Modifying mortgages is just a band-aid

The flurry of announcements by the government and major banks that they are engaging in a massive campaign to modify mortgages that are in or are hurtling toward default and foreclosure will certainly give rise to predictions that the housing market has been stabilized and disaster averted. If only it were so.

Make no mistake, policymakers and banking executives had to launch this concerted campaign to try to stop the wave after wave of foreclosures that seems to feed on itself. As lenders foreclose on one delinquent borrower, and then sell the home at what is invariably a steep discount, that just pushes a number of nearby homeowners so far underwater that they just move out and mail their keys in, which just sets the cycle in motion again.

But anyone hoping that this synchronized effort to modify millions mortgages that are in trouble is likely to be disappointed. Because behind the splashy headlines, there are limits to what the government and banks can hope to achieve. And trying to slow the free-fall in housing markets is akin to the government trying to put its finger in the dike.

The fact is that despite the double-digit declines in housing values in most cities, housing remains significantly overvalued in many markets by all of the traditional benchmarks: One key ratio – the median cost of a new home vs. median income – suggests that home prices nationwide still need to drop another 15% to 20% on average, as you can see in this chart compiled by money manager Barry Ritholtz. And the equilibrium price is far more than that in bubble markets like southern California and Florida. According to this "fair value" calculator, one suburban neighborhood outside Washington, D.C. that I checked (Alexandria, Va., where I lived in the mid-1990s) is now 47% overvalued. Ditto for a few communities in Los Angeles that I surveyed.