The January 25, 2011 DataQuick press release shows that both foreclosures and notices of defaults have fallen almost everywhere in California. Statewide foreclosures have fallen 21.9% from last quarter and more than 30% from the fourth quarter of 2009. The large drop in foreclosures may indicate lenders’ hesitancy to take large losses. After the initial run on foreclosures, banks have been focused on obtaining the best possible price for the home at the lowest possible cost. As a result, the banks are cooperating in more short sale programs. In many cases, sellers are being asked to participate in the pain as they are released from their mortgages, particularly second mortgages, where the sellers may be asked to bring in cash and/or sign a note for a portion, if not all, of the outstanding debt.

According to DataQuick many of the homes foreclosed on had multiple loans out on the property. In other words the homes had the primary loan and additional lines of credit, i.e. home equity lines of credit. This is logical since many homeowners had refinanced their homes when interest rates were at all time lows using said loans to renovate their homes, go on expensive vacations, fund a more lavish lifestyle, and more generally, use their home as a credit card.

DataQuick indicated that foreclosures are still more frequent in zip codes with an average home price of $200,000 or less versus in zip codes where the average home price was $800,000. The less affluent zip codes also averaged more foreclosures per 1,000 homes than the state average. This market consists of lower income families and when the interest rates were lower a large number of low-income families entered the housing market. Traditionally these families had never owned homes because their credit scores acted as barriers to entry. Now, some of them are also losing their jobs, and in this case, default and foreclosure are almost inevitable.

NODs (Notices of Default) have also been falling. Last year at this same time the question of a “W” recession had come up. In reviewing 2008 and 2009 where NODs dropped off severely in the fourth quarter of 2008, and picked up again in 2009 we wondered if 2010 would repeat the pattern. That was not the case and 2011 is looking like it will continue the trend of fewer homes starting the foreclosure process. There are a number of reasons for this. Banks, through the encouragement of the government, have been working with homeowners to avoid the foreclosure process and seek alternatives such as short sale and loan modification. This is mutually beneficial for banks and homeowners. The banks take smaller losses when they go through the short sale process and the homeowner’s financial situation is much less disrupted.

The bottom line is that it looks like 2011 will be a better year in the real estate market but do not expect a rapid bounce back. While foreclosures and NODs will likely continue to decrease, they are still at a level that is abnormally high, too high for a healthy housing market.

The January 27, 2010 DataQuick press release shows that California Notices of Default (NOD’s) fell from 111,689 in third quarter of 2009 to 84,568 in the fourth quarter of 2009. That is almost a 25 percent drop in NOD’s. NOD’s have been falling for three quarters now, which is a nice development. However, foreclosures rose for the third quarter in a row. Though the increase in foreclosures was not as large as the drop in NOD’s this steady increase in foreclosures indicates that all is not well in California’s residential real estate. As well, both NODs and Foreclosures remain historically high. See the charts below.

NOD’s falling from record highs is unquestionably good news. One has to wonder if the rapid decline is entirely due to home owners regaining their financial security or if some of it is due to seasonality. We note that in 2008 there was also drop in the last two quarters only to spike again in the first quarter of 2009. To investigate this farther, we seasonally adjusted the data. These results, blue line on charts below, indicate that foreclosures rose from about 48,000 during third quarter 2009 to 55,000 in fourth quarter 2009, a more sizable deterioration in the market. Otherwise, the seasonal adjustment process did not change the implications from the raw data very much.

The take-away from this data is that California NODs and Foreclosures remain historically high. As a result, residential real estate will continue to endure the damper on neighborhood quality and housing values. On the brighter side, if NODs continue to fall at the rate they did in fourth quarter, they will get down to very low levels in only three quarters. That would provide much needed support for the housing market.

New unemployment claims also rose to 444,000, again exceeding “consensus expectations.”

There was also a report that will receive much less attention, but it is important. Inventories increased in November, the most recent month for which data are available. If inventories were increasing over the Christmas shopping season, and sales were declining, retailers ended the year with excessive inventory. That means reduced production in the first and second quarters of 2010.

2009’s third quarter output (GDP) growth was positive, and many expect a very impressive positive number for the fourth quarter, some as high as five percent. If the fourth quarter does come in with a strong GDP growth rate, it will be hailed as the harbinger of a soon-to-be-realized vigorous recovery.

Don’t buy that, and you won’t be disappointed.

That vigorous recovery may eventually come, but it is unlikely to come in 2010. Whatever growth generated in second-half of 2009 was government-supported consumption, ephemeral, not a solid foundation for economic growth, certainly not the basis for sustained vigorous job growth.

A vigorous recovery will be a result of investment, technological growth, and improved productivity. Recent productivity numbers have been encouraging, but in large part, they are probably the result of firms downsizing. Technological growth and solid job growth require investment, and that is the problem.

Our banks are in no condition to fund any vigorous expansion. Indeed, bank loans have been declining since October 2008. Businesses and consumers remain over-leveraged, unable to increase spending on consumption, unable to invest, desperately trying to reduce debt.

