What will it take to get out of the housing mess?

Many experts don't see a real-estate recovery happening for another two years. Here are the key things they say are needed to turn things around.

By Melinda Fulmer of MSN Real Estate

A deepening foreclosure crisis has many economists and real-estate experts predicting two more years of a real-estate slump unless more action is taken by government and private industry.
Lenders' unwillingness or inability to effectively modify loans is leading the country into a downward spiral of job loss and foreclosures — one that is getting harder and harder to correct, experts say.

"It's been almost a backward cycle," says Rick Sharga, vice president of foreclosure data firm RealtyTrac. "Usually you have an economic downturn followed by unemployment, which leads to foreclosure. In this case, foreclosures ... have led to an economic downturn, which has led to joblessness, which will lead to more foreclosures."

Foreclosure filings were reported on more than 2.3 million properties — or one in 54 homes — in 2008. That's an 81% increase from 2007 and a 225% increase from 2006, according to RealtyTrac. (RealtyTrac is an MSN Real Estate partner.)

Sharga and other real-estate watchers expect that number to jump substantially in 2009, as stated-income loans (also called "liars' loans") begin resetting and a 16-year high in unemployment starts to cause defaults even in fixed-rate prime loans.

Obama's proposed solution. One solution the administration of President Barack Obama is seeking is a change to federal bankruptcy laws that would allow federal judges to restructure mortgages of struggling borrowers.

Senate Democrats are advancing legislation that would allow judges to reduce the principal or "cram down" the amount owed for the primary residences of borrowers who have sought Chapter 13 bankruptcy protection. Chapter 13 is a bankruptcy status that allows debtors to retain assets and pay back their debts over three to five years.

Judges can currently modify the terms of credit-card and other debt, including vacation homes, but haven't been able to modify primary residences since 1979, when the U.S. bankruptcy code was enacted.

Giving judges the ability to restructure mortgages would help borrowers who have been unable to get their loans modified because the loans have been packaged into securities and sold to multiple investors, who won't agree on a solution.

One sign that this may be inevitable: Giant lender Citigroup recently supported this bill, much to the dismay of rival lenders. Rod Dubitsky, Credit Suisse managing director and lead housing analyst, also would like to see money from the government's Troubled Asset Relief Program being used to buy up loan portfolios and modify them as part of a national government program.

"We have outsourced the housing recovery to loan servicers who are inadequately staffed and don't have the freedom to do what is needed to minimize housing costs," Dubitsky says.Ron Faris, president of Ocwen Financial, a publicly traded servicer of subprime loans, says there is no financial incentive for most servicers to help strapped borrowers stay in their homes.

"Mostly it's 50 basis points to the servicer whether (the borrower) is paying or not paying," Faris says.

Writedowns and rewards for helpful servicers. That's part of the reason why we've seen such a dismal success rate with loan modifications to-date, Faris says. The other reason is that many servicers lack the know-how or staff to carefully study a borrower's total financial picture and tailor a solution.

Most of the loan modifications done to date, analysts say, do not involve reductions in principal, rate or term, but rather forestall the inevitable by rolling delinquent payments into a new and still unaffordable loan.

According to the comptroller of the currency, 52% of the loans modified in the first quarter of last year fell delinquent again in six months.

"Something is wrong if you are getting that kind of default rate," Faris says.

With these kinds of inefficient solutions, and with prices continuing their downward slide, more borrowers are simply choosing to walk away from their homes, says Mark Zandi, chief economist of Moody's Economy.com.

"Millions of homeowners are underwater, deeply underwater on their house and with any increase in expenses they are stepping away from their home," Zandi says. "I think the only way to mitigate the surge in foreclosures is to have a government plan to have mortgage write-downs.

"It's costly, but at the end of the day, not doing that and allowing these millions of dollars to go into foreclosure will cost more people their jobs."

Faris, whose firm has received some attention for its successful foreclosure mitigation efforts for subprime loans, would like to see government get more involved in monitoring the performance of servicers and allocating work to those companies that are returning calls and helping borrowers keep their homes.

Jobs and incentives. However, the two biggest drivers needed to set a real-estate recovery in motion are jobs and sales. Economists are hoping that Obama's economic stimulus plan will jump-start the former.

But with real-estate values continuing to slide, buyer incentives may be the only way to resurrect sales.

Economists and industry analysts are urging government to back low, incentive mortgage rates that lenders can offer to qualified buyers, especially those in high-foreclosure areas such as California, Nevada, Florida, Arizona, Ohio and Michigan.

To be sure, rates are already historically low, with the benchmark 30-year fixed-rate mortgage falling 5 basis points, to 5.28%, the week ending Jan. 16, according to the Bankrate.com national survey of large lenders.

The Treasury is working on a plan to get rates down to 4.5%. But rates as low as 3.5% would help offset declining values, getting more people off the fence and improving the character of communities, Dubitsky adds.

"It basically allows you to run the numbers and say, 'I'm getting 2% lower mortgage rates; the home price would have to drop another 20% before I would break even' " on the deal. A drop less than that and you'd still be in the black, he explains.

A slow recovery. However, even with these loan-modification programs and concessions in place, a real stabilization in the market probably wouldn't be seen until sometime in 2010, Zandi says.

"(Foreclosures) will rise for another six months no matter what the government does," he says. So, extending state moratoriums until new government programs are in place might make sense.

Credit Suisse, for one, expects home prices to drop 10% nationwide over the next 12 months and an additional 5% in the following year, and grow 3% annually thereafter.

And that's if Obama's economic stimulus plan works and unemployment doesn't continue to ramp up, as it has in the past month.

"I don't think we'll see any real rebound in the housing market over the next two years," Faris says.