Will the foreclosure freeze hurt or help the housing recovery?

tTl"t HouslNc eusr after the boom I years in 2002-2006 has been without historical precedent. The cause of this cycle was not tight money, but rather the correction for the overbuilding and easy lending standards during the bubble phase. As we have stated on several occasions, the problem this time is an inventory correction. Despite record low mortgage rates and high levels of affordability, home sales have remained depressed, except for the small surge due to tax incentives.

An inventory correction process in any industry requires that production remain below demand until the excess inventory is eliminated. Only then will you see a sustained rebound in production (housing starts). The excess inventory has three components. One is vacant stock of "owner" units (primarily single-family, but also condominiums). Using historical vacancy rates and estimates of foreclosed units that are vacant, this excess inventory is about 1.3 million units.

Another inventory problem is in rental units. The current vacancy rate of 10.67o would suggest about l-1.2 million units of excess rental units. Finally, there is the "hidden" inventory of units that are yet to be foreclosed. Currently, about 87o of all home loans (or 4.2 million loans) are either in the foreclosure process or over 90 days delinquent on payments.

The recent freeze in the foreclosure process will have a profound effect on the crucial questions facing business- es dependent on the housing industry. When will sustained recovery begin? What will the shape of the recovery look like? What will the mix of units be?

At the time of the freeze, almost 1 million houses would have been taken over in the foreclosure process during 2010. The problem is not that people could fix the problem if given more time, but rather that they have fallen behind on payments for one of two reasons: either they have lost theirjob and cannot make the payments or they choose to quit making payments because the house value is now less than the outstanding mortgage. The financial system became overloaded by the sheer volume of foreclosures and a rush to get the troubled assets off the balance sheets.

Although a rapid elimination of this "hidden" inventory is highly desirable, it does need to be done legally and carefully. However, this freeze will delay the correction, not eliminate the need to correct the problem. Home sales will plummet, since about 30Vo of existing home sales were foreclosed units. The financial institutions will have to add staff and ensure proper legal procedures are followed to proceed again. Although this slowdown might take some pressure off of home prices in the near term, it just means an even bigger problem in 201 l. The backlog offoreclosures will build, adding to the uncertainty on home prices in 2011 and2Ol2.

With 4.2 million homeowners already behind on their payments, foreclosure rates will remain high through 2011. Although home prices rebounded this year (up about 3.570 nationally according to the CaseShiller index), some housing experts believe home prices will fall again next year. This means the negative equity problem is not going to be eliminated by rising home prices. Shifting foreclosures from 2010 into 20 l1 increases the probability that home prices will fall further next year when another surge of foreclosed units hits the market. If potential buyers are concerned about house prices, then they will defer purchasing for at least another year or two.

With the foreclosure process getting more difficult and expensive, the financial system will become even more careful in making new loans. Already restrictive lending standards coulLl bee()tne L'\clt nt()re:ttinqenl. So unlike the easv lendine period in 2002-2006. the currcnt criteria will fbrcc t,ounger tantilics to dcf-er orvnership until they can save cnough money firr a cknvn pa) llcnt of gct sul-f icicnt vcrifiablc incontc to ntcct le ndins stanclards. Bccrusc ol-thc casy lcnding stanclalcls. honrc ovuncrship in 2(X)2-2(X)6 rosc abovc 6t)% ancl thc sharc ol' singlc-famrly r-rnits for that pcriod was abor.c 7-5.1 l)r. Ly rt tt M i c ltua I i.s. .lltrrnt, r c lt i a.f (t ('tlttilti\l /r,r' lli rr tll,t, lt.rt t. i.t rt tt niIt. tr.s.sot itttt, ol Rl,\1. H( ( (tt ht' rt'at hetl ul ( 206 ) 1,11 -8 | 02 t tr I ttr i c I tu t, I i.s (t r i.s i lr tn.

Although it is too carlv ro tcll how fhe ll'cczc will af'f'cct lhc ovcrall housing rccolcry, it is likelt'to har,c a protbund eff'cct on the ntix o1'units built ovcr the next three vears. By delaytng thc inventory correction of singlefamily units. lowering erpccted home prices, and makin-e lending standards even more onerous. thc multifamily segment could benefit. People n'ho lose their homes have to live somewhere. Youn-eer families will have to def'er ownership. No one bcliei.'es housine ivill be a -eocrcl invcstntcnt (unless you cun get a great deal on a fbreclosed unit). Atier dclaulting on a mortgtge. these hor-rscholds w,ill be excluded from owncrship fbr sevcral ycars.

Thus. as thc ccononrl,rcboirncls ancl crlployrlcnt rcco\crs. u'c sl-rould scc thc vacancv ratc titr rcntal units drop quickly in 20 1 l. Unlikc singlef'anrily r-rnits. ntultil'antily units arc financcd as a colnntcrcial propertv ancl the clue diligencc clepcnds on thc projectcd financials of thc prcrject. not on the owner's inconte.

Bottom line: the fieeze in the fbreclosure process is likely to delal' a sustained recoverv in single-family starts and is likely to conrribute to a shift in construction torvards multifamily units. This u'ill dampen the recovery in wood products demand grvcn the much lower lumber ancl panel usage in nultilhntill,, units con-rpared to single-llnrill, starts.

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