Homes Prices Reach Nine-Year Low

Home prices have tumbled more than a third from their bubble-induced peak. The last time that happened was during the Great Depression, and it took two decades to recover.

In any market there are buyers and sellers, winners and losers.

With that in mind, there's some bad news for homeowners, but good news for potential buyers.

U.S. home prices fell again in December, reaching their lowest level since the housing crisis began.

The S&P/Case-Shiller 20-city composite fell 1.1% in December, ending 2011 with a 4% downturn. The index hasn’t been this low since February 2003 and has dropped 33.8% from its peak.

If history is a guide, it could be two decades before prices return to their previous highs.

The latest news is a tough way for the beleaguered housing market to begin the new year.

While the data does show increasing housing starts, what does that really tell us? After all, there is already a surplus of existing homes, many of which are in some stage of foreclosure. Are builders just overconfident? Sales of new homes are moving at an annual rate of 321,000 — some 75% below the peak.

The housing market is being held down, in part, by the so-called shadow inventory — unsold homes that big banks, Fannie Mae and Freddie Mac own but haven’t yet put on the market, plus soon-to-be foreclosed houses.

As it stands, distressed sales (short sales and foreclosures) account for a third of existing home sales. That pushes prices down almost across the board.

According to some estimates, the current shadow inventory may include as many as 10 million properties.

That shadow inventory is virtually certain to grow.

By the end of the third quarter of last year, some 12.6 percent of homeowners with mortgages — or more than 6 million homeowners — were either delinquent on their payments or in foreclosure, according to the Mortgage Bankers Association.

And roughly 22 percent of residential properties with mortgages were underwater at the end of the third quarter, according to CoreLogic. This could lead to even more strategic defaults and yet more unwanted inventory falling into the hands of lenders. That would be a nightmare for already stressed banks.

Though home prices continue to fall and mortgage rates are at historic lows, demand — though somewhat improved — remains historically low.

The pace of existing him sales is about 4.5 million a year; still much less than the 6 million rate that’s considered “healthy.”

Home prices have a long way to go before recovering their 2005 peak. The last time home prices fell 33% was in the 1930s, when the full cycle from peak to trough to peak took 19 years.

If that pattern were to repeat, home prices would not recover until the year 2031 — assuming that we've finally seen the bottom. Give that a moment to sink in.

Yet, even potential buyers who feel persuaded by the historically low rates and fallen prices are finding that it is now quite difficult to qualify for a home loan.

Lending standards are much tighter now than during the bubble era. Today, nearly 90% of mortgage applications require full documentation, which is much higher than the pre-bubble level, when it got as low as 60 percent.

And these days, a much higher credit score is also required. Last year, the average FICO score was 730. During the boom, borrowers with scores in the high 500s were routinely steered to high-cost subprime loans.

The National Association of Realtors says 33% of contracts were canceled in January, “caused largely by declined mortgage applications and failures in loan underwriting from appraisals coming in below the negotiated price.”

There’s also less money available for lending. During the housing boom, investors quickly bought up the mortgage-backed bonds issued by Wall Street bankers. That market has all but vanished; 90 percent of new mortgages written today are backed by the government.

Analyst Barry Ritholtz, of the Big Picture blog, is not optimistic about the housing market. He thinks home prices still have a long way to go before rebounding.

"If this is the bottom then this will be the first time that a major boom and bust hasn't careened past fair value," says Ritholtz.

Historically, when a bubble bursts it tends to overshoot on the downside just as it does on the upside. The big question, the one everyone wants an answer to is, Where's the bottom?

As Patrick Newport, an economist at IHS Global Insight, sees it, “Our view is that foreclosures, excess supply, and weak demand will drive prices down another 5 to 10 percent.”

The current state of employment (13 million unemployed and nearly nine million underemployed) is a recipe for further price declines

A housing recovery is being held up by the fact that too many Americans are still unemployed and those who do have jobs have experienced stagnant or declining wages.

