The housing market finally appears to be on the mend, but there are still roadblocks. A key issue is the “shadow” inventory of housing that is unoccupied but has not yet been released into the market, either as a rental property or sale listing. This is of concern particularly in so-called judicial foreclosure states, which require a foreclosure to be processed through the courts.

Once this shadow inventory is released into the market, it might bring down prices in affected states, perhaps reversing some recent increases in home prices.

For now, the improvement in prices seen to date is a positive for investors in private-label securities, since boosts the equity borrowers have in their homes, thereby reducing the likelihood of delinquency or default.

Advances in House Prices

According to CoreLogic, nationwide home prices, including distressed sales, rose on 6.3% in October 2012 versus October 2011. This marks the largest increase since June 2006 and the eighth consecutive increase on a year-over-year basis. On a month-over-month basis, including distressed sales, home prices dipped by 0.2% in October 2012 relative to September 2012.

CoreLogic is calling for a 5% national year-over-year growth in home prices in 2013. Mark Fleming, chief economist at the firm, said in a November interview that the market has been boosted by the current balance in the housing market's supply and demand dynamics. Fleming cited the intrinsic demand from first-time homebuyers supported by the low rate levels and the consumers' faith in their economic situation.

He also cited the homebuyers' existing "under-equitied" position and the fact that they have insufficient money for down payment on new homes. "This supply-lock effect is creating a balance in housing supply," he said.

CoreLogic expects the upward trajectory in home prices to be interrupted by a seasonal month-over-month decline in the beginning of winter into early next year. Nevertheless, barring any major macro-economic headwinds, "on season, we believe in the likelihood that people would want to buy homes," Fleming said, adding that he expects a 3% to 5% longer-term growth in house prices.”

Brian Lancaster, co-head of structured transactions, analytics, risk and strategy at the Royal Bank of Scotland, said that firm is also positive on home prices. "On the demand side, mortgage rates are at record lows and job growth and consumer confidence is improving.  Importantly, there is limited inventory in many markets right now. On average it would take about 5.8 months to sell current inventories.  New construction has been limited for the last five years and a number of potential sellers are withholding properties from the market as they don't want to realize a loss on their properties,” Lancaster said.

He added that stabilizing and improving property values in such an environment should feed on itself, changing consumer attitudes toward purchasing and bank attitudes toward lending.

Lancaster also mentioned that the REO-to-rental market has "grown rapidly, providing support at the lower end of the market in many "sand/sunbelt cities," although it is challenging to get solid data on the market.  Most of the purchases seem to be "moms-and-pops down the street," although there are also institutional investors," he said.

Some analysts are less bullish. Rui Pereira, a managing director at Fitch Ratings, said that the agency’s base-case view is still for moderate growth next year, and that’s assuming there are no shocks to the market related to the fiscal cliff or other macro-economic events.

“We think that moderate economic growth is going to continue to support a slow recovery in the housing market – albeit with important regional differences. While borrower affordability has improved significantly, credit conditions remain tight," Pereira said. "Much of the home price improvement we've seen in recent quarters has been driven by constrained supply that has been easily absorbed. However, there is still a significant backlog distressed inventory that needs to be cleared, which will continue drive volatility over the near-term."

Shadow Inventory

Shadow inventory is the big wild card in many housing market forecasts. In a report published Nov. 19, DBRS warned that the shadow inventory can upset the current supply and demand balance in the market.

In the piece, DBRS defined shadow inventory as properties that are not visible, include real-estate-owned properties not yet in the open market, homes locked up in the foreclosure process, and those that are seriously delinquent (more than 90 days behind on payments) and about to enter foreclosure.

“Despite the rebound, shadow inventory levels add to the uncertainties to the road to recovery along with high unemployment and struggling home owners with little or no equity,” said Quincy Tang, senior vice president at the ratings agency.

Tang pointed to the National Association Realtors’ estimate that it will take roughly 20 months to clear the shadow inventory. The months of supply of shadow inventory vary greatly by state, specifically when it comes to those that are judicial and non- judicial, with the average timeline for judicial ones 29 months and beyond.

“In our loan-level RMBS Insight model, the judicial and non-judicial timelines are incorporated on a state-by-state basis in the calculation of loss severities,” Tang said.

