ForeclosureRadar.com released its June 2009 CA Foreclosure Report today. While foreclosures were generally trending upward, Notices of Trustee Sale unexpectedly dropped, apparently due to the new California Prevention Act that went into effect June 16th. Despite the majority of major lenders in the state receiving an exemption from the act, filings dropped by nearly 50 percent as soon as the act went into effect. Filings were climbing back toward previous levels by the end of June so we still expect the law to have little long term impact.

Resources:

Complete text of California Foreclosure Prevention Act

List of exempt lenders under the CA Foreclosure Prevention Act

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Lots of calls today from folks wanting the scoop on the “new moratorium” here in California. Seems that some have misinterpreted the new law and believe that it may have a big impact.

The new law adds 90 days to the existing 3 months between the filing of a notice of default and a notice of trustee sale, but exempts servicers (lenders) who put in place a loan modification program.

Overall the law makes little sense to me. Why our legislators are pushing lenders so hard to lockvhomeowners in a prison of debt and delay the inevitable is beyond me,
but much like SB1137 last year, they are once again back at it with
another attempt to force loan mods that I believe will again fail to make any real difference.

We expect most lenders have at least applied for an exemption from this law by submitting their loan mod program. As such we expect no immediate change in foreclosure activity. Even if the state gets tough and denies the servicers application for the exemption, those servicers have a chance to resubmit, and the mortatorium still won’t apply to them for 30 days after the denial.

The moratorium also applies only to owner occupied ifrst mortgages made between 2003 and 2007, though that is the majority of foreclosures we see today.

Bottom line – if we see any impact at all it likely won’t be until August or September. But these payment based loan mods are largely better for servicers than homeowners, so I can’t imagine that servicers won’t at least put a program in place. We will of course keep an eye on it.

For the complete details see the bill itself: http://leginfo.ca.gov/pub/09-10/bill/asm/ab_0001-0050/abx2_7_bill_20090220_chaptered.pdf

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According to the latest report from the Mortgage Bankers Association a stunning 12 percent of homeowners with a mortgage are now at least one payment behind. Given the nationwide estimate that 25 percent of homeowners with a mortgage are now underwater this really shouldn’t come as a huge surprise – but it is a stunning number in historical terms in any case.

What is actually MOST surprising to me is that anyone still thinks we have a “foreclosure problem” at all. Or that lenders are “aggressively foreclosing”. Shoot, let’s be realistic, we have almost no foreclosures in comparison to the number of folks that are not making their payment, and even fewer in comparison to the number of folks that are now seriously upside down in their home and essentially stuck in a prison of debt.

So the next time you see a reporter talking about the “foreclosure problem”, or are at the other end of an ACORN bullhorn, let them know that we actually have an unbelievably low number of foreclosures given how many homeowners are upside down and not making their payments. And then politely suggest they are focused on the wrong problem and have completely missed the bigger picture – $4 Trillion in excess mortgage debt.

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Last of a nine-part series.

I appreciate your giving me a bit of your time to read my views on the current economic crisis and how I think we should fix it. While my views are my own, I should say that I’ve had some wonderful influences, not least of which has been my friend Eric Janszen, founder of iTulip.com. His near-perfect foresight on much of what we have seen unfold has helped me not only understand the bigger picture surrounding this crisis, but also stay a step ahead financially. Without his guidance, I would not have had the wherewithal to self-fund ForeclosureRadar.com. I’ve also been fortunate to talk to many leading economists, fund managers and other insiders, thanks to our having truly great and sought-after data on the foreclosure market.

Despite the pain this crisis has afflicted on a great many people and my gloomy overall assessment on where we are in this crisis and what it will take to recover, I remain very bullish on the U.S. and hard-hit California in particular. Despite its flaws, I love where I live. As a businessperson, investor and citizen, I see the forest of opportunity beyond the trees.

As home prices continue to descend back to affordable and sustainable levels with a dash of spring in the air, its hard to dwell on the negatives too long without doing what we American’s do best – dust off the doom and gloom, look at the bright side and get back in the saddle.

Hopefully, we’ll soon find the leadership to put this failure behind us and ultimately realize what a beautiful gift we’ve been given, a chance to see that the course we were on wasn’t sustainable. It’s time to begin living within our means, individually, in business and at all levels of government. It’s time to re-evaluate our priorities and realize that a better life cannot be financed – it just has to be lived.

