This piece seems to be written by someone much more familiar with the CA real estate market in theory than in practice.

The biggest problem with any large-scale bailout in California is that it will artificially prop housing prices up at prices that very few residents can afford. Unless the intent is to maintain this support (at public expense) for ten or more years before incomes catch up to housing prices again, it's only delaying the inevitable.

Also, by the period he's talking about (2005-2007), the vast majority of home sales in California were to people who already owned homes, mostly these were speculators looking to flip the houses they were buying for a profit (part of why they took the ARM, teaser and Neg-Amortization loans was that they planned to have sold the houses in question by the time these loans would reset). Those intending to live in a home had laready been mostly priced out of the market, and in many cases the prospective flippers were buying from other flippers to begin with. This all had the full cooperation of many of the lenders (especially Countrywide, the more diversified banks were probably less enthusiastic) who had a business model which is largely dependent on continuous price appreciation in the collateral of their loans, also the involvement of independent mortgage brokers (many of whom have now gotten themselves retrained to be credit counselors and foreclosure specialists) who were in it for the comission on closing the deal and often left both the lender and the borrower in an untennable situation which both sides had been enthusiastic about closing.

Now that the bubble for speculators has popped, prices in California will and should continue to come down until homes become affordable to those looking to actually occupy them again. Those homeowners who chose to deliberately "cash-out" large amounts of equity which had grown in a very short time (many of these used the money either to buy expensive toys or to enter into the speculation/flipping game that helped price many people out to begin with) without considering that the prices could go back down just as fast made their own bed.

Ideas like Barney Frank's (letting courts redefine signed mortgage contracts as they are able to do with consumer debt presently) will increase lender risk, meaning higher mortgage loan rates in the future, which will have the effect of further depressing prices down the road as it will reduce the amount of principal available to borrowers for the same payment.

Lenders in this situation are no more deserving of a bailout than borrowers, as default is a known risk in lending, and everyone but the "Alt-A" lenders (who were aware of the greater risk involved in what they were doing as well) had plenty of opportunity to protect themselves from making loans which couldn't be repaid. The danger with that side of the equasion, though is that through securitization of loans and trading of bonds and derivatives, most of the financial world has some exposure to these bad loans, and may or may not know about it. At the very least, if the fallout were to lead to widespread bank failures, the pain would extend well beyond the banking corporations, and would lead to huge liabilities falling on the government through FDIC and other organizations.

The real tragedy is that so much of this came to a head during an election year, when elected officials who haven't got the real ability to do much about a lot of this are now expected to look like they're doing something, effective or not.

Bravo, I'm tired hearing about homeowners that bought houses that they couldn't afford by inflating their income and using irresponsible (ARM and worse) mortgages. That less than 4% of the population can mail their keys back to the bank and rent.

I want to hear much more about young people starting out that will actually be able to afford a home now that prices are coming back down to reality.

The real estate "crisis" is actually just an example of a hugely overvalued asset being correctly market to market. I am very liberal but may have to go republican this year if I hear anymore about bailing out irresponsible home purchasers. People may have a right to a roof over their head, but they have no right to own a home. Home ownership must be earned, and with stupidity it can be lost.

Hey,

Thx for an intelligent comment. But we really don't disagree that much. If you're saying that the real estate market was pumped up by speculators and irresponsible mortgage underwriters (and borrowers!) to absurd levels that it should not have reached and from which it must come down then -- yeah! We're on the same page.

But you put it exactly right:

The danger with that side of the equasion, though is that through securitization of loans and trading of bonds and derivatives, most of the financial world has some exposure to these bad loans, and may or may not know about it.

Having let it get to this point, we gotta worry about how it comes down.

One of the best posts I have read. As director of a non-profit affordable housing program in rural Oklahoma I have watched the absurd run-up in prices in not only CA but also AZ and NV and wondered how anyone, let alone someone with even a moderate income could afford a home. Even with the so-called "liar loans" someone making 50K or less a year could not reasonably afford even a 300K mortgage.

Have there been abuses to the system, you bet. Commission only mortgage brokers greatly oversold their products knowing that they had no responsibility once the loan was closed and they collected their commission. Large lenders that could securitize their loans aided the process with slobby or insufficient underwriting and then there were the big financial markets looking for high-yield investments that bought the securities without proper due diligence but the fact is, I believe, that relatively few "little guys' got seriously hurt in the long run. Even now, I can get an applicant qualified for a government subsidized mortgage within 3 years of a bankruptcy and as a very successful but conservative lender that I know likes to say "Not everybody is cut out to be a homeowner" and that is a fact.

I would bet that most of the people claiming now to have been duped and lied to were told up front in no uncertain terms what would happen but they chose to either ignore the lessons or would never understand them. Our applicants are required to attend a Homebuyer Education course plus a lenghty class on the exact nature of their loans and a lot of them still do not or refuse to understand what they are agreeing to.