John Williams of Shadowstats notes that the January 2012 payroll employment level remains below the level that preceded the 2001 recession, more than a decade ago. That's simply stunning.

Housing and employment are inextricably linked. Until the employment picture improves considerably, until the massive shadow inventory is liquidated, and until we have full and true price discovery (i.e. housing hits a true bottom), the housing sector and overall economy will not — cannot — begin to fully heal and recover.

But with housing, what's bad for sellers is good for buyers. However, unlike previous buyers, new homeowners will not be able to view their homes as investments; they will merely be places to live.

That should be good enough.

U.S. Economy Still Facing Many Obstacles to Recovery

Weakness in home building and state and local government spending are major obstacles to recovery, according to the annual Economic Report of the President.

While this is true, these are not the only obstacles the nation is facing as it struggles to rebound from the effects of the Great Recession.

New housing starts remain at roughly one-third of their long-term average levels. Without price stabilization and an uptick in housing starts, a stronger recovery of GDP will be difficult; residential real-estate construction accounted for 4 to 5 percent of U.S. GDP before the housing bubble burst.

Housing also spurs consumer demand for durable goods such as appliances and furniture, boosting the manufacture and sale of these products.

The housing bubble of the last decade gave a huge boost to all of these purchases. What people couldn't afford outright, they financed. And home equity was the primary resource.

From 2001 to 2007, families took advantage of easy credit to subsidize a national spending spree, often buying houses that have since fallen in value. Due to stagnant incomes, many families were only able to maintain their lifestyles by borrowing heavily against their homes.

From 2003 to 2007, US consumers extracted $2.2 trillion of equity from their homes. That amounted to an enormous economic stimulus, which is no longer available.

Excluding the economic impact of home equity extraction, real consumption growth in the pre-crisis years would have been around 2 percent per year — similar to the annualized rate in the third quarter of 2011, according to the McKinsey Global Institute.

This clearly illustrates just how reliant on home equity extraction the U.S. economy was in the previous decade. It was jet fuel for the nation's GDP.

However, consumers are now paying down all that debt, which is restraining consumption and economic growth.

Since consumer spending accounts for 70 percent of GDP, the economy will be held back as long as Americans continue paying off those accumulated debts, are limited by stagnant or falling wages, or are grappling with unemployment.

The annual report says that two million jobs will be created in 2012, slightly above the 1.8 million pace last year.

Such growth will be important to getting out of the enormous jobs deficit the nation is confronting. The government previously reported that 1.3 million jobs needed to be created every year from 2006-2016 just to keep up with the growing labor force.

Economic growth needs to be at least 2.5% to improve the nation's dismal unemployment situation. Anything lower won't even keep up with population growth. There are still 22 million Americans who are either unemployed or underemployed.

The president's report also projects that economic growth will accelerate to a 3 percent annual rate in 2012 and 2013, from a 1.6 percent rate over the four quarters of 2011.

The U.S. surely needs output of that magnitude. But it doesn't appear likely.

The nation's massive trade deficit shrinks GDP because we're consuming more from abroad than we're selling abroad.

And the federal government is about to embark on a major budget cutting initiative that is certain to shrink GDP. Over the past 15 years, or so, the economy became overly reliant on government spending to spur growth.

With all of that in mind, it's not a given that the economy will expand by 3 percent this year, much less in 2013, when most of the budget cuts will go into effect.

Moreover, almost all the states are still struggling economically and fiscally. Most continue to operate with significantly lower revenues and are still in the process of cutting spending. Austerity measures have led to a lot of suffering at the state level. Widespread state budget cuts are also reducing GDP and will continue to do so for the foreseeable future.

As I've said repeatedly, any sort of meaningful recovery is tied to housing and employment. Unless and until both rebound significantly, the rest of the economy will continue to lag.

Debt Deal Will Leave Greece Permanently Indebted

After much debate and delay, Eurozone finance ministers have finally agreed on a second bailout for Greece, granting the struggling nation loans worth more than 130 billion euros ($170 billion).

