I don’t really want to rain on anyone’s parade here - especially because this parade helps pay my salary - but while it’s nice to see that local home sales have rebounded so well, here, as elsewhere, it’s due almost entirely to the $8,000 federal tax credit.

Which means that if we want home sales to continue increasing, that tax credit needs to be extended, and even expanded.

Which will mean that the government is making a concerted effort not merely to prop up housing - but reinflate the bubble.

Ilargi had a hair-raising piece on this yesterday - including the fact (which I didn’t realize) that the government actually allows first-time homebuyers to use the $8,000 tax credit as a down payment on the house:

Earlier this week, a story made the rounds of a 20-year old girl of Salvadorian origin who holds 3 jobs and bought a $155,000 home (and got a $34,000 “embellishment” extension on top of that) with an FHA-guaranteed loan with a 3.5% down payment. That story had subprime written all over it right from the start, and loudly begged the question what on earth moves the US government to move into (make that induce) subprime lending.

But that was just the first chapter of the tale. In chapter 2, we see that the damsel in distress didn’t just see her loan guaranteed by the Obama administration. Crucially, she also qualifies for the $8000 tax credit for first time home-buyers.

Please pay attention. Now it gets interesting.

$8000 may not seem like a lot compared to the $155,000 purchase price. But that’s not the way to look at it. You see, the government allows those who qualify for the credit to use it towards their down payment. And now the picture changes dramatically.

Remember, our protagonist needed to put down only 3.5% of her loan. 3.5% of $155,000 is $5425. Hence, she still has $2575 left on her $8000 credit. So she adds $34,000, which brings the total loan to $189,000. 3.5% of that is $6615. So even with the embellishments, she still has $1385 left.

Subprime round 2. This is it.

Ilargi goes into great detail why the government is doing this - hint: Not for you:

That is, the banks. Which can unload repossessed properties at much higher prices, given the tax credits. Which can keep properties and loans at greatly elevated prices on their books, which allows them to fool their shareholders and depositors into thinking they are far more healthy than they would be without government involvement. Who can use the artificially raised “values” on their books for highly leveraged financial wagers that if they pay off allow for multi-billion dollar bonuses, and if they don’t can be channeled back to the taxpayers’ account.

Why is this so important for the government? Why does Barney Frank proudly declare that the nation has a solemn commitment to those alleged “stable” housing prices?

Because without them, a huge chunk of America’s 8000+ banks will be toast.

So if all this is true, what’s happening - even here - is this:

1. Specific policy decisions have been made to try and reinflate the housing bubble, because without “stabilizing” housing prices at artificially high levels, the banks are in trouble, and homeowners - having seen the value of their primary investment plummet - feel less flush, and spend less.

2. But the only way we can reinflate the bubble is to return to the very conditions that caused the crash in the first place: Luring those who really shouldn’t be in the market into the market, via low down payments and free money.

3. But are they really capable of “affording” the house over the long term? Signs point to “no”:

Opponents fear that many buyers lured by the tax credit, and the low-interest, government-backed Federal Housing Administration loans typically used to finance them, might get in over their heads.

Studies have shown that the less money buyers put down, particularly if it comes from outside assistance, the more likely they will end up in foreclosure. Many new homebuyers are using the tax credit instead of their own equity to handle the down payment.

In recent testimony before a House panel, former Fannie Mae (NYSE:FNM - News) chief credit officer Edward Pinto said a past down payment assistance program resulted in default levels two to three times higher than the norm. …

<snip>

FHA and Veterans Affairs loans now account for more than nine in 10 mortgages with loan-to-value ratios that top 90%, he said, and most exceed 96%. The LTV ratio is the first-mortgage lien amount as a share of a home’s appraised value. The FHA requires just 3.5% down.

“The heavy use of the $8,000 first-time homebuyers credit may result in price and other distortions that effectively eliminate FHA’s protection from its small down payment requirement,” Pinto testified.

So how is all of this anything but a setup for an even bigger crash?

Update: Looks like the home buyer credit will indeed be extended, and expanded. Shocking.

But nationally - home sales fell in September.