Thanks again for your time and support.

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Thanks to U.S. Senate Bill 896, the “Helping Families Save Their Homes Act of 2009“, as amended with Senate Amendment 1036, the “Protecting Tenants at Foreclosure Act of 2009“, tenants are now entitled to stay through the end of their lease, and receive 90 days notice prior to eviction after a foreclosure through out the country. In California this supercedes the 60 days that went into affect with CA Senate Bill 1137 last year.

For those of you buying at the auction it is more important then ever to verify occupancy if at all possible prior to making your purchase unless you are prepared to be stuck with a rental for an extended period. Depending on your MLS you may be able to lookup the rental (if it was listed by a Realtor) to find out if is was advertised as a lease or month-to-month rental. If you do happen to buy one with an extended lease don’t forget that you can still try to negotiate cash-4-keys, and in the worst case you are at least entitled to the rent.

The text of the amendment can be found below, as well as the links above:

SA 1036. Mr. KERRY (for himself, Mrs. Gillibrand, Mr. Reid, Mr. Dodd, and Mr. Kennedy) submitted an amendment intended to be proposed to amendment SA 1018 submitted by Mr. Dodd (for himself and Mr. Shelby)
to the bill S. 896, to prevent mortgage foreclosures and enhance
mortgage credit availability; which was ordered to lie on the table; as
follows:

At the end of the amendment, add the following:

TITLE V–PROTECTING TENANTS AT FORECLOSURE ACT

SEC. 501. SHORT TITLE.

This title may be cited as the “Protecting Tenants at Foreclosure Act of 2009”.

SEC. 502. EFFECT OF FORECLOSURE ON PREEXISTING TENANCY.

(a) In General.–In
the case of any foreclosure on a federally-related mortgage loan or on
any dwelling or residential real property after the date of enactment
of this title, any immediate successor in interest in such property
pursuant to the foreclosure pursuant to the foreclosure shall assume
such interest subject to–

(1) the provision, by such
successor in interest of a notice to vacate to any bona fide tenant at
least 90 days before the effective date of such notice; and

(2) the rights of any bona fide tenant, as of the date of such notice of foreclosure–
(A) under any bona fide lease entered into before the notice of
foreclosure to occupy the premises until the end of the remaining term
of the lease, except that a successor in interest may terminate a lease
effective on the date of sale of the unit to a purchaser who will
occupy the unit as a primary residence, subject to the receipt by the
tenant of the 90 day notice under paragraph (1); or

(B)
without a lease or with a lease terminable at will under State law,
subject to the receipt by the tenant of the 90 day notice under
subsection (1), except that nothing under this section shall affect the
requirements for termination of any Federal- or State-subsidized
tenancy or of any State or local law that provides longer time periods
or other additional protections for tenants.

(b) Bona Fide Lease or Tenancy.–For purposes of this section, a lease or tenancy shall be considered bona fide only if–

(1) the mortgagor under the contract is not the tenant;

(2) the lease or tenancy was the result of an arms-length transaction; or

(3) the lease or tenancy requires the receipt of rent that is not substantially less than fair market rent for the property.

(c) Definition.–For
purposes of this section, the term “federally-related mortgage loan”
has the same meaning as in section 3 of the Real Estate Settlement
Procedures Act of 1974 (12 U.S.C. 2602).

SEC. 503. EFFECT OF FORECLOSURE ON SECTION 8 TENANCIES.

Section 8(o)(7) of the United States Housing Act of 1937 (42 U.S.C. 1437f(o)(7)) is amended–
(1) by inserting before the semi-colon in subparagraph (C) the
following: “and in the case of an owner who is an immediate successor
in interest pursuant to foreclosure–

“(i) during the initial term of the lease vacating the property prior to sale shall not constitute other good cause; and
“(ii) in subsequent lease terms, vacating the property prior to sale
may constitute good cause if the property is unmarketable while
occupied, or if such owner will occupy the unit as a primary
residence”; and

(2) by inserting at the end of subparagraph
(F) the following: “In the case of any foreclosure on any
federally-related mortgage loan (as that term is defined in section 3
of the Real Estate Settlement Procedures Act of 1974 (12 U.S.C. 2602))
or on any residential real property in which a recipient of assistance
under this subsection resides, the immediate successor in interest in
such property pursuant to the foreclosure shall assume such interest
subject to the lease between the prior owner and the tenant and to the
housing assistance payments contract between the prior owner and the
public housing agency for the occupied unit, except that this provision
and the provisions related to foreclosure in subparagraph (C) shall not
shall not affect any State or local law that provides longer time
periods or other additional protections for tenants.”.

