High levels of inventory homes that are for sale, but not selling will be this year's source of pain for the housing market.

In the first quarter of 2007, an average of 542,000 newly built homes remained for sale at the end of each month (roughly 7.6 months of inventory given the current sales pace). In April, new home sales surged as home prices plunged 11 percent over the month. This brought inventory levels down to a 6.5 month supply. However, sales of new homes from January to April of 2007 remained 20 percent below their level a year earlier. And, because prices won't drop so sharply every month, the market is expected to remain soft for the remainder of the year.

Similar conditions prevail in the existing home market: in the first quarter of 2007, unsold inventory averaged 3.7 million homes, or 6.9 months of supply. In April, conditions worsened. Sales plunged 3 percent to 5.99 million units, and inventory rose to an 8.4-month supply. Over the entire four-month period, sales were 6.4 percent lower than a year earlier, which represents a smaller decline than in new homes, but nevertheless a decline.

Hidden inventories

In fact, many analysts warn that real levels of inventory could be even larger than the official statistics indicate due to "hidden inventories," which are homes that are vacant either because the home has been foreclosed, or an investor is waiting for improved conditions before deciding to sell. In fact, the number of vacant homes surged 34 percent at the end of 2006 to 2.1 million that's the fastest rate of increase ever recorded by the U.S. Census Bureau.

At the same time, the vacancy rate for owned (vs. rented) housing units jumped to a record 2.7 percent from 2.0 percent a year earlier. From 1965 to 2005, that vacancy rate had never been above 2 percent. Freddie Mac suggests that these numbers could represent half of the official inventory of new homes significantly raising the amount of time it would take to reduce excess supply.

Delinquencies and defaults

Another key piece of the inventory problem comes from the mortgage market, particularly the sub-prime market, where rising interest rates are pushing many new homeowners into delinquencies and even defaults.

In the early 2000s, low interest rates led to creative lending practices that were designed to enable a larger share of the population to afford home ownership. Lending in the sub-prime market mushroomed during this period. The number of sub-prime loans as a share of all mortgage loans serviced, for example, rose from a negligible 3 percent in 2000 to more than 13 percent in 2006.

Unfortunately, sub-prime loan packages were often based on variable rate mortgages that had low initial rates, but adjusted to a much higher interest rate as the initial rate period ended. Predatory loan practices also rose during this period, particularly targeting those in the more susceptible sub-prime market. As a result, delinquency rates and default rates for sub-prime loans are much higher than for standard (or prime) loans.

For example, in the fourth quarter of 2006, the delinquency rate for all mortgages was just under 5 percent. The delinquency rate for sub-prime mortgages was almost 11 percent.

Further pain

What this adds up to is further pain until excess inventories are appreciably reduced. Expect another decline in home sales (both new and existing), bringing the total to below 7.0 million units for all of 2007. The good news is that the inventory situation should begin to turn around by late 2007.

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