Why Drop in Foreclosures Is Bad for Housing Market

In a normal housing market, lack of supply is generally considered a good thing. When demand outweighs supply, home prices rise and homeowners gain equity. Like so many things in this historic economic recovery, that premise doesn’t exactly apply.

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This housing market has been running on distress for the past year, as investors rush to buy foreclosed properties in order to take advantage of today’s hot rental market. Sales of millions of foreclosed homes pushed home sales higher, off the bottom in fact.

Now that supply of distressed properties is drying up, and pulling overall home sales down with it. Sales of existing homes dropped unexpectedly in June, down 5.4 percent from the previous month, according to a new report from the National Association of Realtors.

Home sales were particularly hard hit out West, where there is the largest concentration of delinquent mortgages and foreclosed properties. Overall sales out West were down 3.6 percent in June from a year ago according to the Realtors, but in the $0-100,000 price range, they were down nearly 36 percent.

“More than 50 percent of all existing home sales have been to "investors" and "first timers" — thin and volatile cohorts relative to repeat buyers — looking for low-end properties to rehab and occupy or rehab and rent/flip respectively. These two cohorts have carried the market for three years,” California-based mortgage analyst Mark Hanson noted.

The distressed share of home sales fell to 25 percent, while it had been running at a third for much of the past year. The first-time home buyer share also fell to 32 percent, down from 34 percent the previous month and from a normal range of 40-45 percent. First-timers are having particular trouble obtaining home loans.

So why is the supply of foreclosures so low when there are so many hungry investors waiting to pounce? There should be plenty to go around, given that the total U.S. delinquency rate is at 7.2 percent, representing 5.57 million loans either delinquent or in the foreclosure process, according to Lender Processing Service’s June Mortgage Monitor.

The answer is the process.

This from Fannie Mae’s most recent quarterly report:

“Our foreclosure rates remain high: however, foreclosure levels were lower than they would have been during the first quarter of 2012 due to delays in the processing of foreclosures caused by continuing foreclosure process issues encountered by our servicers and changing legislative, regulatory and judicial requirements.”

New laws in Nevada, criminalizing faulty foreclosure processing ground that state’s foreclosure machinery to a near halt. Foreclosure filing there down 61 percent annually in the first half of this year according to RealtyTrac.

California just passed a new law requiring mortgage servicers to prove they have the right to foreclose by showing title of the loan. That is sure to create huge delays, as many of these distressed loans were sliced and diced and sold off in strips to investors during the housing boom.

NAR chief economist Lawrence Yun also noted that many foreclosure transactions are either getting delayed or not clearing at all due to title issues, a new phenomenon.

“This is due to increasing legal risk,” said Yun, noting a 10-15 percent fallout rate, up from a negligible rate just months ago.

In addition, major bank servicers are now complying with a $25 billion mortgage servicing settlement with the U.S. Department of Justice and state attorneys general. Part of that is offering principal reduction modifications to delinquent borrowers. Bank of America alone put 200,000 delinquent loans on hold while it sends out letters offering to slash loan balances.

A lack of supply, even of distressed homes, should help settle this housing market, but the trouble is that regular buyers, move-up buyers, are, in large part, unable to participate in this recovery. Negative equity (including second liens) and near negative equity (less than 5 percent equity) is trapping an estimated 30 million potential repeat buyers in their homes, according to Hanson.

— By CNBC's Diana Olick
— CNBC Producer Stephanie Dhue contributed to this report.

Questions? Comments? RealtyCheck@cnbc.comAnd follow me on Twitter @Diana_Olick