The 2011 Housing Market Outlook: Unsettled, Underwater and Unsold

Given the importance of the housing market to the nation's balance sheet, it's no surprise that many observers are looking for any evidence that prices on family homes have finally bottomed out. For those watchers, Nov. 2 had a bit of good news: The National Association of Realtors reported that its index of sales agreements for previously occupied homes rose 10.4 % in October.

But that positive statistic must be placed in a longer-term context of declining prices, bulging inventories of unsold homes and ongoing legal improprieties in the nation's foreclosure machinery. And against that background, the NAR's news doesn't feel all that impressive.

The rise in sales agreements is also clouded by reports that new-home sales fell 8.1% in October to a seasonally adjusted annual pace of only 283,000, a near-record low, while existing-home sales declined 2.2% to an annual rate of about 4 million. In the third quarter, home sales tumbled 25% to a 4.16 million seasonally adjusted annual pace from the previous three months, a rate that was 21% below the 5.28 million clip of 2009's third quarter.

Some real estate analysts foresee another three years of price declines as the massive inventory of underwater and foreclosed homes is slowly sold off, and we need look no further than the basics of supply and demand to understand why: Analysts estimate that as many as 12 million more properties will be put up for sale over the next few years. If about 4 million homes are sold annually, then it would take three years to clear the backlog.

Homeowners in a Money-Losing Position

The so-called "shadow inventory" of unsold homes -- bank-owned properties that are being held out of the market by lenders -- is also rising. Though banks have sold around 700,000 foreclosures in the past nine months, that is down 25% from last year's sales. Analysts from Morgan Stanley estimate that the number of bank-owned and foreclosure-bound homes that have yet to hit the market is close to 8 million.

In light of this imbalance between supply and demand, some real estate observers expect house prices to fall another 8% from current levels.

Nearly one-quarter of all U.S. homeowners with a mortgage -- 11 million borrowers -- owed more than their homes were worth as of June 30, according to real estate analytics firm CoreLogic. Another 2.4 million borrowers had less than 5% equity in their houses and would likely lose money on a sale after paying broker fees and closing costs.

Given the millions of homes in the foreclosure pipeline, it's little wonder that prices are falling in most markets. Demand for foreclosed properties fell off a cliff in the third quarter, providing more evidence that housing appears to entering a second leg down after prices and sales recovered in 2009 and early 2010.

Home Equity Still Way Down

According to the Federal Reserve's most recent Flow of Funds Report, homeowners' equity is down about $6 trillion from the 2006 top in real estate prices. While the recovery in home valuations boosted homeowners' equity from a low of $6 trillion up to $7 trillion, homeowners' equity as a percentage of home values is still down from a high near 60% to 40%. Since one-third of American homes are owned free and clear, most of that equity resides in homes that are unencumbered by mortgages.

Home mortgage debt has slipped modestly from $10.5 trillion to $10.15 trillion, largely as a result of lenders' write-downs in short sales -- where homes are sold for less than the mortgage owed and the bank accepts the loss -- and foreclosure auctions.

So, while the recent recovery in sales and prices has lifted homeowners' equity somewhat, households have still lost $6 trillion in equity, and one-quarter have no equity at all and owe more on their mortgages than their homes are worth. Household mortgage debt is still close to the levels reached at the peak of the housing bubble.

Foreclosure Woes and Tightening Standards Cloud the Market

Though lenders insist they have restarted foreclosure proceedings with more careful attention to due process, a host of legal actions are calling that claim into question.

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In one recent case, U.S. Bankruptcy Court Judge Judith H. Wizmur rejected a foreclosure claim on the home of John T. Kemp of New Jersey, ruling that his mortgage company had failed to deliver the note to the trustee as required when it sold the mortgage. That may leave the new trustee, Bank of New York Mellon, with no standing to foreclose, and the ruling casts doubt on the legality of many, many other foreclosures.

Other legal battles have erupted over short sales as the primary mortgage holders have been stymied by lenders holding second mortgages who refuse to sign off on sales that give them little of the proceeds.

Meanwhile, real estate attorneys are poring over thousands of records, scanning for serious errors which could negate foreclosure claims by lenders, while holders of mortgage-backed securities are pushing banks to buy back improperly transferred mortgages.

As my colleague Abigail Field reported for DailyFinance, thousands of Pennsylvania foreclosures are now in doubt due to the questionable practices of just one foreclosure processing firm.

Modifications Are Working Only Half the Time

The market of possible buyers has shrunk as well. As the Federal Housing Administration has guaranteed more mortgages in recent years, the default rate on FHA loans has skyrocketed. In an attempt to stem this rising tide of foreclosures, lenders have raised their minimum credit score on FHA-insured loans to 640 from 620. That will exclude about 6 million people from the pool of potential homebuyers, according to FICO, which created the formula for the ratings.

With over 9% of prime mortgages now in default, it's especially troubling to industry observers that the loan modification programs designed to save households from future defaults are experiencing redefault rates of 50%, meaning half of the households that receive mortgage modifications end up defaulting again within a year.

Add all these factors up, and it seems likely that the housing market will remain unsettled in 2011.