One Year Later: Housing hits bottom?

A year after the global financial and credit markets melted down, the U.S. housing market is in a good-news, bad-news equilibrium. The good news: prices in many markets have fallen to pre-bubble valuations, home values nationally have stabilized, sales are rising, mortgage rates are low and loans are readily available to qualified buyers.

The bad news: as I recently described here, the foreclosure "pipeline" -- mortgages that are delinquent or in default--is full: since the "cure rate" of those homeowners who get current on their late payments has plummeted, the majority of these mortgages will enter the foreclosure process.
The cure rate has collapsed from 45 percent for prime loans all the way down to 6.6 percent, and it's around four percent for non-prime loans. Clearly, this is a major deterioration. Just a few years ago, almost half of all delinquent mortgages were "cured" (brought back up to current); now only one in 20 are clearing delinquency.

With about 9.6 percent of all mortgages in delinquency or default -- roughly 5 million of the 50 million outstanding mortgages -- this low cure rate suggests the foreclosure pipeline will be clogged for years to come.

Many observers had high hopes that hundreds of thousands of troubled mortgages would be renegotiated -- "modified" by the lender, in loan lingo -- but the available data puts the total modified loans at about 3.5 percent of about one million troubled loans. Other data suggests that most of these modified loans end up back in default within a year. Clearly, the modified loans are often still unaffordable to the borrowers.

The recent surge in sales and the stabilization in housing prices may partly be the result of lenders holding defaulted properties off the market until conditions improve: what some analysts are calling the "shadow inventory" of homes which have reverted to lenders but which are not listed for sale.

Though numbers are hard to come by, there is anecdotal evidence from borrowers who have defaulted on their loans that lenders are not foreclosing on properties, or even issuing the "notice of default" (NODs) which launches the foreclosure process.

Some of the "shadow inventory" may result from the process being slowed by the sheer volume of transactions. The flood of foreclosures has reportedly exceeded the ability of some lenders to process distressed property.

Whatever the reason, there appears to be a large inventory of homes which will have to come on the market sooner or later, and if classic economics holds sway, then this supply will likely exceed demand, suppressing prices.

To some analysts, the continuing transfer of private risk to the public via mortgage guarantees issued by "government sponsored enterprises" (GSEs like Fannie Mae and Freddie Mac) is a troubling continuation of a policy which has led to stupendous taxpayer bailouts of Fannie and Freddie.

As I noted in a recent column here, where FHA underwrote a mere three percent of mortgages in 2006, it now guarantees almost 25 percent of new mortgages -- a massive increase clearly designed to compensate for the implosion of lending by the failed Fannie Mae and Freddie Mac.

While almost everyone applauds the goal of home ownership, the connection between extreme leverage (no or low down payments for homeowners, and 30-to-1 or even higher leverage by lenders) and a higher risk of default is evident.

Thus the two percent reserve requirement for FHA--that its ballooning loan portfolio is backed by a mere two percent in cash, even as its default rate rises to 7.8 percent -- appears as wafer-thin as the high-leverage gambles which sank Lehman Brothers and a host of other high-flying investment banks and mortgage lenders.

The difference, of course, is that FHA will certainly be bailed out with taxpayer funds.

The good news is many new home buyers have made use of the $8,000 Federal tax credit. The bad news is that down payments as low as 3.5 percent for FHA loans mean that modest decreases in home prices can put these new homeowners under-water-owing more on their mortgage than the house is worth.

That is worrisome in a macro sense because being under-water is correlated to a higher default rate.

Lastly, there is some evidence that the speculative mindset which drove housing prices to unsustainable heights is still driving sales and unrealistic expectations for gains. REOs ("real estate owned," the term for bank-owned foreclosed properties) houses in Northern California which were purchased in June for $100,000 are back on the market a few months later at $150,000. Maybe extensive renovations were accomplished in those few months, but it's also possible that speculative buyers are hoping to have "caught the bottom" and are ready to reap the gains of a rising market.

With the pipeline full of distressed properties, that speculative fever might be a bit misplaced.

There is other evidence that much of the buying isn't of the "first-time home buyer" sort but the "investors/speculators snapping up bargains" variety. In certain markets such as Northern California, about 40 percent of all recent sales have been cash transactions -- a profile that is not typical of first-time buyers.

This raises several questions. How sustainable is the "buy the bottom" flurry of cash sales? What are all these new owners going to do with these homes? Rent them out? Re-list them as the market improves?

We might also wonder if the speculative fever of the housing bubble has run its course. If housing returns to its historic role as shelter first and a low-risk way to slowly accumulate equity via paying down debt, then quick profits from speculating in real estate may also be a thing of the past.

Charles Hugh Smith writes the Of Two Minds blog and is the author of numerous books, most recently Survival+: Structuring Prosperity for Yourself and the Nation.
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