A first rescue package of 110 billion euros in 2010 was not enough to halt Greece's deepening crisis.

After five straight years of recession, Greece's debt currently amounts to more than 160% of its Gross Domestic Product.

Yet, in return for these new loans, Greece has only pledged to reduce its debts to 120.5% of its GDP by 2020.

So, under this plan, eight long years from now Greece's debt will still be more than 20% bigger than its entire economy.

Does that sound like a solution to you?

Within the next two months, Greece will also have to pass legislation that gives priority to paying off the country's debts over funding government services.

That won't go over well with a Greek public that is already rioting. The citizenry will feel that it is paying taxes and getting nothing in return.

Many Greeks don't even bother to pay taxes, which only compounds the country's problems.

That said, after raising taxes last year, Greece will raise them yet again next year. But all this has done, and will continue to do, is shrink demand and drain money from the economy. Greek consumers have less to spend, which is shrinking GDP. And the situation will only worsen next year when taxes are raised yet again.

Given the country's massive debt burden, it seems reasonable that the government would spend less and collect more taxes in an attempt to get out from under all that crippling debt.

However, successive rounds of deep budget cuts (or austerity measures), which were demanded by Greece's international creditors, have failed to restore growth. In fact, the economy has continued to shrink considerably. Last year, Greece's GDP fell 6.8%.

This sets up the likelihood that Greece will remain unable to service its debts in the future.

In fact, a February 15 report obtained by Reuters says that the Greek economy will likely remain unstable for many years and that Athens will likely need international aid for an indefinite period.

Most worrisome, the report states that continued delays in highly unpopular structural economic reforms and privatizations could worsen the already lengthy recession.

"This would result in a much higher debt trajectory, leaving debt as high as 160 percent of GDP in 2020," said the report's authors.

That would put Greece right back where it is today; facing a nearly insurmountable calamity.

Despite all the austerity measures already undertaken, the Greek government still spends more than it receives in taxes. That's because the contracting economy is shrinking tax revenues. Government spending is the last cylinder still firing in the Greek economy.

And therein lies the problem: as the Greek economy continues to contract, tax revenues will continue falling, thereby increasing the deficit.

Additional budget cuts are in the works, and though necessary, they will just cripple the economy even further.

The government plans to dramatically cut the minimum wage. Some 30,000 public sector workers are to be suspended. Pay will be cut. Many bonuses will be scrapped. And monthly pensions of above 1,000 euros will be cut by 20%.

But all of this may be for naught.

The only solution to Greece's problems are grants that never have to be repaid. Anything short of that will leave Greece in a hole it can't climb out of. But no one is going to give the country a free ride of that magnitude. Greece created this historic mess, and now it must clean it up.

Yet, these loans merely push Greece's debt further off into the future, with the added burden of interest. The only chance Greece has to repay these loans is to undergo a massive social and political restructuring, and then hope it's economy somehow manages to experience robust growth.

However, that is highly unlikely.

This Greek tragedy should serve as a cautionary tale to the rest of the world's heavily indebted nations. When sovereign debts become this cumbersome, they become unserviceable. The treatment often worsens the symptoms, and things generally don't turn out well.

The Greek economy is small enough to bail out. But there's a likelihood that more than just the private bond investors will eventually take losses.

The larger issue is what to do if an economy the size of Italy's needs a bailout? Italy is simply too big to rescue. There isn't enough money in the European Stability Fund to save it.

What if Japan, the world's third biggest economy and the biggest debtor of any industrialized economy, needs to be rescued? What then?

Such scenarios were previously unthinkable, yet it is time to start thinking of them.

Debt is like the unrelenting monster at the end of a horror movie; it just keeps coming back.

Reducing National Debt Will Be A Long, Painful Process

New McKinsey Global Institute research shows that the unwinding of debt—or deleveraging— is a drag on a nation's economic growth. Historical experience, particularly with nations attempting to reduce debts in the post–World War II era, reveal that the deleveraging process is both long and painful.

