The economic crisis enters a new and more dangerous phase daily, and Americans of all levels of economic sophistication are scrambling to make sense of the myriad remedies and proposals that are springing from Washington.
The Fed has slashed interest rates -- even in the face of inflation and a crashing dollar -- and conjured new mechanisms to inject cash directly into the financial markets, including the bizarre engineering of the Bear Stearns buyout. In addition, legislators and regulators have enacted, or are pushing through, measures that will place a moratorium on home foreclosures, suspend interest rate adjustments and compel Fannie Mae and Freddie Mac to buy more mortgages. Further game-changing proposals are working their way through the think tanks and policy proposal pipelines: loan balance reductions, the suspension of "mark to market" accounting, direct federal mortgage purchases and, most bizarre, the suggestion of a Wall Street Journal columnist that the federal government buy and bulldoze the "least wanted" foreclosed homes.
When lost in the details of these measures, it is easy to miss their unifying goal: pump cash into the market, encourage lenders to keep lending and, ultimately, stop home prices from falling. But try as they might, it won't work.
The government is worried for good reason. The value of the trillions of dollars of mortgage-backed bonds that course through the American financial system is a function of homeowners' capacity -- and willingness -- to repay their mortgages. To an extent not widely understood, this is all tied to home prices.
When prices rise, everybody can repay loans. Price appreciation builds equity, and that allows even overstretched buyers to refinance or sell at a profit -- so mortgage lending becomes nearly risk free. Defaults are rare, but if they do occur, banks reclaim houses worth more than the loan. When prices are falling, this process is reversed and lending to overstretched buyers becomes a losing proposition, no matter how low interest rates drop or how much money the government drops from helicopters. That's why banks have curtailed lending.
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.
After an unprecedented, unsustainable and irrational home price bubble for most of the current decade, authorities have about as much ability to keep prices from falling as King Canute had in stopping the tide.
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.
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.
If left unchecked, these policies may save a few mortgage holders and bail out some Wall Street firms, but they'll also wash away the prosperity that Americans have built up over generations.