SEC. 504. SUNSET.
This title, and any amendments made by this title are repealed, and the
requirements under this title shall terminate, on December 31, 2012.

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Part eight of a nine-part series.

The housing bubble has caused enormous problems in the U.S. economy. To make sure this crisis doesn’t recur, we should:

• Require income-based appraisals for lending purposes. Home prices should be able to rise as high as buyers are willing to bid, but loans based on federally insured deposits or reserves should be limited to amounts that are reasonably supported by local-area incomes. Private lenders should be allowed to lend as far beyond that as they desire, but only with limited recourse against the borrower and without taxpayer support for losses since such support creates a clear incentive to lend incautiously.
• Avoid government actions that support artificially low interest rates. Recessions are okay; they clean out the dead wood and keep everyone honest. Interest rate stability should be a higher priority then non-stop increases in the U.S. gross domestic product (GDP) so individuals–especially retirees–and companies can earn reasonable returns on their investments. This fix is more important than ever since a massive wave of Baby Boomers is about to retire.
• Shine the light of day on credit default swaps. Create a market so these instruments can be valued. Require those valuations to be disclosed so investors can evaluate the risk of investing in companies like AIG. Then let those investors bear that risk alone without taxpayers’ backing.
• Bring back key regulations that were lost in the last decade. It may not make sense to completely repeal the Commodity Futures Modernization Act, Financial Services Modernization Act and Taxpayer’s Relief Act, but clearly these acts went too far. Certainly, there are ways to allow the creation of innovative new financial products without placing the full risk of those innovations on the backs of depositors’ and taxpayers’.
• Limit new housing permits to a rate that’s supported by reasonable projections of population growth. Counties also should require that the size and anticipated cost of approved new housing generally match local-area incomes. One way to achieve that objective would be to limit the supply of new housing separately for each income quartile.
• Make sure no financial institution is ever “too big too fail.” Risk of failure ultimately makes companies stronger and none should be above it, especially at the expense of taxpayers, who were largely left out of the gains. Though I believe it is unavoidable this time, we should work to never again privatize profits and socialize losses.

Next: Wrapping it up

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Part seven of a nine-part series

After significant internal debate, I’ve concluded that repudiation of excess mortgage debt is the only workable solution to the current crisis. I don’t suggest this solution lightly as it has not only national, but also geopolitical implications since foreign central banks hold so much U.S. debt. While some people believe debt repudiation would lead to a complete lack of confidence in U.S. obligations and, in turn, lead to a total financial collapse, I believe the opposite is true. Our failure to mark the value of investments to current market prices and take necessary losses only increases the fear of investing in these instruments. Our refusal to see the plain simple truth that we cannot repay these obligations has frozen our credit markets and, as counter-intuitive as it first seems, debt repudiation is likely the only way to restore lender confidence and get credit flowing again.

Repudiating debt won’t mean the end of lending due to a loss of investor confidence if the debt repudiation acknowledges the mistakes that were made, shares the pain among all involved to minimize the moral hazard and is accompanied by a clear plan to prevent those mistakes from being repeated. If debt levels are restored to sustainable levels and protections for investors are put back in place, then credit markets will return as investors compete for safe debt investments. By taking a proactive approach, we’d be far more likely to minimize losses then we would be if we continued to deal with the problem on a reactive basis. That’s especially true since those reactions, like foreclosure moratoria, only delay the inevitable.

Unfortunately, we currently lack the political will to take this step. It would take incredible leadership to convince not only Americans, but also the rest of the world that debt repudiation was not only necessary, but also in everyone’s best interest. Homeowners who have negative equity would get a second chance. Homeowners who have equity would gain stability in their home’s value. Creditors would gain by seeing losses minimized, risk reduced, and new opportunities to invest. Governments would gain by stabilizing tax revenue. And everyone would gain as the economy would regain health and again be capable of growth.

