The Continuing Housing Bust

0:00Music I'm sitting here with Ed French, the president of the Mises Institute, who's been writing about housing and banking for many years. The latest news, Doug, is that housing starts have slid. You're not surprised by this? No, I think that's good news that housing starts have slid and builders probably should stop building for a number of years while the current housing stock is filled up by demand that is very soft at the moment and probably will continue to be soft for a number of years.

0:52So that's actually good news. That opinion doesn't seem to be shared by most editorial writers. Right, there's something about houses and cars that Washington D.C. would like us all to be buying a new house or a different house and buying a new car to stimulate the economy. But the economy should be, you know, people are doing the smart thing and it's best for the economy if people continue to save money, continue to pay down their debt, continue to delay consumption of homes and houses and this is all good news but certainly in Washington they view it differently.

1:39That's good. It may be wise for the individual household, but the conventional wisdom says that maybe what's good for the individual household is not necessarily good for the economy at large. I mean, can we experience recovery so long as housing continues to fall? The conventional view now, as it was in the New Deal, is that we can't. Right, but this is just what the Austrians would say is a kind of a cleansing of the malinvestments of the last decade or two decades in the United States, and so all the people that have been involved in housing, whether they be construction workers or whether they be real estate agents or work for title companies or work for banks, those people need to be They were in boom time industries and their skills are needed in other parts of the economy.

2:39So propping up old industry, propping up what were boom time phenomena is not going to make the economy any better. He's going to continue this for years and years and years. Do you see this as the beginning of a continuing downtrend or is this the tail end of a fall That was only interrupted by the stimulus package and the low interest rates and all the rest of this. Yeah, I think it's probably more of the latter. I think we'll continue to fall. And with the occasional Washington paddles being applied to the dead patient, which lifts the shock, lifts the dead patient off the table briefly, a few more cars are sold or a few more houses are sold.

3:29But prices need to adjust, the price of cars, the price of houses, so that people can afford them. And this is a process that's being delayed by Washington. And instead of re-inflating the bubble, they're just going to pump a little bit of air into it. But those bubbles and those type of assets needs to deflate further. and the commercial real estate unwinding has just begun and that will just add to this. Okay, it raises a number of things. I'm trying to sort through what's the best question to ask.

4:17Let me just draw attention to this new phenomenon that you've been talking about recently where The number of people just walking away from their homes seems to be rising. There seems to be a debate even about the ethics of this after all in the contract that says look if I don't pay my mortgage you can take my home so the people are walking away from it so maybe it's not such a terrible thing except from the point of view of bankers. Could you explain a little bit about the economic decision to walk away from your home? seems in a way perverse.

5:21is higher and the interest rate may or may not be higher but you're now amortizing more debt than you originally had so your payment is significantly larger, maybe your income is the same but you still have a job and you can't make that payment, that's one phenomenon, but the other one that we're really talking about here are people who still have a job and can make the payment But the asset that is securing that loan has fallen tremendously to the point where they have no equity in the asset. They may own 300,000 and the asset's worth, the house in this case, 150,000 or 200,000.

6:15So what's the sense in continuing to make this payment when they have the opportunity

6:51making various cases here that gee you know the mortgage lender knew going in that they were making a loan you were making a payment based on economic conditions and if it wasn't going to work out you were going to walk away I'm not sure that's I'm not sure that was the understanding going in I think laws are different in various states I think loans are going to be different some are or non-recourse where, okay, if you walk away, then you hand over the keys and you're done. But in a number of instances, then lenders are going to go after borrowers for the deficiency. And so it's going to vary.

7:37I wouldn't even pretend to give anybody any advice because, you know, it's going to vary I think it's going to vary what your situation is and what the laws are in your state, and it's going to vary depending on the language of your mortgage or the note secured by a trustee, depending on what kind of state you're in, but a number of people are doing this, and I think it just puts further pressure downward on housing prices. It's a little bit of a mystery from an economic standpoint, because you say a house that's $300,000 is now worth $150,000 or whatever. How can we really say it's worth anything until it's on the market? It's just an impression that person has, right? That, gee, you know, they're looking around, noticing that there's better deals out there, even though they're getting exactly what they're paying for.

