The Real Estate bubble continues to go strong. I think it will pop as soon as interest rates start climbing. Interest rates are still at spectacularly low levels in historic terms. This has avoided the massive overhang of ARMs.
Normally, real estate drops due to employment. When people lose their jobs, they can't pay the mortgage. They move elsewhere to where jobs are, forcing sale of the house. This incremental shift in the market (2-3%) depresses the market. This is largely due to the uncertainty of remaining market participants, who will delay initial home purchases or upgrades for a year or more (since they fear losing their own job and they are seeing falling prices). When jobs return, the market accelerates.
What we're going to see is an ARM explosion. The economy could still be going strong -- but if interest rates are up at 6-7%, many people forced to refinance by expiring ARMs will be stuck. They can barely meet their mortgage payments in the original environment. So they'll sell. So prices will go down. Triggering a recession, layoffs, house sales, and a second round of prices going down.
There was a solution to the internet bubble. The Fed controlled two major levers in the market -- the discount rate (which drove margin interest rates) and the margin requirements. The discount rate had little impact since in an environment of 50%+ gains, a quarter of a percent was meaningless. The margin requirements were left untouched at 50% (you can only borrow 50% of your total portfolio). Had margin been raised to 55%, the most leveraged people, who were probably in the most bubbly stocks, would have been forced to pull back slightly. It shouldn't cause a collapse -- just take the heat out of the market.
The Fed should do the same thing for real estate. Impose a minimum down payment of 5%. Outlaw "hybrid" loans where a high-risk "down payment" loan is combined with a conventional 20% down mortgage. This way the Fed is not affecting all the other aspects of the economy associated with interest rates. Instead, it is a focused solution driving at the heart of the problem.
The dark secret of the mortgage industry is that it is no longer relevant to banks whether people will pay their mortgages. As long as the origination and servicing fees are kept, that risk is shuffled off to nameless insurance companies and pension funds. In almost any scenario, these institutional investors will still come out ahead, their losses outweighed by the interest rate premium over T bills they collected for years. There are few if any financial institutions exposed to the risk of an S&L type crisis. But the consequence to Americans as a whole and the overall economy is enormous.
Having just failed to avert one financial disaster, because our old tools weren't up to the task -- why do we stand by idly as we approach the next set of financial shoals?