Supply Versus Demand: Housing Inventory by Heath Lefort, Economist

November 26th, 2008 10:56 AM

By Heath Lefort, Economist

The inventory of homes on the market remains very high. It will take about 10 months at the current sales pace to fully clear off the entire inventory. Until months' supply can be brought down to a balanced level of 6 to 7 months, home prices will continue to come under pressure. Some local markets have already returned to more balanced conditions, but broadly speaking, buyers have a clear edge over sellers in many markets to negotiate for a lower price. And until inventory gets trimmed, the uncertainty about the bottom in home prices will continue to lead to rising foreclosures and inflict pain on Wall Street.

There are two ways to draw down housing inventory: by reducing supply or by raising demand.

On the supply side, a sharp cutback in new home construction is helping to reduce the flow of new homes reaching the marketplace. Homebuilders are hurting badly, but it is a needed necessary adjustment.

Another way to reduce supply is to lessen the number of foreclosures. The media and Congress are heaping praise on Sheila Bair and her plans to reduce foreclosures. Her plan to modify troubled mortgages into an affordable payment structure will help more homeowners keep their homes and thereby, aside from lessening the great human and social cost related to foreclosures, help reduce the flow of additional inventory arising from forecloses. Sheila Bair gets great credit for recognizing early the impending tide of foreclosures and the need to do something about it. More than a year ago she had asked banks to voluntarily rework the troubled mortgages. Now, given the slowness of the voluntary plan, she has proposed a government spending program to rework the troubled loans. As FDIC chief, Ms. Bair is not in a position to authorize government spending, however.

The government spending in the form of guarantee payments to banks for some of the reworked loans that may default is under the purview of the Treasury Secretary Hank Paulson. Mr. Paulson has said no to the Bair plan and is getting excoriated by Congress for not doing anything to help the homeowners facing foreclosure. He contends that the $700 billion TARP funds are for investment only - those with a potential for revenue recovery for taxpayers - and not for government spending. That is what he says publicly. However, the likely reason for not supporting Sheila Bair's plan is due to moral hazard and perverse incentive concerns. That is, some of the currently performing loans will turn sour on purpose in order to qualify for the associated better mortgage terms under the Bair Plan. Furthermore, those borrowers who have been fulfilling their original contractual obligations would not benefit, while those falling behind on mortgage payments - whether on purpose or not - get relief. It's a great test of what is fair and what is not.

Some also contend that most of the reworked loans will go into foreclosure after the short delay and that Sheila Bair's plan can only postpone the inevitable and prolong the housing market downturn. One large mortgage broker, looking at loans that were modified 6 months ago, told me recently that 75 percent of these loans have already defaulted or are in the process of defaulting. That is only one anecdotal story and more empirical data should be reviewed before reaching conclusions about the success of the re-worked loans, however.

Lessening foreclosures definitely help lower inventory. Cutbacks in new home construction also lower inventory. But there is another way to quickly chop off inventory. Increase housing demand. Let the buyers soak up the inventory. Right now, there is a great deal of pessimism in the marketplace - and rightly so given the continuing home price declines in many markets. Though some buyers are responding to lower home prices and buying their dream home at bargain prices, there are still quite a few who are saying 'why buy now, when prices will be lower later?' The way to change that mentality is to put money on the table for buyers to pick up. Given that Washington is in spending mode with President-elect Obama speaking of a possible $500 billion in economic stimulus and, of course, the $700 billion already authorized by the TARP plan, it seems sensible to direct a portion of that money into kick starting housing market recovery. NAR has been proposing the following to help the buyers with the associated government cost shown in parenthesis.

• $7,500 homebuyer tax-credit to any homebuyer ($37 billion)
• Mortgage rate buy-down ($100 billion for a 2% point lower mortgage rate)
• Permanently raising the conforming loan limit to 125% of the local median price ($0 billion)

The plan should be only short-term - maybe for one year, because the principal purpose is to get the housing market going in order to get the economy going. My estimate is that even a one-percentage point mortgage rate buy-down (that is, to bring mortgage rates down from the current 6% to 5%) would lead to 560,000 to 840,000 additional home sales. Correspondingly, the months' supply of inventory will fall to about 7.5 months - the level consistent with no further home price declines. An added stimulus beyond the one-percentage point rate buy-down will lead to even higher home sales and even deeper cuts in inventory. Home prices could even rise. If the national median home price was to rise by, say, 3 percent, then the U.S. economy will have surely turned for the better because such a price gain would translate into a wealth addition of about $500 billion for the nation's 75 million homeowners. The rising wealth will lead to positive gains in consumer spending.

Raising housing demand is an equal opportunity incentive. It does not introduce the moral hazard and fairness issue that Paulson is concerned about. Not to dismiss Shelia Bair's plan of reducing foreclosures and inventory, which should be tried - but the priority should be on raising the housing demand.

30yr fixed rates will continue to fall due to the unemployment numbers.  A 30 yr Fixed is currently 5.75%.  This is one of the best times to buy a place to live for the long term.  Please call me, if you are interested in being advised towards home ownership or restructuring your debt.  Happy Thanksgiving to you and your family!

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