Thursday, August 30, 2007

Propping up the Housing Bubble

Yesterday, I wrote about how one critical element of deflating the housing bubble is letting prices fall back in line with historical norms. After all, if the bubble was caused by people making $X leveraging themselves to the hilt to buy a 10x$X house, then getting rid of the bubble means reducing that 10x multiplier to whatever it's been historically.

Yesterday, Bernake came out with a call for the government to come up with some new financing instrument to let borrowers, leveraged to the hilt, stay leveraged to the hilt. He was talking about option-ARMs, many of which are due to reset to higher rates in the next 18 months, but the details are less important than the underlying financial structure which is that they basically let borrowers take an even more leveraged position on their house. Any substitute to this financing, such as a new option-ARM that will reset further down the road, will essentially maintain that highly leveraged position, presumably in the hope that housing prices will go up.

As I stated earlier, I don't see how we can deflate the bubble in any serious way without actually deflating housing prices, and for houses to sell at a loss you need to have very motivated sellers. An owner-occupier, who has refinanced from their current option-ARM to the new Fed-supported option-ARM is not a motivated seller. He's a motivated non-seller, hoping that prices go up and he can cash out his highly leveraged position. A bank that owns a foreclosed home is a motivated seller. Anything that produces more of the former, and less of the latter, will extend the bubble, not deflate it.


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