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Real Estate: Awaiting The Foreclosure Time Bomb

Friday, 13 Jul 2007 | 5:22 PM ET

It’s the classic chicken and egg question. Did falling home prices cause the surge in foreclosures or did surging foreclosures push prices down? New data this week show the number of foreclosures nationwide continues to surge, while realtors predict home prices will fall further this year and next than they had previously forecast.

“One of the things that's worrisome about the current environment is that it's developing a self-reinforcing quality where falling prices are begetting foreclosures, which are begetting falling prices,” says Mark Zandi of Economy.com. “This is an environment that resulted in house price collapses, crashes in places like California in the late eighties, New England in the early nineties, the southwest in the mid-eighties.”

The stories of prices and foreclosures are entirely local, as is all real estate. The monthly foreclosure report from California-based RealtyTrac shows foreclosure activity nationwide is up 87% from a year ago, but there are still ten states that are actually seeing year-over-year declines in foreclosure activity. And then there are the states that are clearly in trouble: California with a 286% increase in foreclosure activity from 2006, Arizona up 168%, Nevada up 279% and Florida up 144%.

Wachovia chief economist John Silvia says foreclosures today fall into three categories: the speculation boom, the second home boom and the basic economics and demographics of the Midwest. The last is self-explanatory, given the trouble in the automobile industry. The second home story tells of wealthy boomers who took a chance on a second home, while holding onto their good credit and good equity in their primary home; when those low-cost adjustable-rate mortgages reset, they walked away. The dominant story is that of the speculator, who lived and breathed in those same markets just mentioned.

“I think when you're looking at areas like California, Arizona, Nevada, you're probably in the second or third inning,” says Silvia. “So you've probably got at least another six months if you're on the California coast, maybe another two to three years if you're on the inland empire of California.” Florida could take even longer for foreclosure rates to turn around, especially due to the vast speculation in seaside condos.

With an estimated 2 million adjustable rate mortgages resetting this year, $500 billion worth of subprime alone, the foreclosure numbers have nowhere to go but up, despite the fact that some lenders are aggressively trying to help those in default. Prices still have further to slide, because affordability got so out of control during the boom.

In the long run, the average home in the United States is sold at about 2.6 times average household income, says David Wyss, chief economist at Standard & Poors. “That ratio got up to 3.4; that’s sustainable at a 5% mortgage rate. We don’t think it’s sustainable at a 7% mortgage rate.” And that’s precisely where Wyss thinks mortgage rates will end up in 2008.

Wyss is predicting a price decline of 8% nationwide in 2007 from 2006, far deeper than many others predict. “The trade-up home is where you have the problems because number one, to trade up you've got to sell your existing house and that's not easy to do right now. Number two you've got to give up that 5% mortgage you just refinanced two years ago and take on a 6.5% mortgage right now that's a big hit on the monthly payment.”

John Burns, a real estate analyst and consultant, took a look at just how far some local housing markets would have to depreciate just to get back to “historic affordability.” Prices in Miami, the poster child for the housing boom, would have to fall 41%. In Los Angeles, it is nearly the same. Washington, DC would have to see a 33% price correction. Chances are, however, prices will not fall that far.

“There would need to be some urgency among sellers to have a drop that quickly,” claims Burns. “You've seen homebuilders in a number of markets drop prices already, so they've adjusted to the market, but with the economy strong and people having their jobs, there's not a lot of urgency for people to drop prices and sell their homes.”

You would think that the lack of real incentive for most existing homeowners to drop prices would help those in default, but that’s not always the case. Prices in some markets may not be dropping too far, but time on the market is increasing dramatically, and for those facing monthly payments they can’t afford, time is, well, money.

But Burns, in turn, says the rising number of foreclosures will force prices down all on its own (back to my chicken and egg dilemma).

“I think it’s going to take 3 or 4 years for a market like Riverside-San Bernadino in California to play out because the foreclosure activity out there is going to be tremendous,” says Burns. “We did an analysis there for a number of zip codes that showed that more than half the buyers last year had put nothing down.”

Those people are going to be staring at an adjustable rate loan that’s going to reset and increase their payments by 20% or 30%, and their mortgage is going to be worth more than their house.

A “bloody” scenario, says Burns.

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