Clouds Over the Recovery

Clouds Over the Recovery

Even as prospects for the economy improve slowly, the outlook for housing sales and home prices remains weak. A consensus is emerging, however, that the recovery will resume in the second half of 2011.

Mortgage Banking
December 2010

By Robert Stowe England

“Caution ahead” is the word to the wise for those in the housing sector. Full recovery remains three or more years away. For now, housing market bears see a double-dip going well into 2011. The bulls see, at best, a market bouncing along the bottom before moving up modestly late next year, with the potential for an improved pace of recovery in 2012.

Sales of new and existing homes began to weaken over the summer with the expiration of the tax credit for homebuyers, further weakened by a slowing economy. Worries began to rise for a double-dip.

“Yes, the housing market is double-dipping,” says Mark Zandi, chief economist at Moody’s Analytics, West Chester, Pennsylvania. “Certainly that’s been the case with respect to sales and starts, and now I think we’re seeing it in prices. House prices are weakening, and I expect more price weakness well into the next year,” he adds. “So, I think it’s fair to say the housing market is double-dipping.”

What are the factors driving this decline? Zandi sums it up as: “The weakening of the job market. The job market is still very soft. It’s weakened a bit since the spring. Of course, that’s served to hurt consumer confidence, which is the key to a big purchases like buying a home.”

“The backside of the third housing tax credit has also been a factor,” Zandi adds. The tax credit ended June 30 for purchases with contracts made prior to April 30. “People moved forward to take advantage of the credit, and that has hurt the market in the wake of the credit,” he says.

And consumers remain cautious. “There are probably potential buyers waiting to see if there is going to be a fourth tax credit. Home sales and construction fell back in August and September. House prices have declined. Then, in the case of house prices in particular, we’re seeing the share of home sales that are distressed tend to rise. The percentage of sales that are foreclosures or short sales is increasing. As that share is rising, house prices are going to fall,” explains Zandi.

He also expects home sales and housing starts to remain essentially flat through next spring’s selling season. “Then I would see some modest improvement through the year” of 2011, Zandi says.

“I don’t think we’ll see significant improvement in sales and construction until 2012, but by the second half of 2011 we’ll see some improvement--just a bit.”

Distressed properties the wild card

The pace at which the nation is able to dispose of distressed properties--those in foreclosure or real estate-owned (REO), plus those underwater where homeowners owe more than the homes are worth--remains a key unknown.

The foreclosure crisis burst back on the front page in late September, when news broke that Charlotte, North Carolina-based Bank of America and other large banks were suspending sales of foreclosed properties due to the discovery of thousands of mortgages with flawed foreclosure-processing documentation. Many foreclosure-related documents were apparently robo-signed without people reviewing them for accuracy.

Most large banks have resumed their foreclosure processing after having reviewed the accuracy of their documents and taken new steps to make sure the process meets all legal standards going forward.

Zandi expects much of the improvement in sales to come from rising levels of distressed sales. The paperwork fiasco has slowed down that process, and its successful resolution will determine the timing of the bottom of the second dip in housing, according to Zandi.

With higher levels of distressed sales, Zandi expects “further declines in prices  through most of next year as the distressed share of sales rises,” he says. The share of distressed sales will peak, he adds, in the second or third quarter--most likely the third quarter, he says.

Zandi’s forecast of the peak for distressed sales is one he makes with only “little conviction” because of uncertainties surrounding the pace at which banks can successfully correct flawed documentation of foreclosures.

“If the [robo-signing issue] turns out to be a bigger problem, it could delay sales for a long time,” he says. “If it does, then we’ll see actually stronger house prices near-term and weaker prices longer-run” when distressed properties are ultimately sold. “So, the timing of the bottom of house prices is very uncertain, given issues like the robo-signing issue.”

“I say with a great deal of conviction that prices are going lower. I don’t say with conviction the precise bottom,” the housing economist explains.

