A Pessimistic Housing Market Outlook

Yesterday capped the end of the week's pretty ugly housing market data. December was a terrible month for new and existing home sales, despite the government's expanded home buyers credit. Foreclosures, defaults and delinquencies continue to rise. Meanwhile, the Obama administration's mortgage modification effort looks like a stinker. Banks are also reluctant to allow the housing market to hit bottom, which merely prolongs the agony. We could be in for a very, very slow recovery in residential real estate.

First, let's take a look at the last of the week's data: new home sales. Recall, existing sales were down 17%, seasonally-adjusted. New sales didn't do quite as badly, but were pretty awful too, as the Washington Post reports:

In December, new-home sales fell 7.6 percent from the previous month, to a seasonally adjusted annual rate of 342,000, according to the Commerce Department. Sales were down 8.6 percent compared with the same period a year earlier.

Here's new home sales in a chart:

new home sales december 2009.gif

While alarming, this information is not surprising. If there's excess inventory and lackluster demand, then existing home sales should attract more sales than new homes through better deals to be had -- especially if foreclosure auctions and short sales are taken into account.

Yet, that excess housing inventory doesn't even reflect how many foreclosures we should be seeing, given the trouble in the housing market. I've commented on shadow foreclosure inventory problem a few times. Those are the homes based on defaulted mortgages that banks hold back from hitting the market. Two posts by Mike Konczal note that banks aren't particularly eager to foreclose, as this chart he provides shows:


What's the holdup in closing these foreclosures? Part of it is modification efforts. In also commenting on Konczal's work, Felix Salmon notes:

The key thing to note here is the bottom, darkest line: while delinquencies and initiated foreclosures have been rising, there's a limit to how many foreclosures can actually be completed, and that limit seems if anything to be falling.

What this says to me is that while we aren't going to see a wave of foreclosures, we are going to see a large and more or less constant number of foreclosures for the foreseeable future -- with all the gratuitous value destruction that implies.

I think that's exactly right. And the modifications aren't working for two reasons. First, many troubled homeowners now have no income stream, so there's no payment amount they can currently afford. But even for those who still have a job, banks can only lower the interest rate so much or extend the term so long. At some point, you would have to lower the principal, which banks are quite uncomfortable doing.

Banks don't want to lower principal amounts for two reasons. First, it's logistically difficult when these loans are part of a securitization. But possibly more importantly, they can't stomach lots of mortgage losses at once. By prolonging the agony, at least they can absorb those losses more slowly, as borrowers re-default or remain in a defaulted home for a period of months or years.

This should make for a very slow-to-recover housing market. That initial jump in demand we saw last spring, summer and fall probably had more to do with government incentives pulling demand forward than a true housing rebound. Recent data indicates even that may be exhausted. Meanwhile, credit is becoming harder to get for potential home buyers. The housing inventory probably can't shrink much, because banks can only hold onto these defaulted homes for so long before having to foreclose.

I take this to all indicate that housing appreciation, on average, should remain very low, if positive, over the next several years. Looking at the chart above, I can't see any reason to believe that foreclosures will decline dramatically for years. I don't know how a housing market recovers if that's the case.