can be sure that a 22% reduction in the supply of homes would have a meaningful positive impact on price.

Other indirect benefits might include:

1. Reduction in foreclosures-Homeowners could sell their house before being foreclosed. Prices would be stable (not decline or possibly increase) and the homeowner would not be competing against dozens of REO listings.
2. Realized losses on mortgage-backed securities could be limited, or at least deferred.
3. Prices on mortgage-backed securities could improve, lessening the impact of mark-to-market losses on bank and insurance company balance sheets.

The potential for unintended consequences is huge. One in particular is the reaction of homebuilders to an artificially improved housing market. If prices stabilize (or rise) homebuilders would increase production of new homes. The resulting increase in housing supply could make it difficult to sell REO's as the program progresses. Treasury would need some flexibililty as to when, and in what volume, the REO's could be sold.

From a theoretical perspective my proposal is sound. The problem with theory is that it rarely translates well into reality. I would love to receive your comments.