1 Big Reason to Be Optimistic About Housing

By many measures, a recovery in the housing market looks to be under way. Nationwide home prices have improved markedly over the past year, as have sales of new and existing homes. There also appears to be a rebound in construction activity, as evidenced by rising housing starts and improved homebuilder confidence.

Rising home equity
Besides fueling investors' and prospective homeowners' confidence in the stability of the housing market, the year-over-year improvement in home prices also has other important knock-on effects. Namely, it's allowing thousands of homeowners to finally reach positive equity in their homes and offering them the option to sell or refinance.

So far this year, over 1.3 million homeowners have reached positive equity in their homes. According to Zillow, a leading provider of real estate information, nationwide total negative equity came out to $1.15 trillion as of the end of June, down $42 billion from the end of the first quarter.

The share of borrowers with negative equity fell especially drastically from Q4 2011 to the first quarter of this year. According to the Federal Reserve's Flow of Funds data, home equity in Q1 2012 improved at the sharpest quarterly rate in more than 60 years. And this trend shows no signs of slowing down.

According to CoreLogic, a leading provider of housing market information and analytics, roughly 600,000 underwater borrowers regained equity in their homes in the second quarter this year. As of the end of June, the percentage of homeowners with negative equity fell by 1.4% to 22.3%, as compared to 23.7% as of the end of the first quarter.

But the improvement in home prices wasn't the only reason for the falling number of underwater borrowers. Rising foreclosures also played a role, as banks seized delinquent borrowers' homes and allowed homeowners to sell their homes for less than what they owed through short sales. In the second quarter, banks and other lenders repossessed nearly 160,000 homes.

Who benefits from improving home equity
Rising home equity is great news because equity makes up the largest component of homeowner wealth. According to Stan Humphries, Chief Economist at Zillow, homeowners with negative equity sport higher foreclosure rates and tend to have greater difficulty relocating, since they would lose money were they to sell their home.

The negative equity issue tends to afflict younger borrowers more, with nearly half of borrowers under the age of 40 owing more than their homes are worth. Homeowners aged between 30 and 34 sported the most alarming rates of negative equity, at 50.8% as of the end of June. Borrowers aged 25 to 29 were at 47.6% and of those aged 35-39, 46.3% owed more than their homes were worth.

Importantly, some of the most rapid gains in home prices were in the states hardest hit by the housing bust and consequently had a large percentage of underwater homeowners. For instance, Arizona, Georgia, Florida, Michigan, and Nevada combined accounted for nearly 35% of total nationwide negative equity. In Arizona, home prices leaped by a staggering 17% compared to a year ago, representing the sharpest increase by far. And in Florida, Michigan, and Nevada, prices rose 6.6%, 4.8%, and 5.1%, respectively. Not too shabby.

So has housing finally turned the corner?
It's tough to say. While a rapid, V-shaped recovery in housing is unlikely, the case for a gradual rebound is strong. Clearly, there's a lot of support for the housing market. Most recently, the Federal Reserve announced its latest round of quantitative easing, or QE3, which is expected to drive down mortgage rates further and make the prospect of owning a home even more enticing. But will it work?

So far, QE3 has had a notable impact on mortgage rates. The average rate on a 30-year fixed-rate mortgage last week was 3.37%, down 20 basis points from September 12, the day before QE3 was announced, when it stood at 3.57%. While this rate reduction is certainly an improvement, millions of potential homeowners across the country are unable to reap the benefits due to extremely tight mortgage credit standards.

So it appears that the Fed's plan, while allowing banks to rake in huge profits from their mortgage businesses, may not have a substantial impact on the number of new loans, at least in the near-term. QE3 also may be bad news for a certain type of company -- the mortgage real estate investment trust, or mREIT.

With open-ended purchases of mortgage debt likely to lower long-term rates even more, these companies' already low net interest margins could decline further. Add to that the trend of rising prepayments, and it could mean some of those eye-popping dividends may be in jeopardy.

That's not to say that all mREITs are in trouble. While these headwinds impact the mortgage REIT sector as a whole, it's important to distinguish among companies. As Fool contributor Sean Williams notes, the situation boils down to differing risk profiles among mortgage REITs.

On the one hand, companies like Annaly Capital (NYS: NLY) and American Capital Agency (NAS: AGNC) invest solely in agency-backed securities, which have the advantage of implicit default protection through the full faith and credit of the US government.

On the other hand, companies like Invesco Capital Mortgage (NYS: IVR) , Chimera Investment (NYS: CIM) , and Two Harbors Investment (NYS: TWO) purchase both agency and non-agency securities. While companies investing in non-agency securities can potentially realize higher net interest margins, they also incur greater risk than companies invested exclusively in agency securities.

Therefore, when assessing QE3's impact on mortgage REITs, one should investigate exactly what type of mortgage-backed securities they're invested in. Some may be more resilient to shrinking net interest margins than others.

Take Annaly for instance. The company has held up quite well in earlier periods of turbulence and has minimal exposure to defaults thanks to a practice of investing only in agency-backed securities. While its margins have declined significantly over the past year and its dividend is likely to see further cuts, these factors alone may not warrant abandoning the stock.

To find out more about the risks facing mortgage REITs and whether or not your investment is safe, be sure to check out The Motley Fool's brand-new premium research report on Annaly Capital Management. It outlines three essential points that all current and prospective Annaly investors need to know, as well as a host of other important information put together by our analysts. On top of that, the report comes with a full year of exclusive updates. To unlock your investing edge, just click here.

The article 1 Big Reason to Be Optimistic About Housing originally appeared on Fool.com.

Fool contributor Arjun Sreekumar has no positions in the stocks mentioned above. The Motley Fool owns shares of Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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