The New York Times had an interesting article yesterday about the unpleasant prospect facing the Obama administration on housing. The specific problem is that the administration is pretty much out of policy options on housing, which continues to drag. Well, “drag” is perhaps an understatement—July new home sales were 26% below those of July 2009, and, as Bloomberg points out, pending home sales in July were down 19% over the same period. The same Bloomberg article points out that, on average, median home prices are down 26% from July 2006. The market isn’t picking up, and it’s not clear what else the Obama administration can do about it. Given that two-thirds of Americans own homes, and that homes represent some 80% of Americans’ wealth, this remains a pretty big deal as the economy continues to sputter along as the stimulus efforts fade, and as unemployment hovers around 10%, in part from the horrible state of the homebuilding industry.

The Times article discusses one possible, but thus far pretty unwelcome, policy option—just let home prices collapse further. Get it over with. All the policy options implemented to date have been designed to try to keep people in their homes while maintaining, as much as possible, the listed value of the homes, or at least trying to keep them as high as possible. The reasons for doing this are obvious—preventing homeowners from losing what they’ve invested in their homes, and preventing the number of unsold and foreclosed homes from rising, dropping prices further. Americans have taken a huge hit on their personal finances as a result of the events of past three years, in part because Americans tend to have their personal wealth tied up in home ownership.

But there are advantages to letting prices drop further. First, it would make housing affordable for more Americans. Many of us know of towns where the young can’t afford to buy homes in the towns they grew up in, or where real estate values have escalated to the point where essential service providers, like policemen and nurses, can’t afford to buy. So dropping home prices isn’t necessarily a bad thing—it widens the pool, which means there are more potential buyers. More buyers, more home sales, employment trends up (in theory). And there are a whole lot of people who want to buy.

Second, it’s hard to know whether home valuations are currently priced correctly. The underlying assumption that house prices can only go up has, thankfully, been disproved by the events of the past several years. But the assumption that home values are currently where they should be is completely unsupported by the market. In fact, if the market is telling us anything, it’s that home prices are still too high, and need to come down further.

Here’s the first problem—a small drop is what everyone wants, but they might not get a small drop, they might get a big one, and no one wants that. The Times comments:

A small decline in home prices might not make too much of a difference to a slack economy. But an unchecked drop of 10 percent or more might prove entirely discouraging to the millions of owners just hanging on, especially those who bought in the last few years under the impression that a turnaround had already begun. The government is on the hook for many of these mortgages, another reason policy makers have been aggressively seeking stability. What helped support the market last year could now cause it to crumble. Since 2006, the Federal Housing Administration has insured millions of low down payment loans. During the first two years, officials concede, the credit quality of the borrowers was too low.

With little at stake and a queasy economy, buyers bailed: nearly 12 percent were delinquent after a year. Last fall, F.H.A. cash reserves fell below the Congressionally mandated minimum, and the agency had to shore up its finances. Government-backed loans in 2009 went to buyers with higher credit scores. Yet the percentage of first-year defaults was still 5 percent, according to data from the research firm CoreLogic.

So the question is whether the government can afford a significant further drop in home prices, given what it has been providing guarantees for since 2006. Probably not, without a large amount of further potential funding (which would be politically controversial). That’s one problem.

The second problem is the one the Times article doesn’t mention, although some of the nearly 400 commentators also bring it up. Think back to everything you’ve (probably unwillingly) learned about mortgages and the sub-prime market the past several years. You buy a house, and get a mortgage from someone–maybe a bank, maybe a dedicated mortgage provider. What happens then? The bank or mortgage provider sells that mortgage on to someone else, who combines it with a whole bunch of other similar mortgages into a securitized instrument (an Asset Backed Security, or ABS). These have been around for a long time, and can be based on a variety of assets—home mortgages, car loans, credit card receivables, commercial bank loans, and the like. And they are everywhere—it’s difficult to think of a predictable cash stream-generating asset that hasn’t been securitized at this point. However, many of these types of assets also find their way into CDOs (Collateralized Debt Obligations), which are leveraged instruments then sold on to investors (often other banks, but also insurance companies, pension funds, hedge funds, any large investor) in various tranches. This was a widespread practice in the decade leading up to the crisis in 2007, and the numbers here are stunning. We’re talking trillions of dollars of assets here. The theory behind CDOs is that you diversify risk away, and therefore reduce it.

As events have shown, the theory was wrong, and banks and other financial holders of CDOs based on mortgages have taken something of a bath. Tens of billions of value have been written down by banks and other holders, and there has been a vigorous debate as to whether enough has actually been written down. And that debate has occurred without the prospect of further significant write-downs of the value of mortgages and their underlying assets. What happens if there is a further, say, 10% write-down of home assets in the United States? The entire financial system will have to write down assets further. And this is unavoidable if house prices fall further. And here’s the real problem—leverage. Read this Barry Ribholtz piece on how $38 million of sub-prime bonds generated $280 million of losses across a range of holders of CDOs based on those bonds. And that’s sub-prime. A significant downward move in home prices would go well beyond sub-prime—it already has, in fact. So how much money are we talking about here? No one has any idea, really.

Banks and other financial institutions have avoided really major mark to market write-downs through a combination of accounting flexibility (which has gotten more flexible over the past several years) and genuine uncertainty over the value of he instruments. Another long round of write-downs would cause a problem at least as severe as the last one. It’s not as if they’re all that better capitalized at this point. And we saw what happened in 2007 and 2008 when these things did unravel. We really nearly did face a global meltdown. There is a legitimate question surrounding whether the bank write-downs taken to date have been sufficient–not just for residential mortgages, but for commercial real estate as well. Another significant drop in real estate values in America will certainly crystallize that discussion again. And as we’ve seen, the Republican party will probably not support further financial support for the financial system—many Republicans (and Democrats, too) had to be dragged kicking and screaming to support the last round, in 2008.

There are plenty of reasons to think house prices should fall further. They got too high, and one could argue that they still haven’t come down far enough to really open up the market. This won’t appeal to those who bought at the top of the market, as many of the comments on the Times article indicate. One has to feel for the people caught in the squeeze here. But there are significant institutional forces that will be doing everything they can to keep home prices from falling further. They’re actively resisting any further asset write-downs. Because they understand how badly they would be damaged if this occurred. Not that I have that much sympathy for the banks and insurance companies and whoever loaded up on this crap earlier in the decade—they’ve had a couple of years now to try to fix themselves, and they’ve spent much of that time trying to fight tighter (and more sensible) regulations proposed by the Obama administration (relatively mild regulations at that).

So this is not a good place to be. I don’t really see much room for Obama to maneuver, and it’s a horrible choice. If the administration stops propping house prices up, they’ll fall, and perhaps by a lot. This is clearly a good thing in one regard in terms of opening up the market. But the potential havoc to the American financial system, and the economy, and to those who have already lost money on their homes and would likely lose a whole lot more, would be significant, and would in all likelihood lead to further federal intervention in the system, not exactly desirable. And a crippled financial system and economy is not likely to be generating a lot of home-buyers no matter where prices end up. The administration been playing a waiting game to some extent, in the hope that the economy would improve enough on its own such that further intervention would not be necessary, but this bet has not paid off. The result is a range of bad choices. This is a mess, and it isn’t going to get better for a while.

Update (9/8/10): Another band aid.