Foreclosures Will Moderate as Home Prices Continue to Fall

by: Michael Steinberg

There will come a time when most of the homeowners that intend to walk away from their mortgages have done so. True, whether defaulting by choice or by the lack of the ability to pay. As the 2005, 6 and 7 vintages mature, their default rates will be more tied to the local economies than bad underwriting. Unrealized losses related to the fluctuations in housing prices will become less relevant.

Some of the strongest banks have recently announced plans to eliminate prepayment penalties on the first mortgages and freeze or lower rate adjustments on the home equity loans that they maintain on their balance sheets. We are beginning the see a divergence between bank owned loan modifications and securitized loan modifications. This trend will strengthen the commercial and savings banks at the expense of the investment banks. No government programs required.

This paints a fairly optimistic picture for the commercial and savings banks, as long as they can maintain the confidence of their depositors. So how can an upbeat forecast for commercial and savings banks reconcile with continued home price declines? Two reasons: First, MBS and CDO trusts have too many conflicting stakeholders to modify loans in a pragmatic manner. This will lead defaults and subsequent foreclosures to skew in their direction. Second, much of the housing stock built recently to feed the investor boom does not meet the needs of current owner occupiers.

I classify investors broadly to include owner occupiers who bought more home than they needed with an eye toward appreciation and second home buyers with the same intent. With energy, insurance, property taxes and home owner association costs rising rapidly, the number of people that can run a 4000 square foot Toll Brothers (NYSE:TOL) home is becoming more limited. As mortgage qualifications tighten, fewer buyers can even enter this arena. And those that can qualify are too cautious to over invest (so says Bob Toll). Clearly this near luxury segment is out of sync with current buyers’ interest.

The near luxury trend will lead to cost problems as this housing stock ages. Kitchens and baths were equipped with non-standard appliances and fixtures. The next generation of owners will be facing expensive repair or replacement bills for the Sub Zero refrigerators and Viking commercial style ranges. A General Electric (NYSE:GE) replacement cannot be popped in. An owner occupier might be scared away.

The South Florida market was particularly tailored to the needs of investors over owner occupiers. As boom gained momentum, condo square foot pricing had the potential to leave out many investors. To address that concern, developers shrunk one bedroom units to under 800 square feet and eliminated second baths. Two bedrooms shrunk to 1000 square feet or less. Beyond investors, New York City dimensions won’t sell in Miami. The limited audience for these will reduce the square foot prices from the $400 to $800 that investors paid back to the $150 level of the mid 1990s.

South Florida also has excess of very large planned gated communities (golf, tennis, boating and others). Most are high cost, high amenity developments focused on ostentation. They lack any sense of emotional warmth that the “new urban” architecture is successfully developing. Boca Raton is a microcosm of the old trend. Golf communities are now spending heavily building grand entrances and on upgrading their amenities trying to stay relevant. They do not realize that they are dinosaurs and their home values cannot be saved.

I like to draw a parallel between the housing market and the car market. As styles change, most owners maintain the payments on their loans. But the resale value of their investments decreases. There is little appetite for extremes when trends shift. Prices for extremely large and extremely small homes will continue to have the most rapid decline, while right sized homes could soon begin to stabilize. Toll Brothers style homes are going the way of the SUV.

No Disclosures.

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