The Dangerous Undercurrents In The US Real Estate Market

The slowing rate of foreclosures might be suggesting a gentle recovery in the housing market, but analysts are pointing to the millions of repossessed or foreclosed homes that …

The slowing rate of foreclosures might be suggesting a gentle recovery in the housing market, but analysts are pointing to the millions of repossessed or foreclosed homes that have yet to hit the market as cause for concern. When added, these numbers would almost double the existing supply of homes for sale, suggesting that prices are set to tumble, forcing banks to take bigger charge-offs than the billions they have already incurred. See the following article from Money Morning for more on this.

According to the latest reports on the U.S. housing market, the 96,400 homes hit with default notices last month were 7% less than in April and 22% less than in May 2009.

And that’s not all. Foreclosure auctions were scheduled for the first time on 132,680 properties last month – 4% fewer than the month before and 16% fewer than in May a year ago, according to the Irvine, California-based RealtyTrac Inc.

In fact, foreclosure filings of all types – default notices, scheduled auctions and bank repossessions – were reported on 322,920 U.S. properties in May, a decline of 3%. All told, this latest report seems to have painted a picture of a gentle and steady recovery for the embattled U.S. housing market.

Unfortunately, these figures are quite deceptive – as is the reassuring portrait they helped create. Despite the apparent improvement in the foreclosure figures, there exist some dangerous undercurrents that threaten to further drag down U.S. housing prices – as well as U.S. investors.

Troubled Waters?

Despite the apparently reassuring May foreclosure report, a second-record month of home repossessions (with more to come) will put pressure on U.S. housing prices, the nation’s banking sector, and the U.S. economy.

All those factors, in turn, will undermine the potential for continued strength in U.S. stock prices – even after a recent rebound that saw the major indices bounce back from temporary support levels.

Here’s the problem. While the “headline” numbers – the summary statistics we cited above – appeared to portray an improving market, a look beneath the surface reveals those worrisome undercurrents.

Consider, for example, the statistics for actual bank repossessions. Those hit a record of 93,777 properties in May – a 1% increase over April’s record and a whopping 44% up from the same month a year ago.

Here’s another stunning stat: RealtyTrac’s Foreclosure Market Report for May 2010 additionally announced that there were year-over-year increases in bank-repossession activity in each of the 50 states.

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Commenting on the company’s report, RealtyTrac Chief Executive Officer James J. Saccacio said that the “numbers in May continued and confirmed the trends we noticed in April: Overall foreclosure activity leveling off while lenders work through the backlog of distressed properties that have built up over the past 20 months. Defaults and scheduled auctions combined increased by 28% percent from 2007 to 2008 and another 32% from 2008 to 2009, creating a build-up of delayed bank repossessions. Lenders appear to be ramping up the pace of completing those forestalled foreclosures even while the inflow of delinquencies into the foreclosure process has slowed.”

Delay and Pray

In spite of the record number of repossessions we’ve seen by banks and mortgage-service firms recently, millions of delinquent loans are still on banks’ books and in mortgage pools. Banks, unwilling to take more write-downs or to incur the high cost of maintaining repossessed homes, have hidden behind federal and state government-foreclosure moratoriums and a host of modification programs designed to keep borrowers in their homes.

But this desperate tactic – known by industry insiders as “delay and pray” (or sometimes as “extend and pretend”) – may have finally run its course in the U.S. housing market.

Instead of having a market in which U.S. housing prices are firming and heading higher, the expiration of the homebuyer-tax credit, stubbornly high unemployment, restrictive mortgage underwriting standards and a growing overhang of unsold properties is putting more downward pressure on home prices. Banks are realizing that the hoped-for “bounce” isn’t coming and are beginning to take back more properties so they can unload them for as much as they can get before prices decline even more.

