Business Week on "the housing abyss"

Arguing that the measures taken so far to prevent an overly large erosion in housing values have fallen flat, Business Week asks what can be done to avoid falling to the bottom of the 'housing abyss:'

The housing crisis is entering a new and frightening stage. On June 24, Standard & Poor's announced that the S&P/Case-Shiller 20-City Home Price Index had fallen more than 15% in April from a year earlier. Adjusted for inflation, the decline is the biggest since 1940-42, according to data collected by Yale University economist Robert Shiller.

The risk for the financial system and the economy is that the price drop, already horrifying, will start feeding on itself. When home values fall low enough, hard-pressed homeowners become less able or less willing to keep paying their mortgages. That forces lenders to repossess homes and then dump them back on the market at fire-sale prices, which depresses prices further and leads to even more foreclosures...

Efforts by the private sector and government to stop the slide before it gets out of control haven't done the job. Poorly designed mortgage securities rife with conflicts of interest, as well as legal disputes over priority between creditors, are forcing many homes into foreclosure needlessly, accelerating the market decline.

Sure, Congress is expected soon to pass a huge legislative package aimed at preventing needless foreclosures and stimulating first-time home purchases. But many analysts and advocates are already warning that more dramatic measures will ultimately be required. "The depth of pain is not being registered in D.C.," says Mike Shea, executive director of nonprofit advocacy group ACORN Housing in Chicago...

...the housing optimists have systematically misjudged the market. Some became convinced that the huge runup was justified by fundamentals such as population growth, rising incomes, and land scarcity. And because sharp national housing price declines are so rare in U.S. history, analysts assumed that prices would, at worst, flatten out for a few years...

What they forgot was that markets can overshoot on the downside just as easily as on the upside, with both financial and psychological forces feeding the decline...

...the fall in house prices is so precipitous that it is changing homeowner psychology, eroding the long-held taboo against walking away from a home. In hard-hit markets such as Las Vegas and Phoenix, many homeowners are beginning to conclude that their home purchase comes with a "put option"—the right to hand the keys back to the lender if things don't work out. Indeed, risky payment-option ARMs that allow unpaid interest to be added to the principal, 70% of which were issued in California and Florida, are going bad even before they reset upward, as homeowners see trouble ahead and bail. "Commercial real estate borrowers have always looked at things this way. Consumers simply caught on to the game," says Tom Lindmark, a managing director of Phoenix-based Metropolitan Real Estate...

Mass foreclosures accelerate a neighborhood's decline, triggering a spiral of abandonment and decay. A survey of agents this year for Inside Mortgage Finance by Geosegment Systems and Campbell Communications found that about half of foreclosed properties have significant damage, which reduces a property's value by about 25% (e.g., $100,000 on a $400,000 house). Ruined floors and carpets, holes in walls, and missing appliances lead the list...

Who can fix this mess? Certainly not lenders. They're part of the problem. To repair their damaged balance sheets, they're aggressively reducing lending. And they haven't geared up for the wave of defaults...

What more might government do? The Federal Reserve has already intervened heavily, of course. In addition to slashing short-term interest rates, it has extended more than $150 billion in secured loans to banks. Anything more from the Fed would leave it open to charges that it was subsidizing the banks and raising the risk of inflation...

If the housing market continues to weaken, action in Washington could heat up next January, when a new President and Congress take office. The next President, whether Democrat or Republican, will have more flexibility to be bold because he will be starting with a clean slate, although Barack Obama has taken a far more interventionist stance than has John McCain...

But expect strong pushback on that last idea from fiscal conservatives. The Wall Street Journal's editorial page observed on June 21 that the FHA lost $4.6 billion last year, making it a less-than-obvious candidate to guarantee billions in troubled loans.