How far will prices have to fall to re-ignite the housing market?

There's an interesting op-ed piece by Peter Schiff, president of Euro Pacific Capital and the author of "Crash Proof: How to Profit From the Coming Economic Collapse" in today's LATimes which argues that the only way the housing market can rebound is if prices fall more in line with incomes.

Ok, fair enough. But also realize that Mr. Schiff has a book entitled "Crash Proof: How to Profit From the Coming Economic Collapse," so in a way this is a free PR gift courtesy of the Times. I'll have to keep that in mind if I ever write a book!

Here are some of Mr. Schiff's arguments:

The government is trying in vain to get funds flowing again and put a floor under prices. But it's too late. U.S. home prices are like a beach house supported by eight pillars: lax lending standards, low down payments, "teaser" interest rates, widespread real estate speculation, pliant appraisers, willing lenders, easy refinancing and a market for mortgage-backed securities. Knock out even half of these pillars and the house comes crashing down. We've knocked out all of them. Yet everyone hopes that this allegorical house can defy gravity and that bubble-era prices can be sustained in a post-bubble world...

At current levels, the average American still can't afford the average house. Despite the creativity of its new policies, Washington can't alter that math. The only mechanism to restore balance and get the credit flowing is for prices to fall steeply to a true market level, and for losses (for consumers and corporations) to be recognized and absorbed.

Anecdotal and statistical evidence supports this. Foreclosed homes at auction quickly find buyers and financing when price declines are severe enough. February's existing home sales figures showed the largest year-over-year price drop on record. And it was also the first month that the number of sales ticked upward in a year...

Ok, but isn't it also possible that the reason median sales prices are dropping is because so many of the homes being sold are foreclosures to buyers only in search of major bargains?

The quicker home prices find a sustainable bottom, the quicker our economy can truly recover.

Instead, the government is trying to float our allegorical collapsed beach house on a flood tide of new liquidity. But the fixes compound the problem. They're creating runaway inflation, shrinking the value of the dollar -- and heading toward unprecedented government meddling in the marketplace and a diminished sanctity of contracts.

Schiff is certainly not alone. In last week's LATimes week-long "dust-up" between economist Chris Thornberg and Paul Leonard, the director of the California office of the Center for Responsible Lending, Thornberg agrees prices must decline while Leonard insists that lax regulation was to blame (and which I think both are true). From Thornberg's argument:

Home bubbles are nothing new. We had one in the late 1980s, another in the late '70s and certainly many others before then. The bubbles are characterized by people buying an asset, in this case a home, and thinking they can sell it at a higher price regardless of the fact that the price being paid is completely out of whack relative to fundamentals such as income. At their root, all bubbles are driven by individual greed -- the desire to make money.

Think of it this way: Every buyer over the last few years had a choice: Buy a home or rent an apartment until income was more in line with prices. Many leaped into the housing market even as prices climbed to such high levels because they thought they could sell at a higher price. To a degree, they were all speculators. This bubble is larger than any we have seen since at least World War II because the sub-prime markets gave buyers the means to speculate like never before. As a result, prices went up like never before. This isn't a sub-prime problem; it's the same old greed problem on sub-prime steroids...

And for many borrowers, this was certainly true.

No one likes to think of a family thrown out of a house. But many people made a very unwise decision in recent years: They bought a house they couldn't possibly afford. Needless to say, they had help from the real estate agent who told them that prices couldn't fall, the mortgage broker who promised them they could refinance easily in a year or two to cover the higher payments, and, of course, from a financial community that bought sub-prime-backed securities despite all the evidence of everything that was going wrong. Now that the house of cards is falling, all parties are taking a hit.

So how do we sort out the guilty from the victims? I'm not sure we can, especially given the past performance of our federal government regarding the financial and housing sectors, which points to a bailout of everyone involved. I know, it's not fair, but few things are in today's world -- especially when politics are involved.

So what does Mr. Leonard say in his part of the 'dust-up' piece?

Sub-prime loans -- many of which had stated-income requirements without verification, low teaser rates, no down payments and aggressive marketing tactics by brokers who had strong financial incentives to close loans -- increase chances of foreclosure. Reckless lending with little regulatory oversight helped get us into this mess.

Foreclosure spillover has much broader consequences -- for neighbors, local government services and our state and national economies. The Center for Responsible Lending recently estimated that 356,000 foreclosures will occur in California in 2008-09. With each foreclosure reducing surrounding home values by nearly 1%, we estimate that 7.5 million owners who live near foreclosed properties will lose a total of $107 billion of wealth in their homes. Possible municipal bankruptcies and deep local government program cuts, combined with historic levels of state budget deficits and the looming national recession, are all byproducts of the highest foreclosure levels since the Great Depression.

People are very big lately on channeling "The Great Depression," but there are some key differences including far different levels of unemployment, a global economy that's still doing ok and a Federal Reserve system that has more levels at its disposal. This might be a good time for HBO to bring back that weird show "Carnival" as a reminder. More from Mr. Leonard:

Given industry apathy toward voluntary loan modifications, the only way to achieve meaningful relief on a larger scale is to tweak bankruptcy laws. Courts should be allowed to restructure mortgages on family's homes. Most loan modifications would occur voluntarily outside of court with no cost to taxpayers. Bills in the House (H.R. 3609) and the Senate (Sen. Richard Durbin's bill, S 2636, included as Title IV of the Foreclosure Prevention Act) would give judges the authority to modify harmful sub-prime mortgages to provide families with one last chance to save their homes. These bills would help some 600,000 families avoid foreclosure.

But what would the consequences of that be? According to Thornberg, higher interest rates to account for more lending risk:

Years ago, in an effort to make buying homes cheaper, the home asset was opted out of the bankruptcy system. Because the home is a secured asset that could be repossessed in the event of a lack of payment, we all have enjoyed lower interest rates. But the game is simple -- if you can't make the payment, you lose the house. To change the game now is to violate this simple rule; that violation will lead to high costs of capital in the long run for anyone playing in the housing market.