If we found the political will, I think it would be important to share the pain. Taxpayers should bear a portion of the losses because they allowed their elected representatives to enable this crisis through the Taxpayer Relief Act of 1997, the Financial Services Modernization Act and the Commodities Futures Modification Act. Loan originators and investors, including foreign central banks, should bear a portion of the losses because they made obviously bad loans, despite whatever assurances they may have received from ratings agencies or the U.S. government. All borrowers who were a part of these transactions should proactively help to resolve the issue, rather than walk away from their obligations, and those who used their house as an ATM should be held to a higher standard of accountability.

To that end, a carrot-and-stick approach for both lenders and borrowers should be brought to bear:

Lenders

Carrots:

• The federal government should offset a percentage of investors’ losses to encourage them to proactively reduce loan balances for borrowers who qualify for a loan modification and allow short sales for those who don’t. The offset should vary depending on the loan position and tranche in accordance with the level of risk for which the lender signed up. AAA-rated first mortgages should have as much as 70 percent of the loss protected while second mortgages likely should have only 10 percent of the loss protected. On a blended average, taxpayers should be on the hook for less than was spent on bank bailouts while this time addressing the real problem.
• Even without government credit, lenders would see higher returns on loan modifications and short sales since they can return 90 percent of current market value compared with 65 percent or less (after expenses) from a distressed home sale.
• Lenders should be allowed to foreclose without delays or moratoria on loans of borrowers who choose not to participate in a short sale or loan modification.

Sticks:

• Lenders should be required to review and either accept or reject short sale offers within 15 days and loan modifications within 30 days of receiving a complete application. If they fail to do so, they should be ineligible for any government relief.
• Bankruptcy cramdowns should be available to bankruptcy judges if and only if the homeowner has first fully cooperated with the lender to try to resolve the problem though a loan modification and short sale.

Borrowers

Carrots:

• Borrowers who qualify should receive a reduction in debt to 90 percent of the current value of their home. This carrot would essentially bring homeowner to the break-even point and allow them to reset and move forward. To qualify, the homeowner must be able to afford to repay the resulting principal balance with a 30-year fixed-rate loan at a market interest rate.
• Borrowers who don’t qualify for a loan modification, but cooperate in a short sale should have their exposure to deficiency judgment under state tax law limited to $10,000 and the impact to their credit limited to two years.

Sticks:

• Borrowers who refinanced and pulled out cash should have to carry a personal note to repay taxpayers for the portion of the loss born by the government. That debt shouldn’t be dischargeable in bankruptcy, except in cases of significant hardship.
• Borrowers who won’t cooperate with a loan modification or short sale and thus force the lender to foreclose should owe income taxes on the amount of debt forgiven and remain liable for any deficiency judgment that may be allowed under state law. Any taxes received should be used to help defray taxpayers’ losses under the program.

This approach is admittedly a rough sketch and many variations on this theme likely would work. The key is to elimintate the excess debt without creating moral hazard. Programs shouldn’t provide incentives to make the wrong choices–and the only right choice is to return to sustainable levels of debt in as orderly a fashion as possible.

Next: How to prevent another housing bubble

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Part six of a nine-part series.

Many people insist that taxpayers shouldn’t “bailout” deadbeat homeowners. But the typical argument–that homeowners created the current situation and should take personal responsibility for their own problems–is wrong.

During the housing boom, homeowners, by and large, did what they’ve always done. They spent as much money as they thought they could afford to buy a house. And most of them did that with significant encouragement from President Clinton, President Bush and Alan Greenspan, who went as far as to suggest homeowners should use adjustable-rate mortgages to save tens of thousands of dollars.

At the same time, industry associations spent millions to perpetuate the idea that there was no housing bubble and house prices would only continue to rise.

It should be obvious that banks shouldn’t lend money beyond the borrower’s ability to repay it. That’s why longstanding usury and other predatory lending laws are on the books. The world’s leading economists in financial firms and government should have figured out that lending at levels twice what was supportable by local-area incomes was unsustainable. And they alone should take the blame for their failure to see what was obvious.

To say, in hindsight, that homeowners should have known better is blatantly ridiculous. And the idea that the firms that made these errors, whether they did so through greed or genuine ineptitude, should receive taxpayer-financed bailouts while homeowners are forced to pay for these lenders’ mistakes or face foreclosure will be looked back upon as one of the greatest injustices of our generation.

Taxpayers who saved, lived within their means and didn’t make mistakes have every right to be angry. But its time for them to realize they share the blame, as they are equally responsible for electing the politicians who repealed the protections that would have prevented this crisis.

