At the heart of the credit crisis in 2007/2008 was the US housing market. The almost one way growth of housing prices led many to discount the possibility of declining prices. Rising prices fed consumption in the form of home equity loans and home equity lines of credit. It also drove consumers to spend not only out of income but also out of capital, namely, home equity.

The response to the subsequent bursting of the credit and real estate bubble had been first to deal with liquidity and then with solvency but always at the mortgage level. Since then there has been a wholesale transfer of distressed assets from private balance sheets to the government’s balance sheet, a move that has boosted equity and high yield markets, commodities and gold even as it stressed sovereign balance sheets.

It is therefore surprising that more attention has not been paid to the housing market. The main topical concerns today are inflation, European sovereign debt, US employment, energy and in particular oil prices, instability in the MENA region… All valid concerns, but what about house prices? The Case Shiller index has slipped into negative territory since Sep 2010 and currently is declining at 3.33% annualized, in what is clearly a double dip. Mortgage delinquencies have stopped rising but remain persistently high. In the Alt A and non-Conforming mortgages delinquencies continue to rise. Housing starts have begun to decline in earnest again, which is probably not a bad thing.

Housing is the one of the largest portions of a household’s wealth. As long as housing fails to recover household wealth is impaired and the ability to borrow and spend is impaired. This argument requires that one agree with Case, Shiller, Quigley (2005) and not with the refutation by Calomiris, Longhofer, Miles (2006) about the housing wealth effect. However, even if one disagrees with Case, Shiller, Quigley, it is undeniable that the value of one’s house is one of the largest sources of acceptable collateral a household may post for credit.

In order for a sustained recovery, house prices need to stabilize and recover. How can the government help?

Interest rates need to remain low. At these low levels of interest rates, the smallest rate hike translates into a sizeable increase in monthly mortgage payments. The Fed may be forced into raising rates if inflation starts to pick up, but given the large weight given to housing with the CPI, its likely that the Fed will be given sufficient room to keep interest rates lower for longer without official CPI numbers picking up too much. Quantitative easing and central bank MBS purchases also aid the cause as they keep longer term financing rates and spreads low and affordable.

Employment needs to pick up. Mortgages are paid out of wages, not thin air, and not from temporary work. Employment, however, is a function of general GDP growth which is dependent on consumption which is in turn dependent on the stock as well as rate of change of wealth. Relying on employment is a circular argument.

The government may assume the role of land owner of last resort and stand to hold foreclosed collateral and purchase real estate inventory for lease back to the public at affordable rates. This may be politically unworkable but it will underwrite the value of real estate. It would also be as difficult to finance as the purchase of financial assets like MBS and USTs.

Quantitative easing debases fiat currency relative to hard assets but the real estate overhang is sufficient that QE policy has proven to be a blunt instrument inflating the value of everything else but real estate. As a blunt instrument it inflates aggregate nominal output. It is not even able to guarantee that it will inflate the nominal output in each asset or good market or in a particular one. And even where it inflates nominal output in a given market, it is not able to distinguish between price inflation and real output growth. Whereas for economic growth it is hoped that real output growth would take place without excessive price inflation, the housing market was one in which it was hoped that policy would effect price inflation without real output growth. As it turned, the overhang in unsold homes has proven overwhelming so that housing starts are moribund, secondary home sales are weak and at the same time house prices continue to fall. It is perhaps indicative of the scale of the irrational exuberance, that drove house prices in the years prior to 2007 that the efforts of the Fed and Treasury to at the very least support nominal output growth in housing have been futile.

The lesson learnt here is that much of the consumption in the US in the run up to 2007 was financed by rising house prices and the availability of cheap credit. These rising house prices turned out to be illusory and not realizable. Therefore the consumption that it supported was transitory, the debt that for which it served as collateral is more than it can now or for the foreseeable future support, and the task at hand of creating rising housing prices is either ill-advised or will be futile.

It is time for non-conventional market operations in the physical real estate market.

The equally unthinkable alternative, which of course everyone says is impossible, is that the US is actually capable of making stuff that Emerging Markets need. Its easy to think of Caterpillar, Apple, Google, even Tiffany’s, Coach, Ralph Lauren, Estee Lauder, or Phillips-van Heusen, but what of low tech manufacturing? Impossible? Desperation is the grandmother of invention.

Ever since the great financial crisis even the most ardent capitalist has had his faith in laissez faire economics shaken. Economists normally critical of Chinese style capitalism and benevolent dictatorships have come to openly commend some of their features. In a recent comparison between India’s democracy and China’s pragmatic mercantilism, Byron Wein holds with the latter. So as we abandon our free market dogma, why shouldn’t the US government buy some real estate. In what other asset can someone obtain 10 X non recourse leverage. Besides issuing US treasuries.

US Treasuries have been used, via a tortuous route, to finance the purchase of mortgages. Some of these mortgages are defaulted or will default. Rather than wait, the government should foreclose on all defaulted mortgages. It can then sell the collateral into an SPV which we shall call the National Housing Board. The NHB will lease the houses back to the former owners who will now be tenants. They will be charged a potentially subsidized rate of rent.