That's bad news for the U.S., where the national debt now exceeds the entire economy.

The combination of too much debt and too little growth has repeatedly proven to be toxic, as is now seen in eurozone countries.

Growth has been, and will likely remain, a challenge for the U.S. The economy grew just 1.7 percent last year, roughly half of the growth in 2010 and the worst since the recession.

Economic growth needs to be at least 2.5% to improve the nation's dismal unemployment situation. Anything lower doesn't even keep up with population growth.

Yet, the economy will have to expand much faster than that just to keep up with the nation's continually mounting debt. The U.S. needs a combination of growth and inflation to pay off years of already accumulated debt.

Long-term projections indicate the debt will grow faster than the economy, which would have to expand by at least 6% annually to keep up. However, the historical average for annual GDP growth since 1948 is only 3.25%.

Given its current constraints, there is absolutely nothing to indicate that the U.S. economy can nearly double the growth rate it experienced over the previous 64 years — a period that saw an enormous post-war expansion.

Net interest payments on the government debt are already one of the fastest rising categories of government spending, yet interest rates are still quite low.

And there's the rub; once interest rates begin to climb, servicing the debt will become quite burdensome and will take precedence over other critical spending needs, such as education and infrastructure.

According to the latest estimate from the Congressional Budget Office (CBO), the federal deficit will be $1.1 trillion this fiscal year. That would mark the fourth straight year of trillion-dollar deficits.

Yes, a significant portion of those deficits has been driven by the recession and post-recession hangover; meaning a shrunken tax base and more safety net payments, such as unemployment benefits and food stamps for the growing number of Americans who have fallen into poverty.

The Census Bureau reports that 44 million Americans were living below the poverty line in 2009, or one in seven people — a rather remarkable statistic. That figure perfectly matches the one-in-seven Americans currently receiving food stamps.

This means that one-in-seven Americans are not supporting the federal tax base, but are instead drawing from it.

The nation is also still paying for the massive costs of the wars in Iraq and Afghanistan. As of two years ago, the cumulative cost of both wars had already surpassed $1 trillion.

According to Defense Department figures, by April of 2011 the wars in Iraq and Afghanistan — including everything from personnel and equipment to training Iraqi and Afghan security forces and deploying intelligence-gathering drones — had cost an average of $9.7 billion a month, with roughly two-thirds going to Afghanistan.

A CBO study said that if the Bush-era tax cuts were allowed to lapse, the deficits would drop sharply. But eliminating these cuts still won't eliminate the deficit, and even eliminating the deficit will not eliminate the underlying debt. That will require years of surpluses, and we are a long way from that.

The U.S. desperately needs economic growth in order to expand its contracted tax base. The nation is still grappling with a serious unemployment problem that will have to be solved by the private sector, not the government.

As economist John Williams of Shadowstats notes, "The January 2012 payroll employment level remains below the level that preceded the 2001 recession, more than a decade ago.”

The government previously reported that 1.3 million jobs needed to be created every year from 2006-2016 just to keep up with the growing labor force. That hasn't happened. Incredibly, job creation was negative for the entire 2000s decade. There's still a long way to go and a lot of ground to be made up.

Even those who have jobs are facing major income hurdles, and that is impacting the tax base.

The median income has declined 7 percent in the last 10 years. More worrisome, Americans' incomes have fallen more during the recovery than they did during the recession. Incomes dropped 6.7 percent during the recovery between June 2009 and June 2011, compared to a 3.2 percent drop during the recession from December 2007 to June 2009.

This decline in incomes is the likely reason that Americans have stopped their debt-spending and are instead beginning to pay down existing debts.

Outstanding household debt in the United States fell by $584 billion (4 percent) from the end of 2008 through the second quarter of 2011. That deleveraging process is still ongoing.

This means that U.S. consumers will not be the powerful growth engine they were prior to the financial crisis and recession.

According to McKinsey, historical experience shows that overextended households and corporations typically lead the deleveraging process. But governments can only begin to reduce their debts later, once they have supported the economy into recovery.

