2010 Forecast

The outlook appears promising despite formidable obstacles that will be realized in 2010, which will pose significant challenges to continued recovery. Our market-by-market analysis of housing values and supply trends shows that most California markets appear to be stabilizing. Home value direction has gone from decreasing to flat and, in some markets, turned positive, while supply of housing in most markets is in balance with demand or less. However, despite the stability of home values achieved over the second half of 2009, there are many factors that suggest 2010 could expose this façade and become another down year for the housing market, with values dropping further before stabilizing. Those factors are addressed below:

1. Rising Mortgage Rates: Just as low mortgage rates were partially responsible for the recovery manifested in 2009, increased rates could be the cause of a housing slump in 2010. Homeowners tend to buy a home not on the basis of what the home costs in absolute terms, but rather on how the mortgage payment will affect their monthly earnings. That is to say, for most home buyers, the key to home affordability is monthly cash flow. A rise in interest rates decreases the overall affordability of the home. Therefore, buyers will be willing to spend less overall, driving economic demand down. This could cause housing to again become overpriced.

2. FHA Restructuring: The Federal Housing Administration suffered heavy losses during the housing downturn, which could lead to additional bailouts from the government. As a result, the FHA slightly tightened standards and raised fees in January. If increased tightening occurs, it could reduce availability of financing and diminish the qualified-buyer pool. That would decrease demand and force further decline in values.

3. Failed Loan Modifications: Loan modifications are the reason many delinquent loans have avoided foreclosure, which has served to moderate the supply of foreclosed homes entering the market in 2009. During 2009, the REO saturation rate dropped 16 from 41.5% in the first quarter to 25.5% upon the release of the HDI Market Report in January 2010.vii However, while 728,000 homeowners have signed up for modifications, just 31,000 have permanent workouts. So it is reasonable to expect that many homes that have been in the modification pipeline will be moved belatedly into the foreclosure pipeline and will add to the supply of foreclosed homes in 2010.

4. Expiration of Mortgage-Backed Securities Purchase Program: The government set aside $1.25 trillion to buy back mortgage-backed securities (MBS), which has been the primary cause of low mortgage rates throughout the downturn. The program is set to expire March 31st. Purchases from the program made up 50% of the MBS issued in 2009, and it is very possible that interest rates will rise without the supplementary demand created by the Federal Government. Also, as stated previously, a rise in rates decreases the affordability of owning a home and will depress demand at current market prices.

5. Mortgage Interest Rate Resets: California has a high concentration of option adjustable rate mortgages that gave the borrower the option to pay a monthly amount less than that necessary to pay the interest on the loan. Thus not only are these loans in a negative equity position due to a falling market, but they are also building negative amortization. Interest-only loans that allowed interest payments for three, five, or seven years were popular with purchasers in expensive markets that did not quality for government-backed loans. Both negative amortization and interest only-type loans are about to reset, dramatically increasing the monthly payments for those borrowers. Of the pool of outstanding Option ARM loans, 88% have not yet experienced a reset event. Research carried out by Fitch showed that 94% of borrowers with Option ARM loans made only the minimum payment. And in the past year, the portion of Option ARMs that were delinquent, in foreclosure, or foreclosed rose from 16% to 37%.1 From the graphs, it seems evident that by the end of 2010, and through 2012, those resets will place heavy burdens on borrowers, who will likely forfeit their homes to banks that in turn will have to foreclose and liquidate the properties. These re-sets will likely cause the next wave of foreclosures, one that will be large and weigh on home values for a long time. Therefore the re-casting of Option ARM loans in the coming months and years will be the source of a tremendous amount of bank-owned housing inventory, which will exert downward pressure on home values.

6. Expiration of the Home Buyer Tax Credit: The program established by the federal government giving buyers an $8,000 tax credit, enacted to shore up the housing market, expired on April 30, 2010. Many home buyers have entered the market prematurely to take advantage of this additional incentive to buy a home now. Many of them perhaps would have waited until 2010 to buy a home, but opted to buy sooner to take advantage of the credit. Those buyers will not be available to buy in 2010. As a result of the expiration of this credit, the demand for housing in 2010 could be greatly diminished, and home prices could decline.

7. More Defaults & Foreclosures: Due to such factors as persistent unemployment and failed loan modifications as aforementioned, foreclosures will likely increase in 2010. There are nearly two million mortgages that are 90 days delinquent, and virtually all of them will end up in foreclosure. About 2.3 million have already been foreclosed on by lenders. Flooding the market with increased bank-owned (REO) properties could increase the housing supply beyond the bounds of demand at current pricing and force lenders to compete by dropping REO home prices. Similarly, short sellers, or property owners attempting to sell a property for less than what is owed on it, will be prominent in most markets, adding to distressed inventory. Home owners with negative equities have proven to have a high rate of default. According to a new study released by First American CoreLogic February 23, 2010, more than 11.3 million residential properties had negative equity at the end of 2009. That is equal to 24% of all mortgaged homes in the United States. This study also reports that an additional 2.3 million mortgages had less than 5% equity. These two numbers combined equal 29% of all mortgaged properties in the U.S. In California, 35% of all mortgaged residential properties are underwater, accounting for the largest number (2.4 million) among all the states. First American reports that once negative equity is 25%, or $70,000 greater than the property’s value, owners tend to walk away from their debt obligations and properties to the same degree as non-occupying investors.

Published with permission from "A STATE IN TURMOIL: Why The California Residential Real Estate Market Has Just Begun To Fall" By Eli Tene, Gil Priel and Jeff Woodsworth. This text may not be redistributed or reproduced without the written consent of its authors.