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 The housing market is where it all started. Today, in spite of impossibly high unemployment, credit unavailability and zillions of foreclosed houses, a recovery seems at hand with both the Case-Shiller and FHFA home price indices bottoming out after for 5 consecutive monthly gains.


Is it magic or is it illusion?

How did this happen?

Since nobody would rush to buy depreciating houses, it was imperative to make people believe that prices were bottoming out.

  1. First get the Fed to expand its balance sheet such that mortgage rates would drop enough to quickly improve affordability.
  2. Then spur demand with a short-window tax credit that essentially provides any first-time home buyers (unburdened with underwater mortgages) with the required down payment.

These two quick steps kick started sales of lower priced new and existing houses, thereby creating some activity in this moribund market.

But supply also had to be controlled. Initially, many states imposed moratoriums on foreclosures. Banks quickly understood that flooding the market with millions of foreclosed homes would be self-defeating so, as Raymond James & Associates notes,

lenders seem to be delaying processing thousands of foreclosures that continue to build in the distressed inventory pipeline

Bingo! The huge supply overhang disappears into Nerverland. These 2 charts confirm that foreclosures are seriously lagging delinquencies.



Chart from First American CoreLogic. (SD= Serious Delinquency) June 2009

In just a few months, demand was suddenly rising as young people wanted to take advantage of the closing tax credit window. This renewed, albeit limited, activity eventually ate into supply, also suddenly evaporating. Prices began to firm up. Media headlines proclaimed the bottom and, soon enough, consumers, economists and investors  began to believe that housing was fundamentally recovering. Meanwhile, the Fed was supportively repeating the Greenspan vow of keeping rates low for an extended period.

Finally, to make sure, Congress extended the expiring tax credit and made it available to just about everybody on just about any type of house. To top it off neatly, the tax credit is claimable on 2009 taxes so that scantly any down payment is needed on 2010 closings (sounds familiar?).

Voilà! Subsidized demand + concealed supply = rising prices.

Certainly a clever, if not brilliant, scheme if the goal was to kick start the root cause of the problem.

But is it magic or illusion?

Lender Processing Services (NYSE:LPS) reports that nationwide foreclosure inventories continued their upward climb in October and, importantly, that

The number of loans deteriorating further into delinquent status is now more than twice the number of foreclosure starts, indicating another major wave of troubled loans in an already clogged loan pipeline. Nearly one-third of foreclosures remain in pre-sale status after 12 months – twice as many as the year prior. The six-month average deterioration ratio has risen the past two months to 300 percent, showing that for every loan that improves in status, three more deteriorate further.

Take a look at Florida which has the largest concentration of active loans in foreclosure across the country with 12.7% of all mortgages statewide in foreclosure and 24.9% of mortgages in some form of delinquency or foreclosure. Yet, according to LPS,

just 1.75% of Florida mortgages are classified as "REO inventory" (bank-owned), only slightly above the national average of 1.37%.

This “lack” of REO inventory meaningfully contributes to the low level of listed inventory, creating the illusion of a more balanced demand/supply situation, thereby helping sustain prices. In addition, there are currently 2 million underwater mortgages in Florida which is 2.6x the current level of “distressed” homes (foreclosures and seriously delinquent loans). These will eventually add to the already large shadow inventory. Similar conditions are found in other distressed housing markets (see for example HOUSING WATCH: CALIFORNIA HOUSING UPDATE).

There is the problem! In spite of all the hoopla!, the improving second derivatives, tax incentives and other creative incentives and “warehousing”,  housing fundamentals just keep worsening.

Even assuming a 50% workout rate on Florida's active foreclosures and seriously delinquent loans (766,800 mortgages altogether), implicitly we (Raymond James) estimate there is an additional 19-month backlog of distressed inventory statewide, not factoring in current bank-owned inventory.

In California:

according to Mortgage Bankers Association data, as of September 30, more than 800,000 California mortgages were either in foreclosure or seriously delinquent. Even assuming a 50% workout rate on those loans, we estimate this implies an additional eight months of supply statewide above what is currently being reflected in the realtor data.

How much inventory there is in total is unknown because REOs are not public, but adding the current visible inventory to the current shadow inventory plus the eventual workouts, it looks like Florida has between 2 and 3 years of housing inventory to clear before the market gets back to normal. In varying degrees, the situation is essentially the same in all distressed markets across the US.

That said, as long as banks continue to slowly process this foreclosure backlog, allowing for its gradual absorption, and as long as the economy keeps recovering, it is possible that the housing market will continue to gradually improve. Unfortunately, artificially maintained markets are difficult to sustain for long periods. The extension and widened scope (70% of current homeowners are eligible) of the tax credit obviously seeks to help until its scheduled expiry in mid-2010.

The tax credit for first-time buyers has resulted in a 10% increase for home sales from March to November, according to a forecast by Thomas Popik, research director for Campbell Surveys. “We’d expect the effect of the proposed tax credit for current homeowners to be about half as large,” he says, or around 5% of an estimated 3 millions transactions.

However, the Fed is scheduled to end its mortgage bond purchase program in March 2010, an untimely date given the extended tax credit program. Were interest rates to rise (Goldman Sachs estimates Fed buying has reduced mortgage rates by 30 basis points), housing demand could be negatively affected and prices could weaken.

First American CoreLogic estimates that

Nearly 10.7 million, or 23 percent, of all residential properties with mortgages were in negative equity as of September, 2009. An additional 2.3 million mortgages were approaching negative equity, meaning they had less than five percent equity. Together negative equity and near negative equity mortgages account for nearly 28 percent of all residential properties with a mortgage nationwide.

 How deeply in the hole are these negative equity homeowners?

The average value for all properties in negative equity is $210,300. The average mortgage debt for properties in negative in equity was $280,000 and borrowers that were in a negative equity position were upside down by an average of nearly $70,000.

House prices must therefore rise 33% before break-even is reached! It is highly unlikely that we would even come close to this for many years to come given the current huge demand/supply imbalance and the fact that this would bring the Case Shiller House Price Index nearly at its recent peak when affordability was at its worst in 2 decades.

Housing is where it all started. But it ain’t finished yet.

Disclosure: no positions