Bottom line, there is plenty of blame to go around and the proposed government fixes are most likely to just screw up the market corrections that will eventually have to occur.

Why do we have to worry about how it comes down? That's one of the worst dogmas of this market correction. Oh no - if we don't bail out all of Paulson's greedy freinds from his Goldman days then the US economy will surely fail.

If the economy can afford to have large airlines and manufacturers hurt their numerous suppliers and customers with Chapter 11 then that's good enough for Bear Sterns also.

The retail banks and pensions that most American's rely on are insured - that insurance can cover any harm that comes to banks and pensions, and it is a much more precise cure that a general mortgage bailout that blindly rescues irresponsible speculators and irresponsible wealthy investors.

The US economy can survive a real estate correction much better that it can survive subsidizing moral hazzard in the financial markets and personal irresponsibility in home purchasing - with government funds financed by China.

Wow, first time an author has responded to one of my comments, I feel honored.

I agree that we need to be careful about how this thing unwinds, but anything that creates direct resistance to housing prices returning to levels which are more supportable by an actual market, and that intervention on the lenders' side should be kept to the minimum required to prevent the whole system from collapsing, but still allowing for those who took irresponsible risks to feel some serious pain when those risks turn out on the bad side. The more everyone is protected from the consequences of their risks, the more likely they are to repeat the same mistakes in the future (not to mention that the burden of mitigating those risks is then carried by the more responsible actors in the population). Of course, I'm not necessarily the most objective on the topic of L.A. housing prices, being one of the prospective buyers who got priced out in this bubble and need to see about a 20-25% fall in my area to be able to afford a modest 2-BR condo on a nearly 6-figure annual income (the L.A. market hasn't fallen nearly as far as the suburbs, probably largely due to gas prices impact on commuters).

The one recurring meme in foreclosure stories that I take umbrage with (especially when the story is specifically about the bubble markets) is the reference to "homeowners" losing their homes in these situations. I know that speculators getting burned on a poor investment choice doesn't generate the sympathy (and by extension the circulation/ratings boosts) that families getting kicked out by the big bad bank do, and I don't doubt that in places like Michigan and Ohio the bulk of those facing foreclosure are homeowners. However, based on statistics which were reported around here at the time, I'd estimate that of the Option-ARM's issued in the 2005-2007 timeframe in CA, the percentage of speculators in that subset is somewhere between 85%-99% (and I'd be surprised if it was really much less than 95%). Also, since these were pretty much all zero-down loans (and there were lenders advertising up to 125% loan-to-value deals for a while), even the borrowers in most of these deals won't feel that much pain (other than in their FICO scores) from walking away.

On a tangent, the "natural" cycle in the real-estate market around here has been on a period of about 10 years, and it hit me the other day to wonder if it's just a coincidence that that duration is the same as the time it takes for a bankruptcy/foreclosure to clear off of a credit report.....

The issue is that now that the risk from these loans is so widespread (through CDO, MBS, SIV, and CDS vehicles among the alphabet soup of acronyms out there), allowing a full unwind at its natural pace could cause a run on too many of the big banks all at once similar to what happened in 1929, at which point the pain would spread well beyond those who knowingly took big risks. At that point, the real estate correction would be the least of our problems.

A free-fall unwinding of all these derivatives could reduce the global supply of "money" by hundreds of trillions of dollars, leading to severe deflation, which is only arguably a good thing for those with no assets and lots of cash. Deflation on an economy such as ours where the vast majority, including the government itself, are heavily leveraged and invested in various assets (real estate, commodities, equities, etc.) or just have lage amounts of debt and little or no savings could be catastrophic, especially with a demographic surge of people coming up on retirement age with most of their retirement dependent on either the government or the stock market. In that situation, the government might be faced with either defaulting on its debts (billions of which are currently owed to the Social Security "trust fund"), or just printing sufficient new currency to cover the obligations (think Germany in the mid 1920s to early 1930s), rendering its currency virtually worthless in the process. With the status of the U.S. dollar in the world, either of these possibilities could greatly destabilize the world economy.

CA can take some blame for AZ and NV as well. There was some legitimate increase in prices in Phoenix and Vegas due to rapid growth in local populations, but when even many of the speculators in L.A. got priced out of the local markets, the brokers here started shopping around deals for L.A. speculators to get into flipping in those two markets since both are very accesable from So Cal (Vegas is 5-6 hours driving from L.A., and Phoenix is about 8 hrs, I've done both drives several times for other reasons)

I don't disagree with anything you've said, except you will never convince me they didn't know. I agree with commenter that the free market should be allowed to take its course. I am a liberal Democrat and I will not vote for John McCain. We've had so-called conservatives in the White House for 8 years, and this is the mess they got us into. They are not to be trusted.

