Is the Housing Market in the ICU or is it DOA?

The nation's housing market recently began to spiral downward, and there seems to be no bottom in sight. There has long been concern that unemployment would relentlessly lead to serious delinquencies and foreclosures, as evidenced in the chart at left. It looks like there will be over 1 million foreclosures this year, a new record. Now, even very wealthy borrowers are walking away from mortgage debt. Apparently, many people are strategically defaulting on their mortgages even though they have the means to pay because they are so far underwater, meaning the market value of their homes does not cover the amount of their mortgage debt. 4.5 million homeowners are deeply underwater. So expect to see massive potential real estate inventory for years to come as banks hold distressed properties off the market and more and more homeowners succumb to the temptation to strategically default. This reality will lead to constant pressure for price deflation in the housing market.

Meanwhile, buyers are running for cover. After the expiration of the home buyer's tax credit, pending sales plunged to a record low level. We recently learned that mortgage applications are plummeting even in the face of record low mortgage rates.

So what does this all mean? Well, first, real estate prices seem destined to fall more, with all of the attendant consequences on consumption implicit in the evaporation of household wealth. Second, bank capital seems exposed to further losses from mortgage lending, meaning more bank failures, more cash hoarding and less capital in the banking system for lending.

I have argued for some time that we bailed out the wrong people. We bailed out reckless bankers instead of their victims. I cannot help but wonder about the extreme shortsightedness of our political leaders on this point. If we had bailed out homeowners with the trillions spent bailing out the bankers, the real estate market may have been saved. Ironically, debt relief for consumers would have saved the financial sector billions in mortgage losses while promoting consumption and forestalling a deep recession. According to an IMF study, targeted debt relief for borrowers is "most successful" in containing financial crises.

We will regret these policy errors if residential real estate markets go into a full-fledged dive.