How falling home prices imperil the U.S. economy

America's economy confronts a vicious cycle of falling home prices and rising foreclosures, and the challenge for policymakers is how – and how much – to intervene.

Top economic officials are already taking some steps that are aimed, at least in part, at slowing the erosion of home prices. The Treasury has been prodding banks to rewrite the terms of loans rather than foreclose on mortgage holders who are in default.

One goal is to help ordinary Americans keep their homes and to keep neighborhoods from deteriorating.

Another rationale is to bolster an industry at the heart of the economy: the banking system on which consumers and businesses depend. When homes go into foreclosure, banks face a pileup of bad assets on their books. Already, that has caused banks to start tightening the spigot on new lending.

But even as US officials look for ways to help avert a deeper credit crunch, they face political and financial limits on how much the government can do to prop up the real estate market after a historic price run-up.

"We're entering an unprecedented period," says Richard Bitner, a former lender in subprime mortgages and author of a book on the industry. "I'm a believer that markets have a tendency to work their way through these things…. My great concern is that Congress is going to go too far."

Falling prices are a drag on borrowing

But "do nothing" doesn't look like an appealing option right now, either.

The problems in housing are part of a broader collapse of confidence among lenders and borrowers – a problem that makes it hard for markets to find an easy path back toward health and balance. An economy teetering on the edge of a recession makes the challenges more acute.

From student loans to corporate buyouts, investor dealings in various forms of debt have been freezing up, as the players reassess the value and risks involved.

Housing remains a central piece of this credit puzzle, because so many Americans buy homes and so many financial firms underwrite mortgages. With home prices falling, many borrowers and lenders are sitting on the sidelines.

"In this environment, buyers will be reluctant to commit to new purchases," Treasury Secretary Henry Paulson warned last month. "Until investors have confidence that [home] prices have stabilized," he added, "they will remain cautious about funding new mortgages."

Secretary Paulson has led Bush administration efforts to prod banks to modify the terms of at-risk home mortgages, rather than watch more borrowers fall into delinquency and then foreclosure.

Banks have been taking steps along that line. The economic stimulus package enacted recently by Congress will also permit government-sponsored enterprises, including Fannie Mae, to begin guaranteeing higher-value home loans. That's a bid to revive buying and lending in high-priced markets such as California.

Some want more government intervention

Some policymakers argue that government should do more. One idea, backed by Democratic presidential candidate Hillary Rodham Clinton, is to impose a temporary moratorium on foreclosures. Others have floated an idea modeled on the mortgage rescue undertaken during the Great Depression. The government could become a buyer of mortgage securities – large pools of now-sagging mortgages – and then move forward with loan modifications that ease the terms for borrowers.

Behind all these plans, whether modest or ambitious, is the notion that the vicious cycle must be broken.

A negative feedback loop in housing is one of the greatest risks to the economy now, say economists. During the boom years, a positive loop was at work: Home prices rose, buoying the availability of credit and making it unlikely that home buyers would default on their loans.

Now the loop is operating in reverse. The more home prices fall, the more owners find that their best financial option is to simply walk away. Because many recent buyers put little money down, they lose little – except their credit score – by handing in the keys on a purchase that is losing its value.

"While many have fretted over the ... resets of adjustable-rate mortgages, falling home prices are a much more important concern," Scott Brown, an economist at the investment firm Raymond James, writes in a note to clients.

"Home price declines threaten to turn many recent homebuyers upside down – that is, owing more than the home is worth," he adds. "Falling home prices and tighter mortgage credit in turn lead to even weaker housing conditions, further home price declines and even tighter mortgage credit, and so on."

But economists see limits to what government can do to help marketplace participants regain confidence.

Efforts to intervene could have unintended consequences, some experts note.

A bailout of mortgages would probably be "a transfer [of tax dollars] from renter to owner ... and from poor to rich," says Morris Davis, a University of Wisconsin economist.

Housing's negative feedback loop, for now, is daunting. The positive element is that markets tend to rebalance eventually. Buyers will bid when prices become attractive enough. And most banks will face losses but not outright failure, analysts say.

"I don't think we're going to see a depression," says Dean Baker, an economist at the liberal Center for Economic and Policy Research in Washington. But he says that at the current rate, $3.2 trillion a year in housing wealth is being destroyed by falling prices – a hard blow to the economy.