Andrew Busch
Global Currency & Public Policy Strategist
BMO Financial Group

US existing home sales (EHS) fell a disappointing 16.7% as the rush from the first time home buyers credit earlier in the fall depleted sales in December.

However, sales had rebounded significantly from the lows last Jan-Mar and have reduced inventories significantly as well.

It's the inventory component that holds the key for prices as they move down from a catastrophic 11.2 months worth of homes down to 6.5 months of supply. Just put up a graph on EHS (as they decrease inventories) with S&P CS home prices and you will the relationship.

2009 was a terrible year for housing on many fronts, but was especially onerous from a foreclosure standpoint. Approximately 2.9 million home went into foreclosure and the outlook for 2010 is similar. As most know, a foreclosed home on average loses 15-25% of its value and also drags down other homes in the area due to comparables. I would posit that the current foreclosure environment is due to a combination of over-priced homes, over-levered borrowers, and the jump in the unemployment rate.

As part of the State of the Union address, the Obama administration is expected to announce changes to the Making Home Affordable program to assist more middle class borrowers. So far, the loan modification program has assisted over 65,000 borrowers with possibly another 45,000 in the works. This is a tiny percentage of what the US Treasury was hoping to assist and is not likely to make a major impact on foreclosures. It's estimated that millions of US homeowners are upside down on their mortgages meaning that they owe more than they home is worth. This negative equity situation has not been addressed due to banks not incented to reduce the principal owed especially if the homeowner is keeping up on the mortgage.

Behavioral scientists are having a field day with this behavior and one professor states these borrowers are suffering from "norm asymmetry. According to a paper by University of Arizona professor Brent White, "Despite reports that homeowners are increasingly “walking away” from their mortgages, most homeowners continue to make their payments even when they are significantly underwater. This (article) suggests that most homeowners choose not to strategically default as a result of two emotional forces: 1) the desire to avoid the shame and guilt of foreclosure; and 2) exaggerated anxiety over foreclosure’s perceived consequences."

"Moreover, these emotional constraints are actively cultivated by the government and other social control agents in order to encourage homeowners to follow social and moral norms related to the honoring of financial obligations - and to ignore market and legal norms under which strategic default might be both viable and the wisest financial decision. Norms governing homeowner behavior stand in sharp contrast to norms governing lenders, who seek to maximize profits or minimize losses irrespective of concerns of morality or social responsibility. This norm asymmetry leads to distributional inequalities in which individual homeowners shoulder a disproportionate burden from the housing collapse."

Writing in the NYT, Richard Thaler provides the disturbing potential conclusion on homeowners changing their viewpoint and strategically defaulting: "An important implication is that we could be facing another wave of foreclosures, spurred less by spells of unemployment and more by strategic thinking. Research shows that bankruptcies and foreclosures are “contagious.” People are less likely to think it’s immoral to walk away from their home if they know others who have done so. And if enough people do it, the stigma begins to erode." If enough people do it, the housing market collapses.

Fortunately if the US residential market continues to recover and prices continue to improve, the desire to walk away will decrease further as the potential recovery will keep borrowers paying. The key is to keep the market recovering. Job growth, low rates, and better access to liquidity will be all needed to keep the housing market recovering. If not, the scenario described by Thaler becomes more likely.

And truly disturbing.

• U.S. Cities With The Most Underwater Mortgages

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Andrew B. Busch is Global Currency and Public Policy Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a frequent CNBC contributor. You can comment on his piece and reach him here and you can follow him on Twitter at http://twitter.com/abusch .