Now that isn’t to say I think every homebuyer or borrower that got in over their heads deserves a free pass and taxpayer bailout. Quite the contrary. But it is high time we recognize that they were given the rope, and cheered on the whole way, towards hanging themselves.

Next: How to wipe out $4 Trillion in excess mortgage debt

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Part five of a nine-part series.

Now that we’ve identified negative equity and the unprecedented burden of household debt as core issues in today’s housing crisis, the next logical question has to be how we can resolve these issues. Below I’ll explore the solutions that have come to my attention and in the next post, I’ll provide my take on what we should do.

Solution: Get credit flowing again
Washington seems to be infatuated with the need to get credit flowing again. Having the credit markets freeze up in August of 2007 clearly caused considerable distress throughout the economy. But let’s not lose sight of the reason why the credit markets froze: The realization that lenders had issued more credit than borrowers had the ability to repay. So while we certainly need functioning credit markets, let’s be clear that more credit won’t solve the fundamental problem, which is that homeowners, corporations and governments are over-indebted.

Solution: Government job creation and other economic stimulus
The notion that we can spend our way out of debt is an idea only a politician could love. The willingness to trade tomorrow for today is the primary reason why we are facing trillions of dollars of negative homeowner equity, ballooning corporate liabilities and staggering government debt. By “trade tomorrow for today,” I mean we too often take on debt that has to be repaid in the future and with interest, so we can live a little better today. Even if we used government stimulus to create jobs, that would help only to stabilize the economy, not bring back the peak home prices reached in 2006 or eliminate the negative equity that will continue to hinder sustainable growth.

Solution: Lower interest rates
The Federal Reserve has quite effectively used monetary policy to lower interest rates, which has helped to spur housing demand. Unfortunately, even with rates in the high 4-percent range, the current loan programs can’t come close to restoring the purchasing power that was offered by stated-income, zero-downpayment payment-option adjustable-rate mortgages (ARMs) with low initial teaser rates. It would take 30-year fixed rates of around 1.5 percent to bring back home prices that were reached at the peak of the housing market.

And why not lower interest rates to 1.5 percent? After all, we’ve made billions of dollars available to banks for less return and depositors can’t earn that much on bank accounts right now. But there are big problems with this approach: First, lower interest rates would mean higher home prices, and higher home prices would mean higher property taxes. Given that the loan payment would be the same either way, I’d rather pay a higher interest rate and lower property taxes because that way my total housing expense would be lower. Second, it’s nearly impossible for people who live on a fixed income to survive when interest rates are as low as they already are. As huge numbers of Baby Boomers retire, low interest rate could become very costly because if those new retirees can’t earn decent returns on their retirement savings, the burden of supporting them will shift to taxpayers. Third, if interest rates were later forced back up, home prices would fall accordingly and that would put us right back in the same situation we face today.

Solution: Payment-focused loan modifications
Loan modifications currently are the hands-down political-favorite solution at both the state and federal levels. But the primary problem with this solution is that nearly all of the loan modification programs to-date have focused on modifying the borrower’s payments to affordable levels, rather than reducing the borrower’s principal balance to eliminate his or her negative equity. The most stunning feature of these payment-based loan modifications is that they typically look like the worst-of-the-worst toxic loans in the sense that they feature ridiculously low payments upfront and interest rates that are adjusted to unaffordable levels in as few as five years. The notion that home prices and incomes will double in the next five years is ludicrous. But that is exactly what would be needed for most loan modifications to not end up back in foreclosure when the payments creep back up after five years. Until then, the homeowner is stuck in a prison of debt and unable to refinance the mortgage or sell the home. Moreover, many of these borrowers are likely to face foreclosure due to a job loss, transfer, illness, divorce or other life event.

Solution: Refinancing
Many people have suggested that we should simply refinance homeowners’ toxic loans into traditional 30-year fixed-rate mortgages. The problem with this solution is that it doesn’t deal with the reality that many of these borrowers are struggling to make the teaser-rate payments on a payment-option adjustable-rate mortgage so they certainly wouldn’t be able to make the much higher payments on a 30-year fixed-rate mortgage. For refinancing to have even a small chance of success on a wide scale, interest rates would need to be in the 1-to-2 percent range and that would create its own set of problems.

