The simple economics behind the situation in housing is beginning to become more apparent as the weeks go by. As we’ve noted for several years now the primary problem in the US housing market remains one of supply and demand. As the jobs market continues to weaken, deflation takes hold of the US economy and the shadow inventory floods the market the math here remains simple enough for an Econ 101 student to understand. In order for the housing market to build a firm foundation that does not require government aid we will need to see a reduction in prices. In a recent research report Merrill Lynch described just how extreme the supply/demand imbalance has become in recent months and years:

“The collapse in housing demand means that it likely will take even longer to clear the inventory of homes for sale. In the new market, builders have continued to slash construction, maintaining incredibly lean inventories, and yet there is still supply of 9.1 months. Even more worrisome, however, is the existing home market where inventory is still on a decisive uptrend. As such, it takes 12.5 months to clear the inventory at the July sales pace. This widening gap between housing demand and supply means that construction likely will remain depressed and prices will dip lower (Chart 5).”

More worrisome is the huge increasing in shadow inventory that Merrill expects:

“The inventory of existing homes for sale is set to increase further as “shadow inventory” moves into the market. According to the latest Mortgage Bankers Association’s report, 9.1% of loans outstanding, which translates to 4.8 million, were seriously delinquent at the end of Q2 (capturing 90+ days delinquent or in the process of foreclosure). Unfortunately, this is not the end of the foreclosure pipeline. There were 2.6 million of mortgages either 30 or 60 days delinquent (Chart 6). It is likely that re-defaults from failed modifications – there have been 616,839 failed HAMP modifications – have contributed to early stage delinquencies.”

Based on Merrill’s estimates the housing market is unlikely to normalize before 2015. The supply/demand imbalance is simply staggering at the current levels and is likely to deteriorate if the economy weakens further:

“We define a normal housing market to be one in which housing starts are trending at the historical average of 1.5 million homes a year. In our view, we are several years away from this state of normalcy. Housing supply has outpaced housing demand by about 2 million homes over the past few years and is on pace to add another 500,000 excess homes by the end of 2012. For this excess to clear, housing starts must remain at a depressed level, not returning to normal until 2015. This would make it the slowest housing recovery in post-war history.

If we pencil in our baseline forecast for housing starts of 590,000 this year and 690,000 next year, another 500,000 excess homes will be created. Looking ahead, we must be more judgmental. A reasonable scenario is that starts slowly edge higher to 1 mn by 2013 and reach the “normal pace” of 1.5 mn by 2015. At this point, most of the excess supply will have nearly cleared, allowing starts to pick up to match the pace of demand.”

Congress is currently discussing creative new ways to prop up this market. It should be plain as day at this juncture that the government cannot fix the housing market with their incessant fidgeting. The market needs to correct further before reaching a sustainable bottom. Lower prices will act as an automatic stabilizer by generating significant demand. At this point, more government intervention merely kicks the can down the road by pulling demand from the future. We can continue to deny the simple economics at work here, but at some point the market will prevail and prices will settle at a level that the market can absorb. In my opinion, the sooner this happens the sooner we can get on with the recovery process. Unfortunately, politicians have elections to win so they will continue to use their law degrees to attempt to change the laws of economics. It won’t work.