There is a component of this mess that no one is discussing.

The reason lenders could sell these bundled mortgages is, of course, because there were buyers. All those institutional investors with googobs of pension funds, make that hundreds of billions if not trillions of dollars, to invest so that people who will live to be 85 or 90 or older can retire at 55 (hello Europe) or 65 and have everything handed to them. Now there is an attitude of entitlement. (I wonder if it is too soon to short the Euro.) We have to resurrect the notion that it is honorable, American, Christian to work until you drop dead, preferably while we're walking home from work at the age of 120, which brings me to one of my favorite liberal topics - socialized medicine in one form or another. We need to keep people healthy so they will be able to work until they are 120. The idea being that you get sick, you go to the doctor, you get better, you get back to work, and you continue to be a productive, contributing member of society.

Thank you for mentioning Michigan. The whole time I read the article, I was wondering what was so special about these option arms, that uniquely would lead people to rationally choose to walk away? I live Southeast Michigan, and my neighborhood, in a fairly nice suburb, has dropped at least 25% and some indications are 40%. I have a straight 30yr fixed, and came in with a 20% down-payment. I am upside down and the decline may not have stopped. I'm wondering why out of the goodness of my heart should I pay for this house at its previous value? I'm going back to school and intend on leaving the state in two years. Even then why should I sell my house at a tremendous loss, and keep paying for the devalued asset even after I have unloaded it, and begin paying for something else? Why shouldn't I give it back to the bank, rent for few years, and buy in a corrected market?

I agree with the author that the real danger is rational people that simply walk away can over-depress the market and precipitate a full-scale collapse. I think a bailout needs to be considered on the basis of preventing a collapse or over-correction and perhaps enabling a soft landing as close to the "real" bottom as possible. For instance, if the "real" bottom is a 25% correction, then it doesn't make sense to let it fall to 50% reduction only to swing up later. It just may be that furhter declines begin to build on themselves, preventing the upwards "re"-correction and leading to collapse. This is why I support the Bear Stearns bailout. It may very well have prevented a 20's type collapse. Investors still got burned, it just wasn't allowed to run-away. As the author notes, the monumental housing correction or over-correction could similarly lead us into a collapse, especially consideing the broad market exposure to real-estate values. I think we need to be careful not to over-bail-out and artificially prevent or lengthen the correction.

I'm not familiar with the markets inthe midwest, but it is my understanding that the price declines there are more a result of actual ongoing economic decline than coming from a speculative bubble bursting in the local markets (for example, in parts of Orange County, CA prices increased by a factor of 2-3 between 1998 and 2003, then doubled again by 2006 and the median home price reached a multiple of 10 times the median household income by around 2005, up from a more normal multiple of 4 in the mid 1990s).

If the two areas are in fact fundamentaly different in what is driving declines, then it should be obvious that they should be addressed differently.

In your particular case, you'd need to look into whether it's cheaper to rent or to continue paying on your current mortgage in the short term, and keep in mind that prices may well bottom out and begin recovering before you're ready to leave the area. Also, if a 25% decline has put you underwater after a 20% down payment, then I'm assuming you're pretty early in your loan, meaning that virtually all of your payments are likely tax deductable (if you have income to offset, I know some grad students basically live off savings or credit through school), and you can make up a good amount of equity by over-paying your loan by a hundred or two dollars each month if you can afford that at this point. If you evaluate all of your options and decide that walking away is in your best interest when everything is considered, then maybe you should do just that (make sure that Michigan isn't one of the states where the bank can continue to hold you liable for the gap between the loan balance and the proceeds of the foreclosure sale), although you could also take a shot at re-negotiating your mortgage rate with the bank (unless your rate is already very low). IMO, any resolution which satisfies terms laid out in a negotiated contract, such as surrendering the collateral in the course of a default, doesn't carry any of the "moral hazard" implications that unilateral government modification of the contract to which they are not a party brings with it. Also, walk-aways don't have the potential for permanent harm that some of the proposed "remedies" being suggested by Barney Frank and Dick Durbin could inflict through unintented but predictable consequences of those policies.

As for the BSC deal, I agree that somebody bailing them out probably did avert a serious domino effect, although I'm not sure I'm comfortable with the U.S. Treasury essentially underwriting the deal (Paulson has said that he'd cover any losses incurred by the Federal Reserve on their loan to JP Morgan accepting non-saleable MBS bonds as collateral). In the long run, JP Morgan will almost certainly profit enormously from the deal, even at $10/share, and they shouldn't need the opportunity to dump the initial costs of closing the deal onto taxpayers.

I don't think "honorable, American, Christian" really describes the idea of working until you die. Possibly "incredibly stupid" might be more correct.