Standard & Poor’s found that default rates on U.S. residential mortgage loans continued to fall in June, but the firm is cautious about the remaining threat posed by shadow inventory.

The report said that low cure and liquidation rates were the cause of the high unresolved levels of distressed properties, particularly in judicial states where local foreclosure proceeding laws usually delay loan resolutions. 

The 2007 loans are unexpectedly outperforming 2006 loans, according to S&P, while the monthly first-default rates have fallen by 20% since the fourth quarter of last year. The current default rate is less than half of the high experienced in March 2009.

Despite falling 10% in the first half of 2011, prime first default rates still have not come down from their highs, which S&P suggested may be a result of unemployment rates following similar trends.

Redefault rates for cures/modifications have declined 30% in the first half of this year.

In spite of the progress made in the housing market, S&P believes that the “looming volumes of properties currently in or destined to eventually be in foreclosure threatens to further depress house prices.” The shadow inventory currently accounts for $405 billion worth of unresolved distressed properties. 

S&P analysts expect that the housing market will not fully recover until this shadow inventory, which represents four years of housing inventory and one-third of the outstanding U.S. nonagency residential mortgage debt, returns to pre-2007 levels. Back then, the inventory was nearly a quarter of the current volume.

With the overall resolution rate currently at a historic low of 5%, analysts believe the only way to achieve a significant decrease in the shadow inventory is through increased monthly liquidate and loan payments (cures/modifications), which are currently each at 2.5%.

However, S&P analysts were optimistic that the inventory was shrinking, albeit slowly, despite the continued low resolution rate, which they attributed to the slowing first-default rates.

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