With the Federal Reserve meeting again this week, it is now time to update our market expectations.
 
As many of you know, I have been expecting a major move down in interest rates, caused by the biggest housing decline since the Great Depression. While many pundits on television have been talking about the problems in the housing market being “contained”, I have maintained that this is simply impossible—-and with price declines of 5-45% depending upon the region—not only are we seeing economic weakness, it would be hard to argue that places like Florida are not in a pretty deep recession.
 
The problems created by having mortgage money too easy at the end of the last cycle—with “no down” no doc” “no credit” etc loans fueling the last run-up in prices have certainly come back to bite everyone with foreclosures rapidly rising throughout the USA, and with price declines across America. These declines [ignore what the media reports] have been anywhere from 5-10% in the “strongest” markets like Los Angeles coastal areas to as much as 45% in many areas of Florida. Las Vegas, Inland California, and Phoenix are also amongst the hardest hit.
 
Declines in prices have varied based on the amount of new home building in any particular area, as wherever there is a large inventory of tract housing or condominiums there has been the greatest decline in price. Much of this has to do with speculators who created an artificial housing “shortage” by buying 5-10 homes a piece with the idea of simply flipping them at higher prices to the next person to come along. As soon as mortgages got tighter, and the inventory of new homes started to manifest itself—the “music stopped” and inventory grew rapidly.
 
There is no question in my mind that Fed Chairman Bernanke is completely aware of the problem, and has come to grips with the fact that unless this is headed off quickly, we may not only be using the “R” word for Recession—but would have to think about the “D” word–for Depression. It must be kept in mind that the last time we had a housing decline like this WAS around the time of the Great Depression of 1929-1933. This HAS to be the reason behind the 1/2% cut in rates at the last meeting
 
I do NOT say these things to scare you–because I think the worst of the housing market decline is behind us—and I expect the market to start its recovery early next year.

I expect the Fed to lower interest rates on Wednesday—and the only issue is whether it will be by 1/4 or 1/2%. Hopefully, it will be by another 1/2%.

I also expect them to lower rates Dec 11th, the end of Jan and March—-bringing Fed funds down to the 3-3.5% range from the 5.25% it was until this past summer.
 
The Fed will be putting the “pedal to the medal”—NOT to bring prices of homes back to their July 2007 peaks—but in order to create a “bid” under the market.

They simply MUST create an environment whereby people can see that houses will resume their normal appreciation levels alongside inflation. At the moment, we sit with 3 years of buyers sitting on the sidelines waiting for the market to stabilize before THEY buy. Once the PERCEPTION of housing weakness passes, expect the market to regain its health—fed by these interest rate declines.
 
Along with the decline in interest rates—and along with the stabilization of the housing market—will come the elimination of the “risk premium”. Historically, 30 year fixed mortgages have tended to be whatever the 10 yr bond was paying [now at 4.40%] plus 1.25%. That would translate to a fixed rate of 5 5/8% and the jumbo at 6%.

However–because of the perceived risk—banks are charging about 1/2% more—which may not sound like much–but it is making mortgage payments 10% higher than they would be—and this has a bad influence the housing prices and the market itself.
 
I’m expecting the 30 yr mortgage to get back down into the 5.25-5.5% area—with the jumbo about 1/2 point higher.
 
The continuing of interest rate reductions have helped to keep the stock market at or near record levels—and I expect the stock market to rally strongly at least until the Presidential election. Since this tends to happen every 4 years anyway–I’m hardly going out on a limb here. This stock market advance will help to bring the more affluent home buyer back into the market along with lower interest rates. This housing recovery will be led by the HIGH-end buyer—-and this is normal, with the last cycle being led by the 1st time home-buyer being the anomoly.
 
The Fed lowering rates will also make mortgages a lot cheaper for anyone willing to get an adjustable rate mortgage and will help to bail out those people who bought homes with adjustable rate mortgages that are–or are about to–reset at much higher rates which could lead to more defaults. I have little doubt that the Fed will be moving quickly to help this group along.
 
While much will be said over the next couple of years about the Fed bailing out the speculators—this will NOT be the case. Those investors/speculators who bought homes at $700k in inflated markets–only to see prices drop to $475k—will be forced under—-but the housing market WILL start its recovery from this $475k level gradually as people realize that prices have gotten back to $500k—and that prices are heading higher. Since full price recovery might take years—the speculators will be in deep trouble, and not bailed out. For the individual homeowner who stays in their home—eventually they will get their money back.
 
The Fed also remembers what happened after the Tax Reform of 1986 which caused real estate to decline—the banks ended up with the real estate–and then YOU and ME had to bail out the Savings and Loans through our tax dollars.

The Fed will be moving quickly here to try to have that not happen—as we have seen disturbing news from companies like Merrill Lynch, Countrywide, Citibank, Washington Mutual etc—the high quality institutions—while we have also seen scores of mortgage companies fail and file chapter 11.
 
I think they will be successful—-and I feel that housing prices will begin its recovery in late 2008—after the actual sales recovery starts this spring when new home builders will be ending their price slashing to clear out unsold inventory. Once we start to see noticeable reductions in homes for sale, we know that we will resume a more normal real estate market with normal levels of appreciation.
 
One thing needs to be kept in mind—-we had a real estate market that was “overvalued”.

After the decline—it is more normal to swing to “undervalued” and then begin a recovery. It is rare for a market to go from “overvalued” to “fairly valued”—so there is probably some catch-up appreciation to be had in this recovery as we eventually get back to a normal market.
 
Those people buying homes this spring should be handsomely rewarded over the years to come.