Zandi predicts prices will fall another 8 percent from the second quarter of 2010 to [bottom in] the second quarter of 2011. That will represent a 34 percent price decline from the peak in the first quarter of 2006 to the trough in 2011, he says.

As most would expect, the states with the highest foreclosures “will be the places with the most severe price declines--Florida, Arizona, Nevada, central valley of California, parts of the Midwest and the Atlanta market,” says Zandi. There will be  further home-price declines greater than the national average of 8 percent in those particular markets.

Among the distressed states, the outlook for Florida is among the worst, according to Zandi.

“The other issue in Florida is that the job market is particularly bad,” he says. The outlook for Florida housing sales and prices will depend on construction, tourism and migration of older households. “All those things are under a lot of pressure,” he notes.

“Mobility is significantly impaired by the fact that there are so many underwater [borrowers]. This proportionally hurts parts of the country that rely on in-migration, like Florida,” Zandi points out. Florida, a state that has seen a perpetual in-flow of people, is, in fact, currently suffering from out-migration, he adds.

Hitting bottom, again

New York-based Standard & Poor’s (S&P) concurs that home prices are likely to see another 8 percent decline in prices from current levels in the S&P/Case-Shiller Home Price Index. “I think they will probably come down to a bottom sometime early spring,” which will take prices “to about where you were in April 2009, which was the low point,” says David Wyss, senior economist at Standard & Poor’s.

If you measure prices in terms of the Federal Housing Finance Agency House Price Index, S&P predicts the drop will be less and will occur a little later than next spring.

As for home sales volume, Wyss says we are seeing an “abnormal trough” in home sales  that is a result of the “abnormal boost” that took place in the spring. “Now we are going to see things stabilize and gradually recover” to an annual pace of just over 5 million in 2011, he says.

While the foreclosure-documentation crisis is “a bit of a wild card,” Wyss says, “my presumption now is that the foreclosure thing will be settled, and it will prove to be much less of a deal than it has been built up to be.” This means that foreclosures will go back up again.

The foreclosure data most often cited are typically foreclosure filings. “That is not what really counts for sales. What really counts is when it becomes REO,” Wyss says. “And that lag between foreclosure filings and actual foreclosure has been getting longer and longer” because of the rising volume of foreclosure proceedings, he says. “The courts are clogged. The banks are clogged. Everybody’s clogged.”

Because of the steady flow of foreclosures and REO properties, distressed sales will remain high, according to Wyss. The Case-Shiller Index, which is comprised of all sales, includes distressed sales. “This probably biases down” the Case-Shiller Index, he adds. “In almost every city, the biggest decline [in home prices] since the peak is in the bottom third of properties.”

Underwater borrowers

How much shadow inventory is represented in the pipeline of foreclosures and expected short sales of homeowners underwater? “Obviously that’s one of the questions” that needs to be answered in order to determine where home prices and sales volumes will go, Wyss says. “And nobody is sure. Our guess is somewhere between 3.5 [million] and 5 million.”

Distressed sales for homeowners who are underwater face a number of barriers to bringing those homes to market. This, in turn, makes it difficult to measure the shadow inventory. “One of the big problems is the existence of a second mortgages,” says Wyss. “It makes it very difficult to get a revision of the first mortgage and very difficult to get short sales [done],” he adds.

“If the second mortgage does not get wiped out, it just adds to the negotiating difficulties,” Wyss says. “The guy with the second mortgage usually has very weak negotiating position. All the mortgage has is nuisance value, and they’re quite prepared to be nuisances.”

He adds, “You are getting some dealings on second mortgages that are, frankly, approaching fraudulent at this point.” Press reports have cited instances where holders of second mortgages have been selling the foreclosed second mortgages, when the second mortgage is “totally worthless,” according to Wyss, because it is subordinated to a first mortgage that is itself greater than the value of the house.

