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Finding the Bottom in Housing


Free market fixing what government can't.


The Holy Grail de jour of financial market prognostication is predicting the bottom in housing. It's a fool's errand, however. Investing based on a perceived end to declining property values has so far been a losing proposition.

Unlike equities and futures, the housing market has no central clearing house: The Plunge Protection Team's reach doesn't extend to real estate. Try as they may, Beltway bureaucrats can't create a false bottom in home values.

Nevertheless, economists at UCLA are out with a report that uses a single data point as evidence that California's housing market may be recovering. They call a recent upswing in sales in Riverside County (east of Los Angeles) a "very dim flicker of the light at the end of the tunnel."

That a few bargain hunters are testing the waters isn't a sign of stabilization. Witness Billionaire investor Joe Lewis' failed attempt to call a bottom in Bear Stearns. Values can't fall forever, but to say the market will recover "eventually" isn't terribly helpful.

To hazard an educated guess about when home prices will stop falling, it's necessary to understand the mechanics of a real estate transaction and what still needs to happen for property values to put in a meaningful bottom.

Homebuilders like KB Home (KBH) and Toll Brothers (TOL) continue to clamor for handouts from Washington to stem the decline. Rational market players, on the other hand, recognize that until prices return to more traditional levels of affordability, said bottom will continue to be elusive.

Contrary to what's reported in the mainstream press, the fundamental factor putting pressure on home prices isn't the rising tide of foreclosures. The National Association of Realtors and politicians who pander would like us to believe that banks, saddled with impaired assets, are unloading properties at below market value and exacerbating the downward spiral.

Bureaucrats aren't necessarily wrong in trying to prevent repossessions (the impact of a family being forcibly removed from its home is on many levels costly), but targeting foreclosures is characteristic of government policies that address the symptom rather than the cause.

Minyanville's Mr. Practical has long argued the most visible manifestation of the current financial malaise -- illiquidity -- is just a symptom of the true problem: bad debt. Likewise, foreclosures are the most visible part of a phenomenon that's preventing meaningful price discovery in the residential real estate market.

Goldman Sachs estimates that 30% of U.S. homeowners will be upside-down on their mortgages by the end of the year. Also known as being "underwater," being upside-down puts a borrower in the unenviable position of owing more on his home than the home is worth.

For the market to find a sustainable bottom, sellers need to reduce their asking prices to levels average homebuyers can afford. For upside-down homeowners, this isn't an option.

To repay the bank in full, an underwater borrower must put up the difference between the sale price and the outstanding balance on his mortgage. Refinancing would require the same out-of-pocket cash - something most troubled homeowners don't have. Many are choosing to simply walk away, a trend Professor Shedlock has covered in detail.

As a result, properties sit on the market for months, the seller unwilling to budge for the simple reason that he can't. This adds to the latent supply on the market and further depresses prices.

The latest in a wave of housing bailouts now making its way through Congress attempts to address this issue. Meanwhile, the free market, as it's apt to do, is solving the problem itself. Market-based solutions will get the job done regardless of the bickering and posturing that goes on in Washington. Those eager to call a bottom and snap up distressed assets would be wise to exercise patience; these workouts take time.

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No positions in stocks mentioned.

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