What if Housing Doesn't Come Back?!

I have been mulling around a simple concept over the past two weeks. Our housing market for many years has been driven primarily by easy access to credit. It allowed many home buyers to overextend, and even more suitable buyers access to extremely (relative to the 80s) inexpensive financing options. Much of this (putting aside much better Fed policies since the 80s) can be attributed to an extremely lucrative market for mortgage backed securities. It leads me to the simple question, what if the mortgage backed securities market doesn't come back...ever?  


Many economists, including Henry Paulson, are calling the real estate tumble a "market correction" which is an inherent acknowledgment that there was something wrong with the housing market that now needs correcting. There has been a lot of discussion about the need to make mortgage backed securities more transparent so investments carry the appropriate risk level to stem a future crisis from happening again (I have yet to hear of one viable option). But no one is really admitting that whatever new form these securities will take, it will never be the same. These new securities will have added cost due to new government oversight, and more importantly they will be sold in a market where investors now consider the security extremely risky, instead of extremely safe. 


Since most individuals purchase real estate with credit, cost of accessing credit is a strong contributing factor for the demand for real estate. Packaging mortgages and selling them in a bulk security greatly lowered the cost of borrowing. It opened the mortgage market up to a world (literally the entire world) of investors. A bank in Ohio no longer needed to hold the entire mortgage amount; they could sell these mortgages on the open market, possibly finding a buyer in an investment bank in India. The attraction for investors was a chance own what was considered a diversified (a wide range of underlying properties in a security), safe asset. The U.S. housing market was perceived as very strong through the 90s and could offer a lucrative return, thereby encouraging more investment. So what happens when the perception of mortgage backed securities moves from being the safest to the riskiest investments? There is the obvious response that credit immediately freezes, we have already seen that, but what happens 10 years from now?  


This may be the end of real estate based wealth building as we know it. For years housing prices were driven upward, I would argue primarily by easy credit. Securitizing mortgages brought borrowing costs down so low there was an influx of new demand into the market. Now, with more investors becoming extremely risk adverse to U.S. housing market investments, there will be an immediate capital drain from the market. Even as the credit markets begin to thaw it will take a significant amount of time before the fear towards the market subsides.  


Looking forward two years from now, after the global recession will begin to (hopefully) ease, and when consumer spending and Fed policy returns to normal; the mortgage market may look very different. With an additional fear factor, investors will be looking for a higher return to account for newly recognized (does not even need to be real, just perceived) risk in the U.S. market, this will translate into much higher interest rates for mortgages. Higher rates means a higher barrier to enter for new buyers, and demand will take a heavy hit. I would also predict this will effect all tiers of real estate in different ways. Those with good credit that remain in the market post-crisis will not be able to afford the principle they were able to pre-crisis because of higher debt service. This means even the luxury home market will take a significant hit. I also believe the overall skittish feeling toward the market will deter eager investors who purchase properties on spec for a short term reward. All of this translates into a long term national depression in demand for new housing. In the end I think this "correction" will adjust for more realistic risk, and once the adjustment is made home prices will appreciate again, but at a much slower pace then we may have become accustomed to over the past two decades. I would predict, after the adjustment is completed in about a year or two, the appreciation of most real estate will closely follow local income growth (which hasn't been too great on a nation scale the last 20 years) of the middle class or better, (those with good-to-great credit) rather than any other external factors. 


To end on a bright note. If you rent, this is great news! Wait out this adjustment period, build your credit now,  save up for a ridiculously high down payment to secure your loan, and hopefully the post-recession, post-crisis, interest rates won't be too far out of reach! Just don't count on your home being your nest egg unless you anticipate a sudden jump in U.S. income growth, similar to the growth we had post world war two, but have not seen since. Your home will just be your home, it will not generate income or make you a millionaire, but at least you get a tax credit on the mortgage and don't have to deal with a landlord! 


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