The foreclosed second mortgages are generally not being sold by banks but by intermediaries who are “buying up distressed loans cheap” and “misrepresenting what they are selling,” Wyss explains.

How long will it take for the housing market to return to a state not dominated by REO sales and distressed sales and all the problems plaguing the current market?

“I think we will be over the worst of it by the end of next year,” Wyss says. However, return to a more normal market could take much longer.

“Frankly, I don’t think we will be back to a normal level of new-home construction starts until 2015,” when prices will stabilize at levels more consistent with income, he says.

Now that’s affordable!

Home prices had fallen so far by September that the Chicago-based National Association of Realtors’® (NAR’s) Housing Affordability Index reached its highest level since it began, according to NAR Chief Economist Lawrence Yun.

The affordability index reached 179.1, which means that with a 20 percent down payment, the median-income family has 179.1 percent of the income it needs to qualify for a conventional fixed-rate, 30-year mortgage covering 80 percent of a median-priced existing single-family home.

In September, the affordability index was calculated based on a median-priced existing single-family home priced at $127,600 and a 30-year fixed-rate mortgage (FRM) rate of 4.68 percent. That would amount to a monthly principal and interest payment of $714. A family earning $34,272 could qualify for such a mortgage, based on an underwriting rule that the monthly housing expense should not exceed 25 percent of the gross monthly income.

By contrast, the median national family income for September was $61,395. For that family, the monthly payment for a median-priced home would represent a very frugal and affordable 14 percent of monthly income.

“Given current very low mortgage rate conditions, [low home prices] may steadily induce buyers back into the market, even without the tax credit,” says Yun.

Shadow inventory not a problem

Further, he does not see any meaningful change in home values between now and the end of next year, either up or down. “They are not going down, because it has already corrected. I don’t see it going up, because the economic recovery and job-creation pace is sluggish,” he said in late October.

What about the foreclosures still to come? “The shadow inventory of foreclosures will not be an overhang on the market,” he predicts. Yet he adds this caveat: “If buyers are not there, then the market will face trouble.”

Yun points out that foreclosures were pouring into the market in 2009, and “we saw home values stabilize during this time period because there were buyers ready to eat into and absorb the foreclosed properties.”

The tax credit pulled buyers into the market earlier who would have been buyers later in the year in the absence of a tax credit, “depleting the pipeline of buyers,” says Yun.

“With some job creation, very low mortgage rates, hopefully these two conditions are able to induce people to come into the market. And if that’s the case, then I think the shadow inventory will not be a problem, just as it was not a problem last year,” he says.

Yun says that beyond the shadow inventory of foreclosed homes, there is also the shadow inventory of newly built homes or housing starts. “There is very little of that,” he notes. “So that is helpful for the broader inventory picture because new-home inventory has been so low.”

Yun estimates 4 million to 5 million  housing units of shadow inventory that could come onto the market in the next few years. If the pace of home sales returns to a pace of 5 million annually by early 2011, as he expects, then it would take 18 months to two years to fully absorb the shadow inventory. “I think that could happen,” he says.

For 2009, home sales reached 5.2 million and they are expected to hit 4.9 million for 2010, once all the data is tabulated, according to NAR’s Yun.

“If we get something around 5 million next year [2011], that will be saying that the housing market will start to normalize on its own power” without tax credits and other incentives, Yun says. After that, the growth in home sales will follow job-creation growth, which would be anywhere from 2 percent to 5 percent, reaching 5.2 million in 2012.

Yun forecasts a sluggish economy, but not an economy-wide double-dip “as long as home values do not change in a meaningful way from my baseline forecast.”

Yet, he would be worried if home values were to tumble close to a double-digit pace of 8 percent to 10 percent. “Then we could fall into a vicious cycle where you have falling prices, which automatically means higher foreclosures, which means further falling prices,” he explains. That is a less likely scenario, given the price stability of the past 18 months. With job gains and low mortgage rates, prices should hold steady, according to Yun.

