By Peter Fugiel, Ph.D.
Something funny happened on the way to bringing the U.S. housing market back: the banking system went haywire. While the country and its policymakers were fixated on finding a solution for the banks, the housing market has quietly been reviving itself. What it will take for the government to assist this housing recovery, without making a major mistake, is the question of the year for housing.

Bringing the real estate market back is not the same as saving the banks.

The U.S. banking system is a complex, multi-regulated, highly centralized industry. On the other hand, the U.S. real estate system is highly decentralized. Trying to fix the banks grew out a single U.S. Treasury “solution,” that concentrated on mostly very large, national banking institutions. But fixing the U.S. housing market is going to require an understanding of the several problems that are ailing different local housing markets.

Three kinds of U.S. housing markets:

In November of 2005, this analyst warned that a handful of U.S. markets seemed to be leaving economic reality. I termed them “Fantasy Island (speculator) markets.” Home market prices in those markets, which included Las Vegas, Miami, and San Diego, had increased 56% in only two years.

The second kind of U.S. market is comprised of regional centers, such as Boston, Chicago, Atlanta, Denver, among others. Prices in those markets had increased 14% between 2003 and 2005. At that time, I said that if prices in those markets went up any higher, they would probably have to be adjusted back to 2005 levels. By now, those markets are adjusting.

The third kind of U.S. market includes large cities that are not regional centers. In the Midwest, these are places like Omaha, Columbus, Milwaukee, and Pittsburgh. Prices for these markets rose only 6% in the same 2003-2005 period.

The big adjustment: Is this the bottom?

Since 2006, most of the very expensive and speculator markets in the U.S. have seen major home price adjustments. The most inflated markets – Las Vegas, California’s inland empire, Miami, Phoenix, and San Diego – have posted, on average, a 38% price decline. Whether each of these markets still has further to fall depends on several factors, including the number of foreclosed and rental properties already clogging those local markets.

Even with big price adjustments in most large U.S. housing markets, there is now tremendous variety among the local markets. San Diego prices have dropped by a third, but that market will remain very expensive, just like New York, Washington, and San Francisco.

On the other hand, many popular regional markets are either at, or below, the national median sale price. These markets include Atlanta, Dallas, Houston, Denver, Charlotte, Tampa, Minneapolis, and Portland. In general, markets that were not that expensive before the 2003-2005 price spiral will remain relatively affordable. Markets that were expensive back then, like Boston and Seattle, will remain very expensive. The only big exceptions are Las Vegas and Phoenix. Both of those markets have seen dramatic adjustments to home prices. Now their prices are much closer to the U.S. median price.

Recent statistics show seven states carry 70 percent of current foreclosures.

The geographic concentration of bad loans and empty properties is remarkable. Seventy percent of all loans currently in foreclosure are located in only seven states: California, Arizona, Nevada, Florida, Illinois, Michigan and Ohio.

It is important to understand why these seven states have the foreclosure problems they have. In fact, there are several reasons. Arizona, Nevada, and Florida are classic speculator markets, with many empty investor units and high rates of bank-owned properties. California has extremely expensive local home markets, where high home costs were financed by an unregulated national securitization industry. California, and markets on both coasts, needs more affordable housing production.

In contrast, Illinois has a high number of defaulted loans which have not resulted in foreclosure. Neither the occupants nor the lenders have very good options in what is still, a very thin buyer’s market. Michigan and Ohio are going through a very bad economic cycle which may result in population losses and abandoned properties. New affordable housing programs, rental preservation if not owner-related, are needed in this kind of mature urban market.

A three-step solution …

  1. The U.S. tax code subsidies housing ownership through the mortgage interest deduction. That subsidy is skewed towards the less than 20% of all taxpayers who claim the deduction. Now that home prices are down everywhere, it might be a good time to review the cost and the effect that this subsidy has had on stimulating high end, vacation, and spec housing prices. The federal government may need to find a way to pay for the production of more affordable housing units, especially in high cost markets. So it may be advisable to redirect the purpose of the mortgage interest deduction. We should perhaps move from stimulating high-end homeownership to stimulating the production of more affordable housing units.
  2. The home lending industry has to be re-regulated according to sane and safe federal lending standards, and implemented by the states. Then there should be less fear of using high leverage to foster homeownership. In the meantime, it is essential that the government put off adding to foreclosure inventories. Instead, there should be a federal re-finance and counseling program that guides every homeowner and tenant currently living in a financially distressed property.
  3. Every dollar spent on stabilizing the foreclosure inventory, likely will be taxpayer funds saved on future bank bailouts and additional foreclosure losses. It is likely that in the next three months, the new government in Washington will be examining policy options that could help stabilize the U.S. housing markets.

Bringing buyers back into the housing market:

It is understandable that the capital markets, especially private lenders, will react to the drop in housing prices. However, now that many U.S. markets have already adjustable to pre-2005 prices, the first government priority has to be to bring buyers back into the markets. The only way to solve the long-term costs of the bank and foreclosure problems is to stimulate the buyer market. There is a backlog of legitimate, first-time buyer demand.

Here are a few short-term ideas that should work in most U.S. markets:

  • Make FHA lending affordable, and buttress the insurance program with substantial buyer incentives to help with closing costs. This can be a short term solution, but it will reduce the cost of the bailouts over the long term.
  • Encourage private lenders and private mortgage insurance companies to lend to creditworthy buyers, regardless of where the home purchase is located. Private lenders who are ’avoiding’ certain markets because home prices are still falling, by now, are contributing to the price decline. With only 50% of all listings resulting in a sale, it is not clear that local markets are fully recovered. Prices have adjusted, but local markets are currently very fragile.
  • Counsel every household affected by the foreclosure crisis. Whatever time it takes to guarantee that households understand their housing options, before they are forced to move, gives local housing markets time to recover.

This analyst has been saying for a number years now that the long-term demand for all kinds of housing in the U.S. is very strong. Demographics, migration, and a backlog of unmet demand are all ready to support a solid recovery in most U.S. housing markets. In the meantime, the damage done by the foreclosure crisis to U.S. households needs to be repaired in a professional, careful manner.

About the Author: Peter Fugiel

Peter Fugiel, Ph.D., is a realtor with Keller Williams & Fox Associates on Chicago’s north side. His housing research web site, Chicago, provides a detailed look at the Chicago real estate market. For more information about specific properties, visit Peter’s Keller Williams real estate site.

Prior to joining Keller Williams, Peter was a vice president and senior housing analyst with Nuveen Investments for many years. At Nuveen, he specialized in housing development financings and mortgage pools in all regions of the country. Peter holds a Ph.D. in public financial management from Northern Illinois University.