The big picture of negative equity in U.S. real estate is enough to make a grown broker cry, and most are. Total negative equity in the U.S. has now surpassed $4 trillion, according to the Federal Reserve Bank of St. Louis (FRBSL).

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Negative equity prolongs recovery

The average loan-to-value ratio (LTV) of leveraged homeowners nationwide is 94.3% — much higher than the “preferred” LTV of 58.4%, which was the average LTV among homeowners spanning the period from 1970 to 2005, as reported by the FRBSL. Using the preferred LTV figure, the FRBSL argues that home prices would have to increase by 62% to bring nationwide homeowner equity back to historical equilibrium levels.

The cost of a government-backed principal reduction program to return nationwide LTV averages back to equilibrium would be $3.7 trillion. Thus, the FRBSL is dubious that the government will step in with enough power to correct the real estate market and instead insists upon an organic market approach to solving the negative equity crisis (which, of course, was brought on by the financial accelerator effect fueled by mortgage lenders).

The answer? Demand. Rather than manually adjusting existing home equities, the FRBSL insists that real estate is still not priced appropriately (it’s too high) to stimulate demand. In order to wake demand for homeownership from its now lengthy hibernation, asset prices in the real estate market need to fall at least 20%.

The logic of this argument relies on the idea that a further decline in asset prices will allow ready, willing and able buyers to step in and “recapitalize” the housing market by purchasing non-performing assets from underwater buyers via shortsales and thereby generating a mark-to-market phenomenon driven by buyers rather than the government or lenders. With this accomplished, the real estate market will return to equilibrium pricing and thus reach a point where it can begin to grow organically.

first tuesday take

The conclusions presented here by the FRBSL are right on target — if, perhaps, somewhat lacking in its perception of the bigger picture.

Fundamentally, the problem in real estate (and the greater California economy) is one of demand. Much has been done by the Federal Reserve (the Fed) to stimulate this demand, primarily by driving interest rates to zero and providing huge sums of cash to lenders via quantitative easing (QE), otherwise called printing money. But, as we have seen, this has yet to do anything in the real estate sector except provide the irrational conduct of speculators ardently hoping for a flip after a couple of years of hyperinflation.

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It’s the demand, stupid!

Although the reasons for this are many, the primary issue at hand is the fact that real estate (California in particular) is still over-priced upwards of 15%. The FRBSL’s commentary that prices need to drop 20% is prudent, as this will bring prices below the equilibrium trendline for a period. This necessary cyclical occurrence makes prices attractive enough to stimulate user demand, sending them slightly upward to the historical mean price.

As the equilibrium trendline for real estate pricing runs at the rate of consumer inflation, prices need to fall below this baseline so purchasing real estate becomes a more attractive store of wealth than government bonds and certainly more attractive than a savings account. Once this occurs, prices will begin a slow but steady climb bumping along the trendline all the way (2% per annum).

Of course, the elephant in the room here is jobs. Jobs move real estate and we will have to see jobs pick up first so those ready and willing buyers in the marketplace can be become able — there’s your demand.

Related articles:

Beyond the basics: asset price inflation in the real estate market

The equilibrium trendline: the mean price anchor

re: “Negative equity gap nears $4 trillion” from housing wire