A demand-side problem

The key to recovery in housing is an improvement in the pace of job creation, according to Douglas Duncan, chief economist at Fannie Mae. He found a glimmer of hope in the November employment report from the Department of Labor, which noted 151,000 jobs had been created in October and the level of job creation in the prior two months had been revised upward.

Job creation in the private sector “has to happen on a continued and increasing basis going forward for housing to move more rapidly to recovery,” Duncan says. This is only one month’s data, so time will tell if it becomes a trend, he adds.

“Our view is that the biggest problem is weakness on the demand side,” he says.

Fannie Mae’s National Housing Survey of household attitudes reflects that weakness, Duncan says. The survey of 3,500 households asked: “If you move, will you be more likely to own or rent?” In the survey conducted from December 2009 to January 2010, 54 percent of respondents said they would be more likely to rent than own. However, in a similar survey conducted in June and July 2010, 60 percent said they would be more likely to rent. “That’s a demand-side weakness problem, from our perspective,” Duncan says.

Expectations about home prices in the Fannie Mae household survey also reflected weakness. Those surveyed last summer expected home prices to rise in nominal terms 0.9 percent, “which means a real price decline,” Duncan says. The same survey found respondents expect rents to rise 3.6 percent.

“That would reflect their view that the demand side of the rental market is going to be stronger than the demand side of the owned market,” he says. 

“There is the sense of caution because of what has happened in the near term, and their concerns are appropriately [two-fold], can they credit-qualify to buy the house but also [can they] sustain the house once they have it,” Duncan says.

“They also understand that credit conditions are tighter, and they expect them to be tighter going forward.” Households surveyed also said they expect interest rates will likely go up. “They are historically low, so that’s a reasonable expectation. So things all line up, from our perspective, to be weak on the demand side,” Duncan says.

Duncan still sees foreclosures, “while they may have peaked or be peaking,” will add supply to the housing market. However, he adds, “Thankfully, the new construction is at a very low level and it just has to stay there while all these vacant properties are worked off to where supply levels get back to normal.”

Once private-sector job growth begins to build, “we will see household formation start to expand, and then when household formations start to expand that will move things on the demand side of the housing market,” Duncan says.

A long way from normal

For now, the housing sector is a very long way from normalcy, according to Duncan. He defines normal as a situation where the demand generates sufficient new housing construction to meet the creation of new households from population growth. When will that be? Duncan expects that to happen in the first quarter of 2014.

“We’re well aware that lots of things can change between now and then,” he says. “But if nothing changes between now and then, that would be our forecast.”

The main reason it will take so long is “largely because of the overhang of vacant properties, which are putting downward pressure on prices,” Duncan says. “We expect more downward pressure on price in 2011, but that, subsequently, prices should start to go in the other direction--although not directly.”

Duncan says a lot of homeowners are sitting on the sidelines who would like to sell, “but either they’re underwater or they are not going to get a price that meets what they’re willing to accept.” That view is picked up in Fannie Mae’s housing survey.

“When we asked people if it’s a good time to buy a house, 70 percent say it’s a good time to buy a house. When we ask them if it’s a good time to sell a house, 83 percent say it’s a bad time to sell a house. So they get it,” Duncan says.

Fannie Mae’s October forecast is for total housing starts for 2010 to come in around 600,000, of which 125,000 to 135,000 are multifamily. In 2011, there will probably be an increase of 100,000 to total starts of 700,000, with maybe 75,000 of that from additional single-family. “Some pick-up, but remember, we were back at numbers of 1.4 million starts or something like that, so we still are a long way off. That’s why you can see it takes until 2014 to get ramped up to that long-run level,” says Duncan.

“In the housing market, change takes place at the margin, and so price is determined at the margin as well,” Duncan says. “But there are vast shares of housing stock that simply don’t turn over for long periods of time. And so to take the price behavior at the margin and extrapolate it to the entire housing stock in some sense really distorts reality.”

