More bad news for the MBS sector came in this week, according to a recent report from RBS Greenwich Capital, which showed that housing starts plummeted in September by over 6%, the lowest level since 1991.

The September drop off was caused by a "disastrous" 12% drop in single-family starts, while multi-family starts actually increased last month, the analysts said.

The combination of extremely tight financial conditions, dire economic fundamentals, and investors sitting on the sidelines "is going to be toxic for the housing market and particularly for the new home market," RBS said.

Indeed, the single-family performance was one of the worst of the entire housing bust cycle, the analysts said. Starts in the South were close to flat, while the Northeast and West fell.

Builders will have extreme difficulty obtaining financing, while also facing a lack of new buyers, the analysts said.

Now that Fannie Mae and Freddie Mac are government-owned and keeping credit available for most homebuyers, existing home sales will probably weaken by less than new home sales and housing starts.

The positive news is that with the drop in supply, demand will come back and when household finances improve, potential buyers will likely find mortgage rates that are still low by historical standards and much more attractive prices than have been available in recent years, RBS analysts said.

"The lower housing starts are over the next several months, the smaller the supply overhang will be when interest in home-buying picks up again," RBS said.

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