Will Double Dip In Home Prices Spur New Defaults?

A new batch of U.S. housing data confirms what many homeowners know in their guts: Their house values continue to fall, erasing years of built-up equity.

And they're the luckier ones.

Hundreds of thousands of buyers who used Federal Housing Administration-backed loans — lured into the market in 2009 and 2010 by government tax credits — are already slipping underwater or teetering on the brink. That raises the specter of a potential new round of defaults, amid a double dip in home prices.

The dip's apparent in an S&P/Case-Shiller report released Tuesday. It shows that in March, home prices across 20 large U.S. cities undercut the April 2009 dip. Prices are off 31.6% from the April 2006 peak, and 3.5% from a year ago.

Some economists think the glut of existing homes and low demand portend another 5% fall by the end of this year. In April the median price was $163,700 and 37% of transactions were distress sales, the National Association of Realtors says.

"Negative equity is the largest factor affecting housing forecasts right now," said Stan Humphries, chief economist of online real estate marketplace Zillow. "It will contribute to more foreclosures and diminished housing demand."

Why the risk of defaults with recent-vintage FHA loans, which were written under tighter lending rules than before, and are so far performing well? It's because the loans were made with the thinnest of down payments — less than 20%, sometimes as little as 3.5% — which don't cushion buyers against any more hard times in housing.

With few private lenders willing to give buyers keys to a home with less than a 20% "skin in the game"down payment, FHA's role skyrocketed to backing via insurance almost 30% of new mortgages in fiscal 2009, vs. around 4% three years earlier. It insured nearly 996,000 mortgages in fiscal 2009.

The federal tax credit — an $8,000 handout to first-time buyers — reinflated the market briefly. Some FHA buyers used that credit for part of their down payment and might have even less skin in the game than their equity suggests.

Zillow estimates that at the end of the first quarter 28.4% of homeowners with mortgages were underwater, owing more than the home's value, vs. 27% at the end of 2010 and 23.2% three months earlier.

Default Danger Zone

Being underwater makes selling tough. It's the top indicator that borrowers will stop paying and walk away, Humphries says. That hasn't shown up yet in recent FHA loans.

The share of seriously delinquent loans in FHA's portfolio fell to 8.29% in the fourth quarter from 8.84% in the third and 8.9% in the fourth quarter of 2009.

"We haven't had a big enough move yet" in pricing to see defaults rise, said Thomas Lawler, a housing economist and former director at Fannie Mae (OTCBB:FNMA.ob - News). "But it is true that, for those areas where home prices have fallen 10% over the last year, once you get another 10% then you start to hit that ugly cusp."

Lawler says he thinks most recent FHA loans will hold up, however.

The Mortgage Bankers Association counted 4.1 million mortgages as seriously delinquent (over three months late) in the first quarter. But the foreclosure pace has slowed as banks choke on the volume.

The MBA says while the numbers are growing, problem states such as Florida dominate. Back out the top five, and signs of improvement appear around the nation. The rate of foreclosures among FHA loans is declining as well, the group says.

The Housing and Urban Development Department, which oversees FHA, seems to have learned obvious lessons from the era of no-doc and "liar" loans, housing analysts say. Credit scores of FHA loans climbed in 2009 and early 2010. More buyer incomes were verified.

Regulators also closed a loophole that let sellers kick back cash to buyers for a "down payment." More than 20% of FHA loans in fiscal 2005-07 involved some sort of gift — often that seller-assist — for down payments. Those loans hit trouble at higher rates.

With stricter standards, fewer FHA loans made in fiscal 2010, which ended in September, have shown early cracks or outright defaults than earlier loans.

Loans from fiscal 2009 are now reaching the typical peak default period of two to four years out. They also are showing fewer early cracks than the prior generation of loans, HUD and independent analysts say.

Herb Blecher, senior vice president of LPS Applied Analytics, says that pool of loans looks solid. However, "We're certainly keeping our eye out looking for cracks again."

Stand By Your Loan

HUD economist Andrew Jakabovics says FHA borrowers aren't typically the type to opt for a strategic default — walking away from a loan even when they have the ability to pay. FHA borrowers aren't investors. They want a roof over their heads and plan to stay for a while.

"Borrowers do whatever they can, even if they fall delinquent, to get themselves covered," said Jakabovics, senior adviser to HUD's assistant secretary for policy development and research.

Yet being underwater, by limiting options to move and refinance, can prime a borrower for possible foreclosure. Then a medical problem, job loss or other shock is the final catalyst, Humphries says.

"That first trigger, activated, lies dormant and not activated until a shock," he said. "That doesn't mean that (foreclosures) are not going to happen. The first trigger has been pulled, and we're still seeing high unemployment rates."

The millions of additional loans underwater or near water's edge also could keep a lid on the housing market for several years. Borrowers with negative equity have trouble moving out and moving up.

"It gums up the conveyor belt of real estate," Humphries said.