And that’s part of the discussion associated with using the Case-Shiller Home Price Index series to value the housing market. Case-Shiller is “overweighted in the portion of the market that were in the bubble and now are sort of melting down.”

For example, Duncan says, “House prices never fell in Northwest [Washington,] D.C. They continued to rise through this entire time period [from after the national peak in home prices in 2006 to the present]. It’s just that there’s not much turnover there. People buy and hold for long periods in that section of the market. So, you have to be a little careful about how you’re thinking about things.”

Duncan explains that of the nation’s overall housing stock some 300,000 units are destroyed by storms, by obsolescence or torn down or replaced annually. He adds, “Then growth in the population and household formation adds somewhere, on average, in the long run, maybe 1.2, maybe 1.4 million households that want to own. And that’s the incremental ‘add’ to housing stock.”

He says, “In terms of new-home sales, we’re probably going to be for 2010 in the mid-300,000s--325,000 to 350,000 units. That will rise to 400,000 in 2011. We’ll still be under 5 million existing-home sales probably until 2012.”

Duncan does not see existing-home sales going much above 4.75 million for all of 2010 and only slightly more in 2011. By contrast, it was 5.15 million in 2009.

What about home prices? “Let’s say we expect a little bit of price decline in 2011, maybe in the 2 [percent] to 3 percent range,” he says.

And of course, it all depends on whose measure of house price you’re using. “From a Case-Shiller perspective, probably more along the 5 percent range,” Duncan says, because that index captures more of the higher-priced properties.

Credit standards will also be a factor in the pace of recovery, according to Duncan. “What has happened is that over the last three years, standards have tightened dramatically. [For now,] they have stopped tightening, but there is only fleeting evidence that there has been any loosening of those standards,” Duncan says. “If there is some loosening of standards, then folks may start to ease the forecasts a little bit,” he adds. Fannie Mae’s forecast assumes credit standards remain tight in the near term. 
Recent house price data

The leading edge of the recent price decline showed up in the August data from the S&P/Case-Shiller Home Price Index’s 20-city composite, which fell from 148.91 to 148.59. The 100 benchmark reading of the index represents the price level that prevailed in 2000. Home-price levels on the 20-city composite now stand at 2003 levels. August prices were released in late October.

Home-price data from Truckee, California-based Clear Capital shows even more dramatic declines through October 2010. The quarterly national Clear Capital Home Data Index fell 5 percent in a composite of the four prior months of July, August, September and October, compared with the three months of April, May and June. The Clear Capital Home Data Index is a rolling-quarter index that compares the most recent four months with the prior three months, and can be calculated for any date.

Clear Capital finds the most recent index through the end of October represents a decline in national home prices of 6.8 percent, measured from mid-August. When Clear Capital posted its index for August 2010, by contrast, there was a gain in home prices of 5.7 percent over the prior quarter, but the pace of gains was slowing. At the time that it published its August index, Clear Capital was predicting there would be no double-dip in 2010. The outlook deteriorated quickly over a two-month span.

Clear Capital measures REO sales separately from fair market sales and combines them into a single index, explains Alex Villacorta, Clear Capital’s chief statistician. In the most recent measure from October, REO sales represented 23 percent of total sales nationally. That is down considerably from a peak of 40 percent in the first quarter of 2009. “Even so, one in four is still a large presence in the real estate market,” says Villacorta.

Clear Capital, which measures price trends in the entire nation in virtually all counties, gives equal weight to changes in home prices for all homes rather than giving more weight to higher-priced homes, as some indexes do. Clear Capital’s index, thus, captures greater price changes than do other indexes because of this, explains Villacorta.

From a peak in home prices in the second quarter of 2006, home prices fell an astonishing 41 percent to a trough in the first quarter of 2009. From there, prices recovered 13.5 percent to a recent peak in June 2010. While prices have fallen 5 percent from the peak, they would need to fall another 7 percent to 8 percent to fall below the previous trough, Villacorta says.