We won’t see a vigorous recovery until balance sheets are improved and banks can lend.

Government programs haven’t helped. Most of the spending programs have been consumption based instead of investment based. Some have been outright counterproductive, programs such as foreclosure-delay, paying interest on bank deposits at the Fed, and cash for clunkers. Even worse, the banking problem has been ignored, and now new taxes on banks are being discussed. That is as bad an idea as I’ve heard in a long time.

Are we out of the woods?  No.  Is this an identifiable trend to recovery?  Not yet. 

From the charts, you can see that job levels are still 3.4 percent lower than they were at this time last year.  Also, the ranks of the long-term unemployed, those workers who have been unemployed for 27 weeks or longer, have grown to almost 6 million.

You can also see that the unemployment rate fell in July, before rising by more than 50 basis points during the next three months.  Hopefully, this time, the unemployment rate will not rise in December, but continue falling.

A key dynamic that has been going on for about a year now appears like it will continue at least through the middle of 2010, and that is the negative feedback from jobs to residential real estate.  This recession started in residential real estate with deflation of an over-leveraged housing bubble.  It then spread to virtually every other sector in the economy, and once job losses started, the negative feedback loop started.  Certain aspects of the housing correction were worsened by the job losses – especially foreclosures.

With high unemployment rates, lots of long-term unemployed persons, and job-levels still relatively low this feedback will continue.  The most recent United States residential foreclosure rate data indicate that the foreclosure problem is worsening.  The most recent data on commercial real estate loan delinquencies also indicate a steadily worsening problem.

What drove jobs down?  One of the biggest factors was the tremendous fall in consumption during the second half of 2008.  Our interpretation of that fall was the household sector moved to correct over-leveraged balance sheets.  With ongoing real estate loan delinquency problems, we are not convinced the household sector will be motivated to increase their spending levels in the near term.

We have said in the past and continue to say that the United States economy will not pull out of this recession quickly. While jobs are a lagging economic indicator, they feed back into the household’s spending ability. The weakness in jobs will imply weakness in median household income. The two biggest factors that drive consumption, income and wealth, have still not recovered to an extent that will motivate a household-sector-driven rebound in expenditures. Finally, Main Street as well as Wall Street will continue to suffer from high foreclosure rates due to the negative employment situation.

While the increase in foreclosures in the third quarter was over nine percent from the prior quarter, the potential increase in 2009 quarter 4 might be much larger. To see this, we look at time to foreclose and foreclosure rate. If it takes nine months from NOD to foreclosure, and if the turnover rate from NOD remains as it was nine months ago, then these two assumptions imply 90,000 foreclosures in quarter 4. This is because nine months ago, there was very large jump in NODs. This admittedly simple calculation presumes that government programs in place to keep people in their homes despite default do not change appreciably from quarter 3 to quarter 4. A key factor in this case includes government programs to keep people in their homes. Working against that are the ongoing unemployment levels combined with continued household sector debt-unwinding. Unfortunately, we do not see how California’s foreclosure level could be any lower than about 50,000 during the next few quarters, and they could be higher than that.

We note that the housing aspect of this recession is different than other recent recessions. What has typically happened in other recent recessions is that income and job losses caused a housing slowdown, and this happened a bit later in the cycle. What has happened in this recession is that the economic problems started in housing, starting earlier in the cycle compared to the typical recession.

A question might be, will this housing slowdown end sooner or later? We believe that the housing slowdown will persist just as late if not later compared to the typical recession. This is because there is still a large quantity of housing inventory that will come to market as a short sale or a foreclosure. In addition, most forecasts (including ours) call for the number of unemployed to remain relatively high for some time. As job creation remains negative or low and as unemployment rates remain high foreclosure rates will remain high. More households who have begun to default will find it difficult to save their home, while new households will face increasing difficulty in maintaining home payments. In addition, ongoing foreclosures and short sales will contribute to further declines in home values. And these factors will contribute to weak growth in household sector wealth. These factors are part of why we remain bullish on housing and the economy for some number of quarters to come. Finally, the implication is that the housing slowdown in this cycle will be longer than in most cycles.

While it is possible that GDP growth will be positive in the 3rd quarter, we believe that the private economy will be weak for some time to come. The evolution of this recession could look like a “W” or an “L”. GDP growth rates will be small, sometimes negative or near zero, with occasional bounces that will be driven by temporary household and/or government expenditures. If GDP is recalculated without foreign or government influences, then 2009 quarter 2 economic activity declined by 4 percent, see my August 5 blog on this topic. Real estate delinquencies and foreclosures continue at historically high levels. It appears that the tide of commercial foreclosures will continue to rise. Foreclosures hit the economy hard, having serious negative consequences for both Main Street and Wall Street. US economic growth might be positive in 2009 quarter 3, but the factors driving economic activity may conspire to reduce GDP growth in late 2009 or early 2010.