8:25Namely, they're living in a house and making the same payment they did before, but then suddenly they feel sort of ripped off in some way, And dumping more money into this house is not a good way to save money, it's not a good investment. Right, it doesn't make any economic sense, it doesn't make any rational sense to them to make a payment towards something that they're never really going to own. Yeah. They're just dumping money into a black hole that they're making interest payments towards something that they're never going to realize the value from. So people are walking away and interestingly people are keeping credit cards current and keeping them paid down and possibly paying down on their credit cards so that they have the availability of Future Credit, rather than pay toward their mortgage. It used to be exactly the opposite.

9:20People would walk away from high interest and high credit card balances and make sure that their mortgage payment was made because that was the biggest part of your credit report and that has completely been turned on its head and it's very interesting. Over time, Scores, trying to find the right word, but say a 700 beacon score a few years ago is not what a 700 beacon score is now. In other words, you've heard of grade inflation, well we've had credit score inflation. The 700 borrower now is not as good as the 700 borrower was a few years ago and the 700 Score Borrower a few years ago wasn't as good as the 700 credit score borrower a few years before that.

10:13At one point, I had heard a short sale would take 100 points off of your credit score and now I hear that's down to maybe 60 or 80. So I think the scoring services are starting to see more and more of people negotiating Short Sales with their lenders, and I think over time doing a strategic default, if you will, will probably not cost you as much on your credit score going forward as maybe it would have in the past. So people will, even if they're going to weigh that in terms of, gee, if I can save 500 a How much bad debt is being hidden in the banks?

11:19You know, I don't know for sure, certainly in any individual case. My guess is that I think that assets have fallen in value on bank balance sheets in terms of collateral for loans much more than maybe the banks are recognizing. and you know there's a lag time in the appraisal process anyway and as especially these commercial loans secured by commercial real estate have not they don't truly reflect what those assets are valued, vacancy rates are way up, rents are down, and capitalization rates are much higher than they were a few years ago when many of these loans were underwritten.

12:20Capitalization rate, by the way, is essentially the inverse of a price-earnings ratio. If you had a 5% capitalization rate, that would equal essentially 20% P-E ratio in stock terms. And so the lower a cap rate is, the higher the value is. And as cap rates go up, then values come down. So there are plenty of commercial real estate loans underwritten at 6%, 7%, 8% cap rates. Well, those cap rates today are 9, 10, 11 percent and so that means that commercial values, values on commercial real estate have fallen 25, 30, 40 percent and if those loans were written at 70 percent, 75 percent loan to value, they are now under water and I think a lot of banks have that kind of collateral securing their loans and they are agitating with regulators that if the payments are current you know please let us keep them on their books at the full loan value I think in some cases regulators are allowing that but over time as commercial borrowers

13:38throw in the towel you know those values will will eventually creep creep into Charge-offs, write-offs and that'll affect bank capital and as that capital erodes and then banks go out of business so and we're just going to see more and more of that as the years go or as the year goes on and as the years go on commercial real estate is heavily dependent on unemployment rates being being low, future development happening, the housing, a robust housing market drove commercial real estate in that, houses would lead to commercial projects being built, so if you had a subdivision of houses, then the commercial developer would say, gee, look at all those houses being built, we need to build commercial property to support that, office projects Architects are heavily dependent on real estate types of tenants in some markets, whether they be architects, appraisers, title companies, whatever they may be.

14:54Many office users are dependent on what was essentially a malinvestment during the boom. It's an interesting point to draw your attention to the integration between these two sectors. Some critics have argued against the claim that this is essentially a housing bubble blown up by these government-backed mortgage companies plus the regulatory interventions like Community Green Investment Act and all the rest of it by pointing to the existence of the commercial real estate bubble too and saying, like Paul Krugman said this, he said, look, the conservatives The Austrian position agrees that it was a generalized bubble, but for different reasons than maybe Krugman would say.

15:47Right. They are integrated, as you say. and so you didn't have a housing bubble in off all by itself without the commercial development following that and I would even say that people being able to borrow against inflated home values not only created a larger money supply growth through commercial banking being able to lend people of Second Trust Deeds on their homes, and thus we had huge money supply growth during this period. But it also spawned tremendous consumer businesses, whether it be casinos in Las Vegas or vacation properties in Florida or whatever it may be, people had this false sense of being rich because their homes had this value that they thought they could borrow against forever.