Solution: Foreclosure moratoria
We’ve heard calls for foreclosure moratoria from all sides, including even the chairman of the U.S. Senate Financial Services Committee Barney Frank. Some people suggest that home prices will bounce back as fewer foreclosures come on the market and that that will eliminate the negative-equity problem. However, this thinking fails to recognize that buyers simply can’t afford to buy homes at the prices reached in 2006, unless lenders bring back the toxic loans that created this mess in the first place. Foreclosure moratoria can result in just one outcome: a temporary delay in the inevitable clearing of negative equity through foreclosure. That would ensure that the core problem would stay with us even longer.

Solution: Principal-balance loan modifications
Principal-balance loan modifications directly address the problem because they eliminate negative equity while allowing homeowners to stay in their home and return to normal consumption patterns. The problem is that these modifications will never happen if the choice is left to the banks alone. Banks actually might benefit if they reduced loan balances rather than foreclose because many homeowners would continue to make payments if their loan balance was marked down to the current value of their home or perhaps 90 percent of that value. Foreclosure, on the other hand, is likely to return only 60-to-70 percent of the home’s current value after expenses. But while principal-balance loan modifications might sound like a smart approach for the banks, keep in mind that 20 percent of U.S. homeowners who have a mortgage are underwater while only about 8 percent of those who have a mortgage aren’t making their payments. The last thing banks want to do is to offer borrowers principal-balance loan modifications because that would entice the 12 percent who are still making payments to come looking for such discounts too.

Solution: Bankruptcy cramdowns
We have seen multiple attempts to modify bankruptcy law to allow bankruptcy judges to modify mortgages. Given that bankruptcy judges can modify just about any other type of debt, it has always struck me as odd that this rule exists. Given that a bankruptcy judge can wipe out a corporation’s responsibility to pay on it’s promises, it seems only reasonable that these judges also should be able to wipe out a little negative equity on behalf of individuals. That said, I’m not a huge fan of seeing $4 trillion in negative equity eliminated through the bankruptcy court. Having purchased property out of bankruptcy myself, I simply can’t imagine bankruptcy cramdowns as an effective solution to deal with a problem of this size.

Solution: Short sales
Like principal-balance loan modifications, short sales get to the heart of the problem by directly eliminating negative equity. The primary difference between this solution and several others is that with the short sale, the homeowner loses the home and won’t be able to buy another one for two years under Fannie Mae’s and Freddie Mac’s current guidelines. Lenders have been downright awful about short sales to date, even though they’re likely to recover more principal this way than if they foreclose on the loan.

Solution: Foreclosures
Foreclosures directly address the problem of negative equity as well, and they don’t create any “moral hazard” since they are equally brutal to all involved. The homeowners’ credit is ruined, they can’t buy another home for at least 5 years and, in some cases, they remain liable for deficiencies. Lenders suffer higher costs and losses through foreclosure than through such other loss-mitigation methods as loan modifications and short sales. So while foreclosures certainly help to eliminate the core problem of negative equity, there are certainly less painful alternatives for all involved.

Solution: Home buyer incentives
Many people who take the simplistic view that real estate prices are a simple matter of supply and demand suggest that we can bring back higher prices by giving buyers incentives to increase demand. This view fails to take into account the distinction between what we want and what we can afford. Home prices have corrected by more than 50 percent in California not because people don’t want to own homes, but because they can’t afford them. The currently offered $8,000 tax credit doesn’t change that fact. That said, I suggested a more radical way to create demand in October 2007, when I proposed that we should grant U.S. citizenship to foreigners who bought a home and made the payments for at least five years. An article in The Wall Street Journal made a similar suggestion just last month. In the end these demand creation concepts simply can’t overcome the general inability of the population to afford the prices reached at the peak – at least not without the help of toxic loans.

Solution: Debt jubilee
The concept of widespread debt forgiveness dates back to Biblical times and certainly would work to directly address the issue of negative equity by simply eliminating it across the board. The mechanics of how this massive debt relief would work are staggering, and it is nearly certain that lenders couldn’t bear the losses that would result alone.

Solution: Inflation
While inflation is rarely talked about as a “solution” to the negative equity problem, it certainly could be used to reduce debt. As prices and ultimately wages rise, debt becomes smaller as a percentage of income. And since home prices are a function of income, levels of inflation that are sufficient to increase income would certainly have a positive impact on prices. Still, having sufficient inflation to return prices to peak levels would be extremely painful as wages always inflate last. Plus, inflation would quickly result in higher interest rates and since home prices are also a function of loan terms, higher rates would push prices lower and that would offset the gains from higher wages in the near term.

