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American Dream's Harsh New Reality

Foreclosures are on track to outpace new-home sales over the next two years.

As the housing boom of the early part of this decade unwinds, the U.S. is facing a harsh new reality: Annual home foreclosures may surpass new-home sales from builders.

Nearly 2 million homeowners are expected to lose their houses this year and next as the mortgage mess becomes a painful experience for condo-flipping gamblers and struggling families alike.

The latest data from the Mortgage Bankers Association Thursday showed that the nation's foreclosure situation continues to worsen. A

record number of mortgage holders -- 0.65% of all borrowers -- entered the foreclosure process in the second quarter. Loans already in the foreclosure process accounted for 1.4% of all mortgage loans outstanding at the end of the second quarter, slightly lower than the recent high in 2002.

Most of the foreclosure problems are stemming from homeowner payment shock tied to the trillions of dollars in adjustable-rate mortgages that are having their rates reset for the first time in 2007 and 2008.

As adjustable-rate mortgages reset to require much higher payments, many homeowners can only escape the blow by selling the home or refinancing the loan. But with housing prices falling, homeowners could face negative equity in their homes and may find foreclosure to be the only option.

The federal government has taken small steps to help ease the pain. President Bush last week outlined tax breaks and the federal government's guarantee of certain loans for low- and moderate-income borrowers who are behind on payments. The

Federal Reserve

has urged loan companies to work with homeowners to renegotiate loan terms or allow payments to be deferred.

But while the government may try to help, the ultimate level of foreclosures will be largely determined by how far housing prices decline -- a complex function of market psychology and plain old supply-and-demand forces.

"My view is foreclosures and defaults will soar through '08 into '09 regardless of what policymakers do," says Mark Zandi, chief economist with Economy.com. "But policymakers can have a beneficial impact and can mitigate some of the more serious erosion in foreclosures."

Zandi predicts a total of 1.8 million foreclosures for U.S. homeowners in 2007 and 2008. As a comparison, sales of homes that were newly constructed by builders were at an annual selling rate of 870,000 units in July, according to Census Bureau figures.

That sales rate could decline even further, since more foreclosed homes on the market will mean that the nation's big homebuilders, such as

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, will have even more trouble selling houses.

Moreover, Zandi's foreclosure projection is relatively optimistic and based on the idea that the U.S. economy will remain recession-free. If it doesn't, foreclosures could balloon even further.

Zandi's forecast assumes that the unemployment rate, currently around 4.6%, will not rise above 5% for more than one or two months over the next two years. The projection also assumes that the Federal Reserve will lower the fed funds rate 50 basis points to 4.75% by the end of the year -- something that's far from a certainty.

The foreclosure estimate also is based on the projection that the national median price for homes will fall just over 10% from its peak in late 2005 to a trough that Zandi estimates will occur in late 2008.

For the first half of this year, about 573,000 U.S. households have entered the foreclosure process, up 58% from the same period a year ago, according to RealtyTrac. Rick Sharga, marketing director of the firm, says he expects between 1 million and 1.2 million households to ultimately begin the foreclosure process this year, up from 735,000 a year ago.

A big determinant of where the default rate ultimately settles out is housing prices. In the second quarter, prices fell 3.2% from a year ago, the largest decline in at least 20 years, according to the S&P/Case-Shiller home price index.

The increasing inventories of homes for sale will continue to put downward pressure on pricing. Buyer psychology also will have an important impact on where prices go and may hurt foreclosures even more, says Robert Shiller, a Yale economist and co-creator of the home price index.

"The problem could get much worse if home prices continue to fall and put more people into the negative equity, or marginal equity category," Shiller says.

The issue could be further exacerbated if homeowners begin to worry that long-term housing prices are no longer rising.

Shiller's recent field studies in San Francisco and Los Angeles showed that many homebuyers and owners are still expecting annual median housing price increases of 5% for the next 10 years. A similar trend is occurring in Boston.

"People still have sanguine expectations. They won't default as long as expectations hold up," Shiller says.

The foreclosures aren't just hurting real estate investors who sought to make a quick buck flipping houses. According to the Mortgage Bankers Association, only about 16% of prime loans in the U.S. that are defaulting were for investor houses, or houses whose owners do not live in them. About 12% of subprime loans in default were to these speculators.

Investor loans, though, were a major driver of the defaults in Nevada, Arizona, Florida and California. These four states faced the fastest increase in delinquent loans in the first half of 2007.

In Nevada, the worst market from a default standpoint, about 32% of prime loans that are defaulting and 24% of subprime loans defaulting were those held by such investors.

Preventable Pain

Of course, nearly 2 million foreclosures over the next two years represents only about 1.8% of all U.S. households. What is particularly troublesome, however, is that much of this fiasco could have been prevented.

"The entire debacle you are observing -- there is nothing unexpected about it. It is astonishing to me that people were unprepared, " says Michael Bykhovsky, founder and CEO of Applied Financial Technology, a division of

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that provides mortgage default models for banks and other institutions.

To justify the pricing on many of the subprime loans originated in recent years, lenders had to assume that home prices would increase 10% to 15% a year, Bykhovsky says. The people who originated these loans were either gambling with institutional money and expected this trend to continue, or they had faulty models, he says.

If they had performed even a minimal amount of analysis, he says, they would have found that "the gamble is not only risky, it is almost highly likely to lead to where we are now.

"In most cases," he says, "the extent of incompetence is mind-boggling."