He noted that a few areas of the housing market are exhibiting improving trends.  Short sales and deeds in lieu “have increased as alternatives to the foreclosure process, it’s a trend that we believe is positive in terms of shrinking housing stock. Some servicers have been frustrated with the traditional loss mitigation techniques, so they are increasingly employing these two methods.”  In addition, he said, real estate investors see opportunities in discounted homes and have been buying and renting such properties.

DBRS said that these trends, coupled with overall consumer sentiment, might be working as visible inventory has dipped 23% from a year ago and shadow inventory has decreased 10% for the same period.

Fitch has incorporated the length of time it will take to clear the shadow inventory as a component of house prices in its stress levels. “I think that there has been a general improvement across the board in home prices, although we think into 2013 there are still a lot of markets, specifically in the Northeast, that have not yet fully experienced a correction,” Pereira said. “Many of the judicial states have a lengthy foreclosure process and more extensive levels of inventory that they have to work their way through the system.”

Pereira said that Fitch has incorporated conservative assumptions into the timelines in judicial states.  In New York and New Jersey, for example, the base case liquidation timeline assumption is 19 months, which gradually increases under each rating stress scenario.

 Effect on the RMBS Market

Rising housing prices are definitely a plus for RMBS, since it gives homeowners more equity, thereby reducing the risk of default.

"In terms of the impact of the improving housing situation on non-agency RMBS, its biggest effect in my opinion has been what I would call a "marketing effect," RBS’s Lancaster said. This means a housing market that has brought in more investors to non-agency MBS looking to make a housing play. 

He added that credit metrics in non-agency MBS have been improving for a year or more, depending on the product, by and large because of "burn out" and loan modifications. 

Lancaster sees the impact of rising home prices on credit metrics as limited, however. “While our modeling definitely shows a positive impact from an improving market on some bonds, if you had a 120% LTV loan, a house price rise of 5% doesn't do much," he said.

Moody’s Investors Service believes the impact on LTVs varies by market and loan type. In a November report, the rating agency noted that the increase home prices enjoyed in 2012 produced a concurrent dip in the average loan-to-value ratios of borrowers who have always made timely payments on their loans in all collateral types. Option ARMs, which are more prevalent in parts of the country that have enjoyed above-average home price appreciation, have experienced the biggest dip in average LTV and a correspondingly large net rise in the portion of borrowers with positive equity in their homes.

“Looking at the future of RMBS performance, the falling LTVs may lessen incremental defaults most significantly in the jumbo sector because it features the highest proportion of borrowers that have made timely payments and are yet to default,” Peter McNally, vice president at Moody’s, said. “So a rise in home prices will benefit comparatively more of these borrowers and reduce the potential that they will eventually default.”

There are other factors working in favor of the private label market, however.  Lancaster said the Federal Reserve's purchases of agency MBS purchases are also helping private label RMBS. That is both because they help to bring down mortgage rates, which is supportive of home prices, and because it increase the relative cost of agency MBS to other fixed-income products such as non-agency MBS. 

"The Fed is generally a non-economic player buying agency MBS with the goal of boosting their price. That makes other alternatives, such as non-agency MBS, not to mention CMBS, CLOs and a host of other alternatives, relatively more attractive," Lancaster said.

Going forward, in terms of the secondary market, the effect of home price increases will not be that significant in the majority of non-agency securities that are not levered, according to Scott Eichel, global head of securitized products and head of U.S. credit at RBS. "We saw along with the rally in the third quarter that risk assets have not struggled and that residential is not as sexy a secondary trade anymore,” he said.

Rising home prices do tend to encourage issuance of new securitizations, though regulatory issues are also at play. “On the primary side, you're starting to see broker dealers acquire loans to create securitizations as economics have returned to favorable status, something we haven't seen in years,” Eichel said. “Securitizations remain scarce. Really the hope is that in the first quarter we'll have a better idea of risk retention and what the reps and warranties are." 

"The problem most banks have is that the deposit-to-loan ratio is not where they want it to be and the net interest margins on the jumbo conforming paper are some of the most attractive seen in years," Eichel said. "Being sellers, there's a lot of fixed-rate duration and managing, that is where I think the biggest opportunities lie. Banks' funding is the best it's been in a long time, and there's a huge incentive to keep loans on balance sheets where risk weights are more favorable than securities."

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