Next: Perhaps my most controversial post of the series… Why homeowners deserve a bailout

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Part four of a nine-part series.

So far, we’ve looked at the factors that created the credit and housing bubbles and the beginning of their demise. As prices leveled off in 2007, speculators and borrowers who had subprime loans realized further appreciation was unlikely, so they simply stopped making payments and foreclosures rose. The possibility of this outcome appears to have been completely unforeseen by lenders because their models simply didn’t account for the fact that borrowers might default and, even worse, that those defaults might lead to losses. In August 2007, lenders woke up and removed from the market the majority of the more aggressive home-loan products that had propped up home prices.

Much of the blame for the nearly unprecedented fall in prices that followed the removal of those loan products has been placed on foreclosures. But that blame is largely misplaced. The reality is that prices fell because without the aggressive interest-only and payment-option adjustable-rate mortgage (ARM) loan products, very few people could afford to buy a home. Sales began to recover after prices dropped because buyers could once again afford to purchase a home, given their income and the loan products that remained available.

I want to be crystal clear on this point: Many people feel that borrowers were out of control, that they exhibited what Robert Shiller termed “irrational exuberance.” I totally disagree. Buyers did what they have always done, which was to spend as much as their banker told them they could afford to buy a home. Skeptics may argue that borrowers should have known better. But let’s not forget that politicians, government officials, economists and financial industry leaders all claimed that there was no housing bubble and that it was a good time to “invest” in real estate. That’s not to say there was no irrational exuberance–certainly there was–but rather, that it was politicians, officials, economists, regulators and investors, not borrowers, who were truly irrational.

As home prices naturally plummeted to a level home buyers could afford, consumer confidence plummeted as well. See chart:

Note the fall in home prices occurs immediately after the loan products that enabled people to buy homes the twice the price they could really afford were removed from the market in August of 2007.

Unfortunately, the notion of a home as an investment, rather than a place to live and own outright during retirement, left most homeowners with the mistaken belief that this engineered home equity equaled net worth. Thus, as prices plummeted, so too did homeowners’ sense of financial security. And since so many homeowners had tapped their home equity to live beyond their means, the drop in home prices also turned off a major source of consumers’ purchasing power. Worst of all, many homeowners now owe more on their mortgage than their home is worth, so they’re essentially trapped in a prison of debt with no ability to sell their home or refinance their mortgage.

Negative equity, I believe, is therefore the core problem. With 20 percent of US and 30 percent of Californian households with a mortgage now underwater, it is impossible to fathom how consumer confidence can return, or how the U.S. economy can begin to grow again, given that 65 percent of U.S. gross domestic product (GDP) comes from consumer spending.

How big is the negative equity problem? I put it at just under $4 trillion. I arrived at this estimate a couple of different ways, the simplest being based on the Flow of Funds data published by the Federal Reserve. According to the Fed, our nation’s housing stock had a combined value of $11.8 trillion in 2000 with mortgage debt totaling $4.8 trillion. Compare that to the peak combined value of $21.9 trillion, an increase of 85 percent, in 2006 or the peak debt of $10.5 trillion, an increase of 117 percent, in 2007.

To be fair, incomes have risen 24 percent over that time and since price is a function of income and loan terms, it makes sense that prices should have risen a similar amount. Our housing stock is also about 11 percent larger. Taking these increases into consideration, combined values currently should be about $16.3 trillion, a loss of $5.6 trillion from the peak. Interestingly, Zillow recently estimated total housing losses to date at $6.1 trillion. To return to a housing market as healthy as the one we had in 2000 with a roughly 42 percent debt-to-value ratio (roughly one-third of homes are owned free and clear), mortgage debt should total around $6.8 trillion, which would require mortgage losses of around $3.7 trillion.

To put this analysis in perspective, I estimate we’ve seen around $250 billion in realized losses on foreclosed homes since this crisis began. I know we’ve had only $170 billion of loans foreclosed on so far in California, and the actual losses on those loans are far less than that amount since the eventual resale of the home recoups a portion of the loss.

Our financial system has nearly collapsed and yet we are only about 1/16 of the way through the core problem of negative equity. And let’s be clear on another point: Neither home buyer tax credits, stimulus checks or loan modifications nor any of the other current efforts in Washington address this problem.

Next: Searching for solutions

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