house for saleFinancial analyst Meredith Whitney recently joined the ranks of those who foresee a serious decline in housing prices in the second half of 2010. Her reason: Banks are starting to unload higher-priced homes in their bulging "shadow inventory," and with sales dropping sharply now that the federal tax credit for homebuyers has expired, there's a massive mismatch between supply (rising) and demand (falling).

Evidence for falling demand is plentiful: Pending home sales have tumbled 30%, hitting two records. Mike Larson of Weiss Research recently said: "Demand has fallen off a cliff in the wake of the tax credit expiration, with pending sales falling by the biggest margin ever to the lowest level ever."

The consensus is the sharp decline in home sales is the result of the federal tax credit ending, but few analysts have hazarded guessing where new demand will come from, absent the tax credit. Meanwhile, the supply of homes for sale or in default marches ever higher in all price segments.

To the surprise of those who reckoned that higher-end homes were holding up better than the rest of the market, the delinquency rate on investment homes with an original mortgage of more than $1 million is now 23%. And a staggering one in seven homes over $1 million is in default. Even the posh Beverly Hills zip codes have seen prices shrivel by 31%.

An Ever-Larger Shadow

Lenders are thus rightly worried that many of the 11 million homeowners who owe more than their house is worth -- the 24% of homeowners who are "underwater" -- will walk away from their mortgages, especially if the real estate market rolls over again. Such an increase in so-called strategic defaults would burden lenders with even more unsold homes -- a category known as "shadow inventory" because lenders don't always list a newly foreclosed home for sale immediately.

This shadow inventory could reach as high as 7 million homes by some estimates. Other analysts have calculated that it will take 103 months (about 8.5 years) to clear this gigantic inventory of foreclosed, distressed and defaulted homes.

To put these numbers in context: according to the U.S. Census Bureau, 51 million households have a mortgage and 24 million own homes free and clear (no mortgage), and about 37 million households rent.

Even more sobering, the total number of vacant dwellings in the U.S. increased to a record 19 million in the first quarter of the year, up from 18.9 million in the fourth quarter of 2009. As new homes continued to be constructed, inventory rose last year by 1.14 million to 130.9 million, while occupied homes increased by 1.07 million to 111.9 million.

Concern Over the Fed's Housing Exit Strategy

The Census Bureau places some 4 million of those vacant housing units in the category of vacation or second homes. Even if millions more of these empty homes are in areas few want to live any longer, or suffer from severe habitability issues, that still leaves well over 10 million vacant dwellings in the U.S. -- a massive overhang of supply.

No wonder some housing observers are issuing extreme forecasts that the nation faces a 50% decline in housing values.

On top of this long-term structural imbalance between demand and supply are concerns that the Federal Reserve's exit from buying mortgages could cause home loans to either rise in cost or become less readily available. Some analysts see this unprecedented Fed intervention in what was once a largely private mortgage market to be a development with negative consequences going forward.

The Fed, the Federal Housing Administration (FHA) and the government-sponsored housing agencies Fannie Mae and Freddie Mac have not managed mortgage risk very well. FHA problem loans have risen to 24% of all loans originated in 2007, and taxpayers face $1 trillion in losses on Fannie and Freddie alone in the years ahead.

Add a supply that overwhelms faltering demand and a mortgage market dominated by government or quasi-government agencies that have shown poor risk management, and you get a very unhealthy, vulnerable housing market.

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