16:55So we've had a number of businesses develop that is wholly dependent on that and those businesses are beginning to unwind. It must at some level really shock the American psyche because the conventional wisdom for a half a century or more has been that the best way to save money is to dump it into your home. Well that's exactly right. The, you know, homes would do nothing but go up in value. The conventional wisdom was to buy the most house that you could possibly afford because it would go, you would essentially be leveraging the upside of housing to greater wealth. Most people make the The assumption that the largest asset that any one person has is their home.

17:49And that is right and the way it should be. There were plenty of schemes going around and plenty of money advisors telling people not to pay down their mortgage, that they should make the minimum mortgage payment and put the rest into the stock market. That was advice that was very prominent and people took that to heart and of course now the value of their home has gone down. They haven't paid it down much and so now they're underwater and more than likely they invested in a bunch of stocks that were cut in half during the 08 financial meltdown, 08-09 financial meltdown.

18:38You know, all of these things, this whole bubble economy is not just houses, not just commercial real estate, but it's stocks and even lifestyle in general is thrown into this. We've been hearing about the recovery now for a very long time, really probably two years, right? about how the economy is recovering, but there are very few indicators out there that you can point to that show any good trends. Right, I haven't seen any, and of course the government's numbers are suspect anyway, but you know, unemployment is still very high, and if you look at the the broadest measures of it say the u6 that takes into some discouraged workers not all the scourge workers but at least some of them were you know 16 70 17 percent unemployed and so we're approaching a point where one in you know one in every five people is unemployed and and if you We throw long-term discouraged workers in there. It's even higher than that in the cities.

19:58If you just count cities, urban areas, it's even higher. Not to mention young people typically are unemployed and minorities. In some sectors, the economy is very bad and we continue to to see more and more filing of bankruptcy, more and more defaults being filed, both on the commercial side and on residential, so I don't see any evidence as much as some commentators would like to point to. Green shoots, if you will, I just don't think they're out there. What about the magic bullet of low interest rates? You know, people hear bad news and The very first response from the planning elite is, well, there you go, we've got to push interest rates, so we've got to hold them down to zero for a longer period of time.

20:57Well, Japan's essentially had their interest rates at zero for 17 years now, and it's done nothing for that economy, in fact, their GDP, even at very low levels, has fallen off a cliff in the last two years. and I fear the same thing is happening here, that we're going to keep rates at zero, but we have a banking system that is still trying to heal itself. And what's the incentive for bankers to go out and make loans at 3 or 4% when they know that higher rates are possibly coming or that the economy is bad and the potential for charge and a large officer high. So, you know, we should have higher interest rates to entice lenders into making loans, not force interest rates down, that takes away that incentive.

22:00So it works exactly the opposite of what policy thinkers think it might. This is, to me, a brilliant insight and one that I reflect on all the time and as much as I'm willing to believe that government bureaucrats and central bankers are stupid, it still strikes me as really an incredible thing that people miss this obvious point that the lower the interest rates, the less incentive there is for lending. Well, they get trapped in this Keynesian point of view that they get caught in their own liquidity traps, so to speak, and essentially the government and Keynesian policy cannot pull an economy out of something like this.

22:59As Murray Rothbard pointed out in America's Great Depression is that the government needs to lessen its impact on an economy and that will lead to the pay down of debt and capital accumulation and as long as the government stays involved that will do just the opposite and just prolong the agony. So the French plan is massive cuts in government spending, higher interest rates, any other I don't anticipate this being enacted overnight, but you've got state and local governments that are extremely bloated, and you've got retired workers that are earning every bit as much as they made when they were on the job.

23:54So instead of local municipalities paying for one fireman on the job to put out a fire or tape up the kid's ankle that he sprains at a baseball game, you actually have to pay for him and the retiree or maybe two retirees that are in the system. And eventually this math won't work either and that's what local governments are struggling with these kinds of obligations that essentially put Detroit under and so you've got this massive battle going on with these legal obligations that politicians have made for the taxpayer and eventually it's all going to fall apart but these things would take time but it would It would certainly help that if government would back its way out of at least trying to stimulate real estate and stimulate big purchases like cars and let those markets correct themselves, that would certainly be good for the economy.

25:04Well the PPI figures just came out and there's other factors related to inflation that we should talk about some other time but I know I interrupted you today right in the middle of very busy work running the Mises Institute so I'll let you go and thank you very much. Well thank you.