There are probably a few million homes of inventory. I’m only guessing because I’ve read so many conflicting reports but 2 – 5 million homes sounds about right.

As prices fall, more foreclosures mean more inventory, triggering more foreclosures resulting in a self reinforcing death spiral. The devaluation of collateral hurts mortgages.

By buying the underlying real estate instead of the mortgages, the government would immediately put a stop to falling prices. How would it pay for these houses? How was it paying to acquire the mortgages supported by dwindling collateral?

By supporting the values of the underlying collateral, one supports the LTV of the mortgages.

The NHB would finance its purchases by raising debt with a guarantee from the government. Some of the inventory will be acquired through foreclosures.

The NHB would receive rental income and pay out financing costs. It would become the one of the largest if not the largest landlord in the world.

It could begin to gradually sell longer leases on its stock of housing. It could plan development on a longer time scale and use its landbank and inventory as a signal to the private sector.

It could establish policies and processes for the rationing and allocation of housing based on the needs of the people.

It would likely never be unwound even once the housing market has stabilized but remain as a supplier of last resort of affordable housing for the lower income while maintaining minimum standards of quality for the entire housing industry.

Can the stock market rise when the economy is faltering? As long as monetary conditions are exceptionally loose, the answer is yes. But there are limitations.

Corporate profits in the US have rebounded from 2009 lows. GDP growth has recovered albeit not as robustly as one would have expected given the concerted effort of the Fed and Treasury to reflate the economy. It would have been very disappointing if profits did not recover and the stock market didn’t rise.

But now TALF, TARP, PPIP and QE have taken risky assets off private balance sheets onto public balance sheets. This has taken the form of direct purchases by the Fed, or purchases by Treasury funded by issuance of treasuries purchased by the Fed. In the last year, commercial banks began to load the boat with treasuries as well, as the yield curve afforded sufficient carry and roll down, a strategy which is very capital efficient under Basel rules. The resultant effect has been that risky assets such as MBS, ABS which were formerly in private hands are to a significant extent now in public hands. Private holdings of US treasuries has risen significantly. Alarmingly, public holdings of US treasuries has also surged. In the jaws of the crisis of 2008 I suggested a wholesale exchange between the government and the private banks of US treasuries for asset backeds. Its taken 3 years and an rather convoluted route but we are largely there. Where do we go from here?

The idea behind TALF, TARP, PPIP and QE was to stabilize the banking system, to encourage bank lending and to stimulate a moribund economy. If the Fed was exogenous to the banking system then the banking system is stabilized. Bank lending, however, has been slow to recover as banks have preferred to lend to the government. The economy has not recovered as much as would have been expected given the scale of stimulus. Under QE, nominal output in each market tends to grow. This, however, includes asset markets. Where output has been constrained, prices rose, implying inflation whether goods price or asset price inflation. Where output is not constrained, real output has risen. QE has worked to a certain extent but it has created acute inflation across goods and assets in unexpected areas.

Under QE, equities suffer, but they suffer far less than bonds which in turn suffer far less than cash, in real terms. As QE tends to be inflationary and debase the currency, gold and commodities did well. In nominal terms, everything rallies, except cash. For this reason we have seen a bull market in equities lasting over 2 years.

It is therefore not surprising that while emerging markets equities peaked in November of 2011, as they started raising interest rates to address inflation, and European equities drifted higher until February 2011 with the ECB maintaining a hawkish stance until it raised rates in April 2011, the US equity market barreled ahead shrugging off the Japan Quake, MENA revolution, high oil prices and sovereign debt crises in the Eurozone.

As we come to the end of QE2, which officially ends in June 2011, volatility has returned to markets in equities, commodities and credit. Markets it would seem are being required to stand on fundamentals once again.

While economic growth appears to have bottomed across the globe, although I would argue, possibly not in the US, the relative growth rates are divergent. Emerging markets are on a tear while Europe and the US are recovering less robustly. The fundamental equity trade therefore is to be overweight Emerging markets and underweight developed markets.

On top of this, the US is behind the curve in addressing inflation. The US breakevens have been rising steadily since Sep 2010 and still US inflation is underpriced in the markets. The ECB has been more hawkish to the alarm of peripheral Europe. There are limits to how vigilant the ECB can be even as European inflation picks up. Then we have India and China, countries which were very early in addressing inflationary pressures because the inflation was originating from commodities and in particular food which constitutes large shares of their consumption baskets. From the looks of things even though they were early in addressing inflation, the problem will persist and rates will need to not only head higher but stay higher for longer.

There is one country which could benefit from a bit of inflation, and which is currently engaged in quantitative easing. The earthquake, tsunami and subsequent nuclear crisis in Japan has required the BoJ to maintain and operate a policy of stimulus and quantitative easing. History has taught us to be skeptical of any recovery in Japan driving equity market recoveries. This situation is a little bit different. I argue for stronger equity markets in Japan because the economy is weak, the quake fractured more than rock and dirt, it fractured Japanese manufacturing. I argue that because of that weakness, the BoJ and the government will need to print more money and will need to spend more money to rebuild.

With the Fed buying MBS and UST’s all the last 3 years, how much of a rate hike could the Fed make before it was itself insolvent?