Analysts: Price Drop Could Sink New Loans

New York-Concern is growing that despite tighter underwriting standards and the demise of the riskiest loan products, falling home values could put newly originated loans underwater, raising the risk of default.

The S&P/Case-Shiller home price index showed home values fell at a record quarterly pace in the third quarter, amid few signs of improvement in the market.

And with unemployment - a key default driver - still rising, further price declines could leave many borrowers who took out home loans this year or will next year at risk of owing more money than their home is worth, according to economist Karl Case, a professor at Wellesley College and founding partner of the index.

"If prices keep dropping, 2008 and 2009 mortgages could be bad news. If prices continue to fall substantially next year, then that book is going to be underwater, too, and that's going to be very devastating to the economy," Mr. Case said during a conference call with reporters.

He noted that projections for a recovery in the housing finance industry have assumed that loans currently being originated will perform well and remain profitable.

S&P/Case-Shiller reported that home prices nationally were down 16.6% in the third quarter from a year earlier. That was higher than the rate of decline posted in the first and second quarters of this year.

The third-quarter decline puts prices back to where they were in 2004 nationally, down 21% from their peak on a national average basis, with the largest declines being posted in once-hot Sun Belt markets, including Phoenix, Las Vegas, Miami, San Francisco, Los Angeles and San Diego. Moreover, the index shows that prices declined on a month-to-month basis in September across all metropolitan areas covered by the index.

The concern about today's new home loans ending up being underwater comes amid few signs that housing markets are stabilizing.

Already, foreclosure-related sales are forcing a high number of bank home sales, and these distressed-sales are hurting market prices, Mr. Case said.

"It's clear that there's bottleneck. The number of mortgages that are actually under water is very large, and so the auction numbers are not going to slow down anytime soon," he added.

Last week, the National Association of Realtors reported that both the number of existing home sales and the average sales price fell in October, with "distressed sales," including foreclosed homes and short sales, accounting for 45% of all sales in October.

Moreover, Mr. Case said that widespread loan modification programs that reduce the principal or monthly payments for borrowers could backfire if they are too generous. People currently struggling to make payments may stop paying and deliberately default on their loans, hoping to qualify for relief. That creates a "moral hazard" that could further escalate home loan default numbers.

"They see their neighbors getting a break and they want to get one, too," Mr. Case said.

Separately, FirstAmerican Core Logic said its mortgage risk index rose for the fourth quarter 12% from a year ago. That puts the risk of home loan delinquency 54% higher than it was in the index's base period, the first quarter of 2002 as the nation was emerging from its last recession.

The NAR found that the pace of existing home sales fell below 5 million units annually in October, with the largest median monthly price decline on record.

Separately, the Federal Housing Finance Agency also reported that home prices declined in the third quarter. The FHFA's "all transactions" price index, which includes data from home sales and appraisals for refinancing, showed a 2.7% price decline in the third quarter.

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