At some point, the dodgy loans of the housing bubble will be recycled, delinquency rates will fall back to normal, the shadow inventory will be processed, and foreclosure rates will decline to the point they no longer dominate market sales and keep prices from rising. But when will that happen?

Based on the most recent data from Lender Processing Services, I have extrapolated recent trends to attempt to answer that question. But first, we need to understand where we are in the process.

In early 2012, lenders halted processing shadow inventory of long-term delinquent loans to attempt one more round of loan modifications to comply with the national settlement agreement. They have taken advantage of this to greatly reduce their standing inventory, particularly in non-judicial foreclosure states like California.

CA – Foreclosure Inventories

As a result of this shift in processing, the ratio of aged loans to the total pipeline of foreclosures has been rising abruptly (see chart below).

And shadow inventory has started rising again.

Lenders hope they can cure the loans of the long-term delinquent through HAMP loan modifications because then they can pass those losses on to the US taxpayer. At least some in Congress are fighting this, but the banks will likely win in the end. Regardless of whether or not these loans can be save through loan modifications, the delays gives more time for the market to heal and time for banks to liquidate their standing REO inventories. By the end of 2012, banks will not be storing any REO outside their normal processing pipeline.

I took the long-term chart of mortgage delinquencies from LPS and projected the current rate of decline forward to the future to see when we get back to a normal rate of delinquency. The result was January of 2015 (see chart below).

The data series for extrapolation was two and a half years of data, and the trend is easy to define. I feel confident that unless lender behavior changes, we will see normal delinquency rates by early 2015.

Foreclosure Rates

The foreclosure rates are much more difficult to project because we have not turned the corner on foreclosure processing. Banks have been flatlined at the maximum rate of foreclosure processing their balance sheets can take and the housing market can absorb. Projecting the rate of future foreclosures first requires an estimate of when foreclosure processing will come off this plateau, then it requires an estimate of how quickly foreclosure processing will decline.

My estimate of when foreclosures will begin to subside from the plateau is when delinquencies approach the normal range. Since the declining delinquency rate happens in part because lenders clean up long-term delinquencies, the rate of foreclosure processing should slow down as lenders begin running out of borrowers to foreclose on. This rate should start to turn down before delinquency rates stabilize. I estimate foreclosures will begin to drop in early 2014.

Based on the rate at which foreclosures increased, I estimate it will take another three and a half years for foreclosure rates to drop all the way down to their historically low levels prior to the housing bust, but it may take much longer as the large number of underwater loanowners creates a long tail. However, somewhere in between, the total number of foreclosures being processed through the MLS will decline to where they no longer dominate total sales. At that point, foreclosures will no longer be a strong drag on prices. I estimate the market will reach this magic threshold sometime in 2015 or 2016. At that point, the choppy bottoming period of seasonal ups and downs will be replaced by normal market appreciation based on income and job growth. Some of the most beaten down markets may see above average appreciation as they rebound back up to levels of payment affordability matching historic norms.

If I am right, the housing market will begin a true recovery in 2015, a full ten years after the crash began. The bottoming period will have lasted for seven full years. I might be wrong. It may take even longer.

Analysis: In the U.S. housing market, recovery or Lost Decade?

Published: Sunday, 15 Jul 2012 | 8:04 AM ET

(Reuters) – The worst U.S. housing crisis since the Great Depression has been declared over. But is it?

What some of Wall Street’s forecasts for a recovery may be underestimating are tectonic shifts in the U.S. economy that make the housing market a different place from a decade ago.

Record levels of student debt, 15 years of flat incomes and the fact that nearly half of homeowners are effectively stranded in their houses look likely to weigh on prices into the indefinite future.

The housing bottom consensus could be very wrong.

… “We’ve gone through half of a lost decade since the crisis started in 2007,” said Robert Shiller, co-founder of the Case-Shiller U.S. housing price index and an economics professor at Yale University.

The so-called Lost Decade in Japan occurred after the speculative bubble in the 1980s, when abnormally low interest rates fueled soaring property values. The ensuing crash has continued to afflict the Japanese economy ever since.

“It seems to me that a plausible forecast is, given our inability to do stimulus now, for Japan-like slow growth for the next five years in the economy. Therefore, if there is an increase in home prices, it’s modest,” said Shiller.

Our monetary policy has certainly mirrored the Japanese experience during their lost decade, and the sluggish economic growth we have been experiencing during this so-called recovery has been equally as anemic.

A Reuters poll published on Friday showed most economists think the U.S. housing market has now bottomed and prices should rise nearly 2 percent in 2013 after a flat 2012.

Only the realtors believe prices will go back up quickly.

GENERATION STAGNATION

Consider the plight of college graduates, who go on to become the biggest group of first-time U.S. home buyers.

Many graduate into a climate of falling wages and soaring rents, members of the most indebted generation in history who owe an average $25,000 in student loans.

They elbow their way into a labor market so rough that the number of people with jobs is at a 30-year low, health and retirement benefits are shrinking and the young workers face a greater chance of losing their jobs than any generation before.

Tomorrow’s buyers have too much other debt to afford large mortgage payments.

… Housing prices and income usually move in lock step. But real median household income is stuck at the same level as during the Clinton Administration in 1996 — at about $49,000.That means the housing market will remain troubled for “an extended period of time,” according to Sam Khater, a senior economist at housing data company CoreLogic.

“It’s not about job growth. It’s about income growth,” says Khater.

Now that people have to qualify to repay the mortgages based on real, verified incomes, prices can’t go up until incomes do.

Back in 1996, the median home price was around $80,000. When house prices soared to $200,000 in 2006 — the market peak — it was due to jumbo mortgages, not jumbo pay raises.

Banks lured consumers with low interest rates that later turned much more expensive and blew up monthly payments, eventually helping to cause the housing crash.

On the one hand, the housing implosion has created a bonanza for those buyers who can take advantage of it: U.S. real estate is now 36 percent cheaper than in 2006.

In nearly every city, it now costs less to own than to rent. …

As I noted, Monthly cost of home ownership down over 50% from 2006.

BUSTED CONVEYOR BELT

The housing market, as economists often like to point out, is a conveyor belt. A homeowner sells a house. The new buyer moves in, and the seller buys a better house. In time, that buyer in turn sells, and buys a better house.

Normally these so-called move-up buyers are the housing market’s biggest consumer group. They are what keep that conveyor belt moving.

Today the apparatus is broken.

That’s because about half of homeowners with mortgages simply can’t move.

Twenty-four percent owe more on their houses than they are worth. Another 25 percent are equity poor, meaning they have less than the 20 percent of equity required for a down payment to trade up to a new home, according to housing-data company CoreLogic.

Sean O’Toole, the CEO of foreclosure-data aggregator ForeclosureRadar.com, estimates that it will take at least another decade, at the housing market’s current pace of growth, for homeowners who are underwater just to break even on their houses.

“We went from $4.5 trillion of mortgage debt in 2000 to $10.5 trillion of debt in 2008 — and we are still only down to $9.8 trillion,” says O’Toole.

“All those people with negative equity, they can’t sell. They are stuck in a prison of debt.”

The strength of the market is the below median price points. Very little above the median is selling well because so few buyers have the necessary income and down payment to buy a move-up house. This problem will persist for a very long time. We need to get a new generation of buyers in at the bottom, and allow prices to rise about 25% before that group will have enough equity to sell and make a move up. If the market doesn’t start moving higher until 2015, it will take another five years for it to move 20%-25%, so we are looking at 2020 before the move-up market begins to function as it did prior to the housing bubble.