If "Heard on the Street" is anything to go by, Wall Street and the financial industry still doesn't understand what happened and why.  

David Reilly, writing in Heard On The Street, (Wall Street Journal, January 2, 2009, page C12) may have been listening to the Wall St. gossip, but has turned a blind eye to the facts.  Suggesting that real estate can help bring an end to the recession, his primary question is whether the present low mortgage rates will lure new buyers back into the marketplace.  The question he should ask instead is whether banks are willing to continue making loans to people without equity interests in the property they are buying.  In other words, are they willing to return to 100% financing deals.  So far, the answer has been "no."

The problem with the real estate markets in 2008 was that the banks and other financial institutions began to realize the fruits of several years of unsafe lending practices.  As a result, and in a fit of self-protectionism, they cut back, altogether too late, on these practices.  The marketplace, which depended on their continuation crashed, while the bad loans manifested in the portfolios of commercial banks, investment banks, brokerage houses and real estate mortgage lenders.  Today, you can still find buyers.  I know Realtors here in the Houston area who get at least one new potential buyer a week, but these buyers face a problem.  They have little or no down payment money available, have less than sterling credit records, and the banks won't lend to them. 

The primary question facing any financial market is "what level of risk is acceptable."  Under normal circumstances people don't invest in excessive risks.  For many years real estate lenders allowed only reasonable risks, and wanted a down payment to ensure that they could have coverage of their costs in the event of a default.  When subprime lending became the norm, it left many lenders with excessive levels of risk in their portfolios setting the stage for the inevitable meltdown.  At the same time it duped altogether too many people into believing that the boom in sales and lending was normal, rather than a manifestation of abnormal and certainly foolish business practices. 

As the financial papers have noted, lower interest rates have fueled refinancing, which is logical.  People owing money will want to pay less interest, and if they have a good credit record and/or sufficient equity in their homes, they will find it easy to get lower interest rates.  However, when it comes to home sales the situation is different.  Under normal circumstances first time buyers can't get into the market without a down payment.  Existing homeowners can, in theory trade up, but they will probably be depending on selling their current home to obtain the down payment.  With no one to buy the current home, the process stalls and people are essentially forced to stay where they are. 

To make matters worse, in some markets homeowners are finding themselves in what is often referred to as an "upside down" position.  Their home is now worth less than what they owe on it, preventing a sale when the buyer wants to pay market price. So we are faced with the following situation:  Lenders will no longer lend on excessive risks.  Buyers cannot reduce the risk to reasonable levels without down payments, which they do not have.  As a result, the market will remain at a low level of activity until personal savings or some other means becomes available to reduce lender risk. Because of the above, real estate is not going to lead America out of the current recession.  No matter how much money the government throws into circulation, it will not matter one iota to the real estate markets unless that money finds itself equity positions for homeowners. 

One extremely intelligent caller to the Michael Medved show a few days back suggested that if the government was committed to throwing money at the recession, one of the best ways to use it would be to pay down homeowner mortgages.  This would 1) reduce lender risk and improve lender balance sheets; 2) increase the equity positions of homeowners who might be able to increase the level of activity in the market, and 3) allow borrowers to increase their level of savings and investment which would benefit the entire economy over time.  This idea is probably too simple and too reasonable for government to consider.  It also, benefits homeowners directly, which top business management is likely to object to.  They will likely want a government handout plus the ability to collect on the loans. 

Now don't get me wrong.  I am not proposing that this idea would be a cure-all for the economy.  It won't be, and it will certainly cause externalities in price relationships within the economy with resulting inflation.  But at the same time, it might be the best of a bad lot.  Government seems committed to a foolish policy of bailing out everyone who made a stupid business decision.   It is not the business of government to do so, although it has assumed contrary ideas within the last century, to the detriment of the American economy and of popular sovereignty.   Still, if we have to make a mistake, let's make one that may do the least harm while possibly create the greatest benefits.   It is better than throwing money at people who have already proven themselves poor custodians, hoping that next time they will do a better job.