“At the national level, what we’re looking for is to see if the most recent drop in prices is a function of the tax credit pull-back or a larger issue related to the economic health of the country,” says Villacorta.

“We will see if the rate of decline continues well into the first quarter of 2011. If so, the nation itself will start to see a double-dip,” he says.

From Clear Capital’s perspective, a double-dip would require a new trough below the old one. If current trends continue another three or four months, “it will cross that threshold,” Villacorta says. “If the current decline is simply a function of a tax credit pull-back, and a lot of markets start to stabilize and hover in a stable pattern over the winter months, a lot of markets will be poised for recovery come mid-2011,” he adds.

The Clear Capital Home Data Index already is showing important differences from market to market. New Orleans; Columbus, Ohio; and Atlanta showed the sharpest declines from last quarter at 15.8 percent, 13.7 percent and 13.4 percent, respectively. On the other hand, Washington, D.C.; New York; and Bridgeport, Connecticut, showed the highest quarter-over-quarter gains at 2 percent, 1.6 percent and 1.5 percent, respectively. The only other market with a gain was Honolulu, at 0.3 percent. 

California, after recent home-price surges, started down again but was still significantly higher than a year ago, according to the Clear Capital Home Data Index. Los Angeles declined 1.1 percent in October from September, but was still 7.4 percent above a year ago. Of all sales in Los Angeles in the October index, REO sales represented 27 percent of all transactions. San Francisco saw its home prices decline 2.4 percent, but were 8.4 percent above a year ago, with 25 percent being REO sales.

Caution in the new home market

New-home sales, as of September, had not been hit by a double-dip, according to data released by the U.S. Census Bureau in conjunction with the U.S. Department of Housing and Urban Development (HUD). Sales of new homes totaled 307,000 for September, up 6.6 percent from 288,000 for August but down from 391,000 from a year ago in September 2009.

This left a new home inventory that would take eight months at the current sales pace to unload. That is a considerable improvement from conditions in May (the trough), when sales came in at 282,000--the lowest level since 1963.

Sales of newly built single-family homes rose in three out of four regions in September from August, with the Northeast posting a 3.4 percent gain, the South a 3.2 percent gain and the Midwest a remarkable 60.6 percent gain following a big decline in August. New home sales in the Midwest nevertheless declined 20.9 percent in October from year ago levels. The West posted a 9.9 percent decline in September from August in new-home sales.

Even as sales picked up, new-home construction continued to decline, which is a “positive sign,” according to David Crowe, chief economist with the National Association of Home Builders (NAHB), Washington, D.C. “That said, the concern is that builders’ ongoing difficulty in accessing production credit will keep the razor-thin supply of new homes from being replenished as consumer demand revives, thereby hindering the positive momentum.”

Bouncing along the bottom

Some view the current dip as actually the third one for the housing market. “In the first half of 2009, we had a pretty strong increase--particularly in home sales, but also to some extent in home values,” says Stuart Feldstein, president and founder of SMR Research Corporation, Hackettstown, New Jersey.

“The last half of 2009 and early 2010, it kind of collapsed. We call that the double-dip that already happened,” he adds. “The potential is for a continued cycle of rises and dips. Some even argue that this is actually the triple-dip for housing.”

With affordability levels now so high, the missing ingredient is consumer confidence, according to Feldstein. The new Congress “will probably have a positive impact on consumer spending,” he says. That’s because “less will get down in terms of radical change,” which he believes will boost consumer confidence. “Despite high unemployment,” he notes, “for those who do have jobs, incomes look pretty good.”

Feldstein is not worried that the foreclosure-documentation problem will spin out of control. A cascading series of foreclosures driving down prices “is the kind of circuitous thinking that leads to a cycle where you can buy Donald Trump’s mansion for 5 cents. I don’t think it will get to that,” he says. Meanwhile, the slowdown in the pace of properties moving from foreclosure to REO to “for sale” will be “good for home values,” he says.

