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Housing Slump at Root of Financial Crisis

Published 09/18/08 Craig Harrington - Print Article
E-mail - editor@economyincisis.org

There are many hypotheses regarding why the United States financial sector has been shaken so badly over the last year. The problem stems from the rise of the housing bubble and the crisis which followed, according to CNN Money.

Home values have soared over the past decade, topping out at all-time highs in 2006 and 2007 before crashing down to earth. The effect of this housing crash is still rippling through the economy, and there seems to be no end in sight. Policy-makers are completely out of their league in dealing with a crisis of these proportions.

In the past two weeks we saw the collapse and takeover of Fannie Mae and Freddie Mac, the bankruptcy of Lehman Brothers, the acquisition of Merrill Lynch by Bank of America and the precarious government buyout of American International Group. In spite of their feverish action, the ad hoc attempts by the Treasury Department and Federal Reserve to stabilize the system could prove to be a waste.

All of the above firms posted staggering writedown-losses associated with unpaid mortgage debt. Had the housing bubble never burst, the market would never have seen such a dramatic natural correction. Most experts agree that the financial system will continue to falter until the housing market finds its natural bottom. Housing prices must stabilize before any recovery can be implemented.

Treasury Secretary Henry Paulson agrees with this assertion. In a statement released on the day of the Fannie and Freddie takeover, he said that the biggest risk to our economy was the slide in housing prices.

"Our economy and our markets will not recover until the bulk of this housing correction is behind us,” Paulson said.

However, instead of merely standing aside and allowing the natural process to occur, many government officials have clamored to soften to blow. Stimulus programs and mortgage bailouts, meant to stem the tide, may actually be drawing out the problem.

The government likes to tinker with economic mechanisms to give its constituents the illusion of control, but their meddling may be worsening the crisis. The government has spent much of the last year trying to figure out the problem and taking steps to alleviate market stresses. In spite of these efforts, the Dow Jones Industrial Average – the largest collection of indices in the U.S. – has slipped more than 2,300 points in the past year.

This cycle of boom and bust is a natural market phenomenon; anyone who believes growth can continue indefinitely is either misguidedly optimistic or unaware of economic fundamentals. We need housing prices to bottom out for the financial sector to stabilize. We need this because the repository of America’s wealth is in its homes. During the last few years, the wealth was inflated beyond its true value. Homes were worth 50 to 100 percent more than their previous appraisal.

What we are seeing now is the correction for this overvaluing. This is strikingly similar to the Japanese Asset Bubble of the 1980s and 1990s, during which time assets accrued value overnight (particularly housing) before crashing down to their natural bottom. The eventual correction took several years, and has led Japan to be more cautiously optimistic about future fiscal responsibility. The U.S. could have learned its lesson a decade ago when a similar economy suffered through the same shock which grips us today. We did no such thing and are now paying the price.

Source CNN Money:

But in the end, it all comes back to one issue - housing.
Earlier this decade, it was much easier to get a mortgage. Home prices soared about 85% from 1996 through 2006 in inflation-adjusted dollars, creating a bubble.
Then the bubble popped. And the fallout isn't over yet, experts say.

…

"These institutions, which weathered all kinds of calamities before, including depressions, are being knocked out," said Lakshman Achuthan, the managing director of the Economic Cycle Research Institute. "It's a testament to the significance of the problem we have here."

…

Home prices, while sharply off from the 2006 peaks, are still high in comparison to long-term gains in income, rents or overall prices, suggesting that they still have a way to fall, according to experts.

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