According to Lender Processing Services Inc. (NYSE: LPS), there are 3.5 million homes for sale today. Another 2.9 million have been repossessed or are in foreclosure, but have not yet hit the market. And 4.5 million borrowers are 30 days delinquent – a factoid that may cast an even larger shadow over the outlook for the U.S. housing market.

As bad as these numbers are, they still aren’t telling the entire chilling story.

Bad News for Banks

In April, 12.7% of all U.S. mortgages were delinquent, but Lender Processing Services reported that only 3.18% of mortgages nationwide are in foreclosure.

Here’s the truly frightening question: What will happen to U.S. housing market prices when foreclosures catch up with delinquent borrowers and the greater-than-50% of modified loans that are now re-defaulting? Once foreclosures are completed and titles to repossessed homes are in the hands of banks and mortgage servicers, they have no other option but to unload their unwanted inventory as fast a possible. Otherwise, they’ll incur even more expenses – those involved with maintaining the properties, listing them and paying taxes on them.

Additionally, the vicious cycle of tumbling prices is likely to accelerate: As more distressed properties get dumped into a weak market, they can’t help but establish lower comparable sales values for other area properties.

Of course, the weight of foreclosures, repossessions and dumping unwanted inventory on an already weak market also will further weaken bank balance sheets. Craig Emrick, a senior vice president at Moody’s Investor’s Service (NYSE: MCO), estimates that Citigroup Inc. (NYSE: C), Bank of America Corp. (NYSE: BAC), JPMorgan Chase & Co. (NYSE: JPM) and Wells Fargo & Co. (NYSE: WFC) could record charge-offs of as much as $196 billion this year and next – an amount that’s considerably higher than the $166 billion worth of loan losses taken in 2008 and 2009, during the height of the global financial crisis.

And it’s not just the big banks that will take a licking. The community banks will feel the pain, as will the banks’ banks – the Federal Home Loan Banks. Community banks and the FHLB are desperately trying to stave off what may be the inevitable.

A Terrifying Revelation

The Federal Home Loan Bank of San Francisco – the largest of 12 regional Federal Home Loan Banks, which are owned by community and other area banks and that make loans to their member banks from the pooled capital of their stockholding members – is in big trouble.

In a stunning revelation, which resulted from the San Francisco Home Loan Bank suing to force Wall Street dealers to repurchase $20 billion of mortgage-backed securities they claimed were sold to them based on “materially untrue and misleading statements,” the Home Loan Bank had to identify the securities on its balance sheet.

Interestingly, while the San Francisco Home Loan Bank was suing because of huge losses claimed on the purchased securities, it was actually carrying those same securities on its books as if most of them would pay off in full. The San Francisco bank predicted credit losses on the $20 billion portfolio of $688 million, or about 5 cents on the dollar.

But according to Espen Robak, president of Pluris Valuation Advisors LLC – which analyzed the Bank’s books on behalf of American Banker (magazine) and determined that the losses would more likely be in the $5 billion range – “the bank here has a highly aspirational view of what things are worth.”

If the losses are real and realized, they would wipe out the bank’s retained earnings, breaking the $100 par value of the bank’s stock held by its members and preventing it from paying dividends to members. Additionally, it would make impossible the return of nearly $5 billion in capital stock that’s likely being counted on by needy members.

What’s happening at the San Francisco Home Loan Bank is obviously not an isolated case. The greater question is this: How many other banks are “mis-marking” the assets on their balance sheets, meaning they will face a continued erosion of those assets if a continued deterioration in the U.S. housing market causes housing prices to tumble further.

From this analysis of the undercurrents brewing below the often-optimistically spun headline news, it’s clear that danger lurks in the housing market.

Investors are always looking for the story behind the news – or, at least, they should be.

And while a situation can always change, it’s unlikely that the growing wave of repossessions will have anything other than a negative impact on the value of the nation’s housing stock, its banks, its economy and the U.S. stock market.

This article has been republished from Money Morning. You can also view this article at
Money Morning, an investment news and analysis site.

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