Throwing cash at the housing market will make it worse

Home prices are at a 9-year low, and it should come as no surprise. For the past three years, tighter lending standards and record foreclosures have driven an unusually higher number of homebuyers to pay for discounted properties in cash. The bulk has come from investors eyeing fixer uppers, as well as foreign buyers armed with wads of cash for properties from California to Miami.

But there’s a new buyer in town: Current homeowners. And unlike their cash-flushed rivals, these buyers are actually looking to live in the homes they purchase. Investors still make up the majority of all-cash transactions, but increasingly, your typical buyer looking to downsize, upsize or relocate is paying 100% cash to purchase a home rather than go through the hassles of getting a mortgage.

This comes even though the cost of borrowing is at near record lows — the weekly average for a 30-year fixed rate mortgage has been below 4% since December 2011. Between October and January, cash sales by current homeowners surged from 30.8% to 34.1%,  according to respondents of the latest monthly Campbell/Inside Mortgage Finance Housing Pulse Tracking Survey, which polled about 2,500 real estate agents nationwide.

During the same period, all-cash purchases by investors and first-time homebuyers remained nearly flat – although still higher than when the housing market was healthy. The survey doesn’t pinpoint where the cash sales by regular buyers come from, but it’s likely in some of the most distressed housing markets with deep discounts such as Arizona, California and Nevada. If the trend continues, nearly half of current homeowners buying new homes will pay in cash by the end of 2012, the survey suggests.

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This might sound encouraging. After all, it seems any pick-up in sales is welcome after years of gravely weak sales following the housing market crash of 2007. Regular buyers had been frustrated by losing to investors with ample cash for discounted properties. And at a time when debt has become a dirty word across the U.S. And Europe, it might come off as good news that households aren’t buying more than they can afford.

But while all-cash sales might reduce the glut of empty homes on the market, the unintended consequence is that the trend does little to support home prices. Because many sellers prefer all-cash transactions in hopes for a faster closing, buyers often enjoy a discount – approximately 10% on average.

Beginning in February 2009, all-cash transactions rose rapidly – making up about 30% of all existing home sales, according to the National Association of Realtors. Since then, such sales have stayed elevated – roughly double where they were in October 2008, amid the height of the housing market crash.

The upswing in cash sales by regular homebuyers doesn’t necessarily signal renewed demand for homes. Tom Popik, research director at Campbell Surveys, points out that it may have more to do with buyers anticipating that the Federal Reserve would keep interest rates ultra low for several more years. In September, Fed Chairman Ben Bernanke approved what’s called “operation twist,” a policy intended to drive long-term interest rates lower. And in January, the Fed explicitly said that it would keep short-term rates at nearly zero percent until at least the end of 2014.

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While the Fed hopes its policies will eventually help boost the economy by encouraging everyone from homebuyers to business owners to borrow more, it ends up leaving those who’d rather save their cash at a loss. Which probably doesn’t bode well for many, given that the U.S. Savings rate has nearly doubled from 2.4% in 2007 to 4.4% in 2011, according to the U.S. Commerce Department. This comes at a time when it may not make sense for some to hold their cash in a certificate of deposit, where yields on such an investment for one year is currently at 1% or lower.

“I think a lot of affluent homebuyers just threw in the towel and decided to use all cash,” Popik says.

Besides, it’s not easy even for the most stellar borrowers to get a mortgage approved. There’s the possibility that appraisal of the property might come in less than the asking price, which during a down housing market could ultimately kill a deal since many sellers are pricing at close to what they owe on the property. Also, if you’re a self-employed business owner, producing financials to qualify for a mortgage might be too much of a hassle.

To be fair, however, it’s hard to cast all the blame on the Fed’s low interest rate policy. After all, there are those who would argue that hiking up rates could prove even more disastrous.

The housing market’s troubles are complex. And throwing cash at it — no pun intended —  will do little to fix it.