Feldstein expects a gradual recovery in housing sales, and prices to be “well established” by mid-2011.

He notes there has been a spike in building permits. In the second quarter that jumped to 142,000 new one-family units, which exceeded anything for the prior six quarters. “We have plenty of pent-up demand for housing, as construction of new homes is not keeping up with population growth. So, home builders are showing some confidence” by filing for building permits, Feldstein says.

The public is also spooked by a constant barrage of media reports that housing prices will continue to fall, he says. “People are both scared about the future and they are believing in a lot of widely disseminated, pessimistic forecasts,” Feldstein says.

Feldstein thinks the price indexes frequently cited by the press do not accurately reflect home prices. Many foreclosed properties are damaged properties and, thus, while lowering the average price, do not reflect the fact that other homes are selling well.

Clear Capital’s Villacorta says that the degree of REO and distressed sales in a given geography determines to what extent the price index will be pushed down by the presence of REO sales.

Feldstein thinks consumer psychology is really the key to forecasting what is going to happen to sales and home values.

“Part of the problem is you have so much negative news from so many pessimists who always get the headlines. No one is telling the positive story, which, in fact, does exist,” Feldstein says. The message is simply that home prices are very low, homes are very affordable and mortgage rates are as cheap as anyone has seen.

William Wheaton, a professor holding a joint appointment in the departments of Economics and Urban Studies and Planning at the Massachusetts Institute of Technology (MIT), Cambridge, Massachusetts, is also casting a keen eye on pent-up demand. After another six months of slow demand in the aftermath of the expired tax credit, demand will rise. The question for now is how much it will rise, according to Wheaton. “Are we going to be stuck at [an annual sales pace of] 5 million?” he asks.

Wheaton expects that if we have a stronger recovery, sales will rise to a 5.5 million or a 5.8 million annual pace. Prices will depend on what is happening to the “duration” of inventory--that is, how many months of supply are on the market.

Currently, inventory is at 3.9 million units and has been stable for several months, according to Wheaton. If inventory can be stabilized at an eight-month supply, “it is enough to stabilize prices and start them on a slow recovery,” Wheaton says, “but it is not enough to make a significant recovery in prices.” He expects prices to rise next year because housing sales will rise to a pace of 5 million a year with an inventory of 4 million units.

Wheaton sees positive signs in the fact that while foreclosures and REOs are pushing a million homes onto the market every year, home construction is about 1 million units lower than it would normally be. “So those numbers are almost perfectly counteracting each other,” he says. Inventory, at 3.9 million units, is not really rising, and it’s “a perfectly reasonable number,” he says.

Inventory could come down suddenly if there was a policy to force banks to renegotiate mortgages to solve or help the foreclosure problem, an outcome few expect. That would reduce the inventory of homes to six or seven months because fewer would be coming on the market as foreclosures. Then, prices would rise significantly, he says.

The threat from strategic defaults

Wheaton sees the estimated 10 million underwater households as a continuing challenge to the full recovery of the housing market. He says people are already engaging in strategic defaults. A lot of buyers of second homes, for example, “have walked,” he says.

Wheaton points to a Federal Reserve study published in May as providing insight into what causes those not driven by loss of jobs or other income shocks to default on their loans. The study, titled The Depth of Negative Equity and Mortgage Default Decisions, is authored by Neil Bhutta, Jane Dokko and Hui Shan.

The authors find that strategic default does not occur until equity falls to an average of minus-62 percent of a home’s value. This contradicts the popular view that people are walking away from homes with much smaller levels of negative equity.

Wheaton, whose former student, Shan, is one of the co-authors of the Fed study, says the study finds that negative-25 percent to negative-30 percent is the trigger point when people are more likely to engage in a strategic default.

