Are Home Prices Fated to Fall Farther?

The U.S. housing market is a mess. Home sales have been incredibly weak ever since the buyer credit expired back in April. There are still many struggling homeowners out there defaulting and foreclosing. So many homes are underwater that even those who can pay are questioning whether or not doing so makes sense. And of course, a new fiasco has recently ensued with some banks and servicers revealing that their procedures weren't as clean as they should have been. This has slowed foreclosures and created fear among potential buyers. The likely result from all of this badness: home prices are bound to decline farther. Is there any way to stop that inevitable outcome?

In a sense, there isn't. There are still a significant number of borrowers out there who cannot afford their mortgage payments. A handful might find a solution in a modification program, but most will not. Until all of these borrowers finally are foreclosed on or complete a short sale, the inventory of homes will rise at an unnaturally fast pace. That will put downward pressure on home prices, particularly as buyer demand remains anemic.

Some government fixes attempt to solve this problem. The first was already alluded to -- mortgage modifications. Although this might help a small number of borrowers, it isn't a silver bullet. Re-default rates tend to be incredibly high, often exceeding 50%. So modifications actually prolong the market's misery as most of those borrowers eventually face foreclosure again anyway.

The second is some sort of attempt to spur demand, like the home buyer credit. As we saw there, however, that mostly tends to distort the market. So this won't hold up home prices in the long run either.

But there is one thing that would absolutely help home prices: if borrowers who can afford to pay their mortgages continue to do so. Nothing would be as dangerous to home prices as another wave of strategic defaults.

In a sense, strategic defaulters create a self-fulfilling prophecy. They are angry that their home price is so low, and don't expect it to rise quickly to again match the cost of their mortgage. Consequently, they walk away and go rent for cheaper. As a result, home inventory grows, and prices decline, or don't rise as quickly, because demand can't keep up with supply.

As home prices continue to decline again, homeowners who can afford to make their payments will feel even more tempted to walk away. While that might seem a more rational response than living in a home worth less than its mortgage, it will also make matters much worse. This is a situation where, if all homeowners who can afford to keep paying agreed to do so despite home values declining, then they wouldn't fall as far. Unfortunately, these choices are made on an individual basis, so they can't benefit from everyone agreeing to tough it out.

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Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.

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