The key to end this mess, especially in banking sector, is to stablize the housing market. Without any policy interventions, let’s look at how far we are close to a housing bottom.

The first graph (all graphs curtesy of Calculatedrisk) shows you the price-to-rent ratio. Historical average is around 1.1, now we are at 1.2. Looks quite optimistic.

So does this mean we are near the housing bottom?

Not necessarily. Just like stock price, housing price tends to overshoot (in this case, undershoot). The overshooting scenario is very much likely giving the monthly supply of existing homes still remains at historical high level — we still have more than 9 months of supply to clear, that’s 4 months more than normal.

Looking at the same problem from a different angel: if we compare the existing home sales with new home sales— in the past, the two sales figures moved closely along with each other. But since early 2007, this relationship has diverged, with existing home sales trying to hold up and falling at a slower speed, while new home sales suffering almost a free fall.

This partially explains why the inventory of existing home sales has built up and remained high -a lot of home buyers suffered a huge blow to their wealth as their mortgage values are significanly higher than the current market price (underwater mortgage). And imagine the impact on consumptions: home owners basically have to cut their spending to fill the hole of falling housing price.

With huge inventory buildup, it’s very likely housing price will overshoot on the downside. But without price correction, the inventory will not clear. It’s a dilemma for policy makers. If policy makers try to intervene and stop the price from falling at current level, it will delay the market clearing process, and we are likely to see a very anemic recovery of housing market and consumption.

Economic history shows when recession happens along with housing bubble, the recession tends to last much longer.