Where is the Bottom?

I have been following these economic occurrences pretty throughly the past two years. Nearly every day I have been getting online and reading the latest news. I even wrote a paper in my finance class making an analysis of where the market was heading last year. The market I speak of is the housing market and everyone seems to be in an uproar over what is happening.

Congress passed a major bill today that provides for 300 billion in bailout money for Fannie and Freddie. It also provides for new regulation over them. Together they own nearly half the mortgages in the country. The bill was passed quickly without much applause and fanfare, and many think it is too little, too late. At the very least, people think it was a very political move for an election year.

In any case, I predicted from last year (2007) that two things could happen. The market could stabilize and we would see some regional effects that were bad, but overall prices would be stagnant for at least 3 years. In other words, we would have some regional price drops, but nothing too significant nationally. And that it would take until 2011 for the overall economy to catch up with the housing market.

My second thought was that with all the factors coming together like a perfect storm we would start to see some major price corrections. My prediction was that in 2008 prices nationally would drop between 10-15%. My reasons were many, but I tied it to the fact that home prices started to be based more on speculation than on inflation and population growth which is what they have been historically.

Recently I have found a lot of people arguing that real housing prices should be based on growth of the median household income. I feel like this is a good predictor as well and should be thrown into the mix, but things should not be based entirely on it.

Here is a quote I took from today's msnbc article called, No sign yet of a bottom in home prices. "Based on those historical comparisons, and current trends income growth and rental prices, Vitner figures the housing market will hit bottom sometime between mid-2009 and mid-2010. When they finally do hit bottom, he estimates prices nationwide will have fallen on average between 22 and 29 percent."

I believe his estimate is one of the best I have seen thus far and let me tell you why. As I stated previously, the housing market has been mostly speculatory for awhile. Since 2000 the median house price has increased 100%. If we simply erased inflation, population growth, and speculation, we would see a drop back to 2000 levels. In other words, a 50% drop off of current prices. If there was no speculation in the market we would have simply seen a "normal" growth of about 20-25% in the past 8 years. Thus, without any speculation the median house price should be about 35% lower than it is. (if the math doesn't make sense, comment me and I can explain)

Now a 35% drop just isn't going to happen, and here is why. For one, houses aren't like stocks. They aren't financial vehicles, they are places where people live. They have intrinsic value other than their price on the open market. People will simply not sell their house if they desire to live there and can financially afford it. What we are seeing are a lot of foreclosures for people who got into "silly" loans such as ARMS. Not to mention the other "silly loan", the home equity loan. This is starting to affect everyone, and is certainly the wild card in the deck. We simply don't know how many there will be or how it will affect everything else.

What we do know is that foreclosures cause the market supply to increase. With the number of foreclosures increasing drastically it causes the supply to increase by a significant amount. Simple supply and demand says that when supply increases, without demand increasing, prices will come down to match demand. Thus we are seeing houses sell for a lot less than what many people bought them for. Thus, we have an increase in bankruptcies because people have no choice. They are stuck. (One more reason to be as debt free as possible!)

What you don't know is that all this government help is going to have unintended side effects. Good for the overall housing market, bad for you. One word: Inflation. With the government putting so much money in the market, along with the investment banks, inflation is sure to happen. We see it already. Rising gas and commodity prices are a symptom, not the cause. As I stated earlier, rising house prices were speculatory at best. And this was on the part of the banks, and mortgage companies. They made a bet that if they loosened the rules on what it took to obtain a house many people who couldn't afford one previously could now do so. They could increase their business, get even higher interest rates, and even higher returns. Well, their bet succeeded in the short run, but ultimately failed because it just wasn't sustainable. Good play sirs, good play. Who suffers though? The American public does.

Here is the kicker though. Is the number of foreclosures still a wild card? Yes. Besides that though our only answer to prop up home prices is for inflation to occur. The fundamentals stay the same. House prices increase because of inflation, population growth, and rises in the median household income. The government has a control on all three, but it's most powerful control is on inflation. It can control population growth by opening its borders more, but will those people buy houses? And it can help median income in small ways, but nothing significantly, and certainly nothing quickly. Yes, its fastest and most powerful control is inflation. By passing this bill it floods the market with $300 billion that technically didn't exist before. Once again, supply and demand. Increases in supply cause prices to fall. In this case, the price of a dollar. When the dollar falls prices for goods and services go up. Thus, inflation.

Hopefully this helps people gain a better understanding of our current economic situation. Many of these things were coming anyhow. The dollar had to correct itself eventually if we were ever going to correct our trade deficit. The environment had to change if we as Americans were ever going to be weaned off our consumer lifestyles. Does the housing market suck for us? Yes, it's going to take another 3 years minimum to break even on our house if we want to sell it. The plan was to rent it out anyhow so the adventure will continue.

The housing market and economy be what may, there is little cause for fear. We still live in one of the best societies on earth with the most creature comforts. The vast majority of us have food to eat, clothes to wear, and a roof over our heads. Much more the 2/3 of the world's population. I am happy to have what I do. I am just hopeful and glad people are learning to become much more wise stewards of their resources. At least, I am hopeful they will be...