“When RealtyTrac [Irvine, California] says that 20 [percent] or 24 percent of homeowners are underwater, a lot of those people are 5 [percent] or 10 percent underwater,” Wheaton says. “I wouldn’t really worry about those,” he says. “But there are probably 2 [million] to 2.5 million Americans who are seriously underwater, at least 30 percent or more,” he adds. “And according to all the research we have, those people are probably sitting around the kitchen table thinking very seriously about strategic default.”

Wheaton is worried about the additional 2 million potential foreclosures that “are looming out there.” If those were pushed into the market, “inventory would jump back up to 4 [million] to 5 million, and that might actually cause another double-dip in prices,” he says. But he does not see a double-dip in prices without “something drastic” happening.

Wheaton has put together a proposal that would address the problem of underwater homeowners. Wheaton proposes splitting current mortgages into two parts. The basic part would be a mortgage against the current reduced value of the home, and the second part would be a claim against some fraction of any capital gains above the reduced value when the home is sold.

The lender’s claim on future gains could be capped at a value equal to the difference between the original mortgage balance and the new reduced standard mortgage. Wheaton thinks the availability of such loan modifications could “eliminate the growing potential of strategic defaults.”

Without such a proposal, homeowners 30 percent to 40 percent underwater have already lost all their equity and prices would have to recover 30 percent or 40 percent before they get back a nickel. There are very few markets that will recover that much in the next few years. This prevents people from moving when they get a better job or to change school districts. “So, it’s not only degraded their wealth, it’s blocking their mobility,” Wheaton says. “We do not know how many people are unable to move merely because they are underwater.” It would be better for the banking system and for the economy if underwater homeowners could move to better jobs, he adds.  

What might start the 2 million homeowners who are 30 percent or more underwater to rush for the strategic-default exit? Wheaton believes a stronger recovery with better jobs might ironically cause a surge in strategic defaults. The other thing that could do it would be a “realization that the housing market is not going to zing back, and that they’ve lost their equity for years and years,” he says.

Riverside-San Bernardino, California, is one of those places where there are a lot of underwater borrowers, according to Bruce Norris, president of The Norris Group, a real estate investment firm in Riverside, California. “A huge number of people [in California] are delinquent, but the property is not in foreclosure,” Norris says. He points out that if you go back 18 months ago, there was a 4 percent delinquency rate and a 1.2 percent foreclosure rate in California. Now, there is a 12 percent delinquency rate and a 0.8 percent foreclosure rate.

“There’s a tripling of people who are delinquent and a one-third decline in the number of foreclosures. Mathematically, it doesn’t make sense,” he says.

So, there is a policy to let people stay in their house and not flood the markets with inventory. “Realistically, we should have 500 percent more inventory for sales than we do” in California, he says. There is about a six-month supply of inventory now, but if all this shadow inventory were suddenly to come on the market, it would represent three years of inventory, according to Norris.

Norris is wondering whether this huge store of delinquencies will lead to a rash of strategic defaults. He cites the case of a Realtor® he knows who is working on a short sale for a family that claimed it had been able to make a payment yet had not done so in 32 months--and the family is not even in foreclosure. “That word gets out. You can imagine they are not quiet about that to their inner circle: ‘Come on, this is what we’re doing. You’re still making your payment?’ And it does catch on. Strategic default begets strategic default.”

How big is the shadow inventory of homes where the mortgage is delinquent but the property is not yet in foreclosure? If the government does not intervene, Norris says, there could be a huge surge of foreclosures down the road that could drive down prices once again. 

So, it’s not really out of the question that we could be looking at a fourth dip in home prices just as we were starting to climb out of the hole. MB

Robert Stowe England is a freelance writer based in Arlington, Virginia. He can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

Copyright ©Mortgage Bankers Association of America. All Rights Reserved. Reprinted With Permission. 



Robert Stowe England is an author and financial journalist who has specialized in writing about financial institutions, financial markets, retirement income issues, and the financial impact of population aging.

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