However, the U.S. economy remains weak and is still quite dependent on government support. Unfortunately, that has been the case for many years.

Private-sector GDP is roughly where it was in 1998. The economy has only grown because a substantial portion of GDP the last few years was the result of government debt.

That's about to change.

After the November elections, Congress will have nine weeks to decide on $5 trillion worth of tax and savings decisions. This is the moment Congress has been avoiding for years. There will be more ugly public battles fought by the political class. Regardless, no matter how those battles are resolved, the outcome will be harsh.

As the government begins the absolutely necessary process of deleveraging, it will have serious and unintended consequences. Budget cuts will undoubtedly shrink the economy.

McKinsey gives three recent examples of nations that went through the deleveraging process: Finland and Sweden in the 1990s and South Korea after the 1997 financial crisis.

All of these countries followed a similar path: bank deregulation (or lax regulation) led to a credit boom, which in turn fueled real-estate and other asset bubbles. When they collapsed, these economies fell into deep recession, and debt levels fell.

In other words, the U.S. should have seen this coming.

In all three countries, growth was essential for completing a five to seven-year-long deleveraging process. That's the challenge now confronting the U.S.

Absent a sovereign default, significant public-sector deleveraging typically occurs only when GDP growth rebounds. And that usually doesn't occur until the later years of deleveraging.

That’s because the primary factor causing public deficits to rise after a banking crisis is declining tax revenue, followed by an increase in automatic stabilizer payments, such as unemployment benefits.

That same pattern has played itself out in the U.S. over the past few years. Now Washington is tasked with the challenge of eliminating its mountainous debt burden, potentially allowing the economy to resume more robust growth.

Finland, South Korea, and Sweden could rely on exports to make a substantial contribution to growth. However, due to its massive trade imbalance, the U.S. will not be so fortunate.

U.S. economic growth will be held back by the enormous, and still growing, public debt and by the massive trade deficit, which shrinks GDP.

The Federal Reserve could simultaneously create an export boom and reduce the national debt by devaluing the dollar through the process of money printing, or quantitative easing. And this may in fact be the underlying intention of the Fed.

But every nation seeks to be a net exporter, with an under-devalued currency that is favorable to that goal. Such a strategy can't work for every nation; someone has to buy. Traditionally, that has been the role of the U.S.

As McKinsey notes, during the three historical episodes discussed here, the housing market stabilized and began to expand again as the economy rebounded. However, a similar outcome in the U.S. is not likely for many years to come.

By the end of the third quarter of last year, some 12.6 percent of homeowners with mortgages — or more than 6 million homeowners — were either delinquent on their payments or in foreclosure, according to the Mortgage Bankers Association. And roughly 22 percent of residential properties with mortgages were underwater at the end of the third quarter, according to CoreLogic.

Housing prices have declined to levels not seen since February 2003 and the equity in residential real estate has fallen severely as a result.

According to RealtyTrac, 8.9 million homes have been lost to foreclosure since 2007, the height of the credit crisis. In the process, more than $10 trillion in home equity has been wiped out since the June 2006 peak.

Additionally, lending standards are now tighter and are keeping many people out of the market. In 2010, one-third of American consumers were considered sub-prime and couldn't even qualify for a home loan. When a third of your market is disqualified, that's obviously a very bad sign.

An economic recovery in the U.S. will have to be led by a major rebound in employment and housing. Yet, both appear to be a long way off. Until they bounce back to pre-recession levels, the U.S. will continue to muddle along, at best.

At worst, we could be headed for our own "lost decade", much like Japan, which has actually been economically stagnant for two whole decades.

When the bond market determines that the U.S. debt is unstable, and that economic growth cannot possibly allow the repayment of those debts, it's game over. Finding buyers for Treasuries will become difficult and prohibitively expensive.

At that point, the government will have no choice but to let the Federal Reserve print, print away, destroying our currency and standard of living in the process.

Sadly, such an unthinkable outcome may be just a few short years away, well before the end of this decade.