The housing market may have reached a bottom, but investors should not expect the market to return to pre-bubble conditions when prices and sales ran up unsustainably, according to a structured products research report by Wells Fargo Securities.

The market can also expect heavy losses among Option adjustable-rate mortgages (ARMs), a product that allowed negative amortization by letting borrowers choose to pay only the minimum monthly payment. Fitch Ratings expects significant payment shocks over the next several years as a wave of Option-ARMs recast from the minimum amount to a fully amortizing principle and interest payment. These recasts are expected to drive substantial losses among the Option-ARM sector.

"Several of our investors have questioned the current loss severity in light of negative amortization and home price decline," researchers wrote in the report. "Our analysis suggests that option ARM loss severity will likely range between 60% and 70% provided home prices have stabilized."

Wells Fargo researchers said investors can instead look for a return to longer-run measures. Existing home sales excluding foreclosures are likely to cap at around 3m units annually. foreclosure sales are likely to contribute 1m transactions to total sales, with a peak in foreclosure rates likely to occur in mid- to late-2010 between 1.8m and 2m units.

"Overall, our forecast implies a total of 7.2 million foreclosure units by 2014," researchers wrote. "Although the foreclosure inventory will likely dampen home price appreciation, we believe most of the home price damage due to foreclosure inventory is done and that home prices will likely remain stable over the period."

In light of the projections, Wells Fargo revised its loss estimates on various credit sectors. Wells Fargo researchers expect cumulative losses on prime ARMs to range from 2% among '04 vintages to 6% among '07 vintages. Cumulative losses should range between 6% and 11% among Alt-A/B ARMs and between 11% and 36% among subprime ARMs.

Write to Diana Golobay.

Positive signs of economic recovery — led by summer gains in house prices touted by industry participants — should not be overstated as adjustments still need to be made to strengthen the weak economic growth, according to Federal Reserve governor Daniel Tarullo.

“After a period in which there seemed to be only two plausible scenarios — very bad and even worse — financial and economic conditions have steadied,” Tarullo said Friday in an address to Phoenix-area community leaders.

At the same time, he indicated the securitization market often faces blame for the extent of the economic fallout related to a wave of structured finance that failed to perform to the industry's expectations. Instead, the industry should embrace ways securitizations of sound loan products can potentially drive further recovery by providing credit.

Tarullo said that each financial crisis has its own narrative, but that each share common elements that must be understood before fashioning a response.

“Instead of tulips in the seventeenth century Dutch Republic, South Sea Company stock in eighteenth century England, or the Nikkei and real estate in late twentieth century Japan, we had subprime mortgages and securitizations,” Tarullo said.

Tarullo called for an improvement in regulations both centered on financial firms and the linkages between them and the markets that could cripple the entire financial system if failures are realized.

The speech was prompted by Tarullo’s conversations with bankers, business people and consumers about a return to normalcy in the credit markets.

“During these discussions I have realized that just about everyone understands we will never return to the credit markets of the middle part of this decade, but very few people believe they understand what the 'new normal' will look like once the crisis has fully passed and the economy is on a sustained recovery path,” Tarullo said. “I suspect that this uncertainty is itself an impediment to stronger growth, since it makes financial planning more difficult.”

Tarullo said that the industry should welcome the demise of some features of the pre-crisis credit world such as subprime lending. But Tarullo said that securitization is not to blame despite reckless practices and the risk of exotic financial instruments.

“There is little to lament in their disappearance. But securitization is not in and of itself a bad thing. On the contrary, a well-functioning system for securitizing well-underwritten loans can make capital available at lower cost to businesses, homeowners, and retail consumers,” Tarullo said.

But beyond the complicated structures on Wall Street, Tarullo urged consumers to also make a needed adjustment.

“The habit of building personal savings predominantly through appreciation of one's home is one that many Americans will have to change,” Tarullo said.

The adjustments by individuals, financial firms, businesses, regulators and nations are a mandatory prerequisite to the end of the crisis, Tarullo said.

“How deftly we adjust is the question whose answer will weigh heavily in our nation's economic performance over the next decade,” Tarullo said.

Write to Jon Prior.

The Commercial Mortgage Securities Association (CMSA) and Mortgage Bankers Association (MBA) sent a comment letter this week to banking regulators, requesting capital requirement relief for certain structured finance products under new accounting rules set to go into effect in 2010.

The joint letter — filed at the Federal Reserve, Federal Deposit Insurance Corp. (FDIC), Office of Thrift Supervision (OTS) and Office of the Comptroller of the Currency (OCC) — addresses proposed risk-based capital treatment of residential and commercial mortgage assets backing private-label securitizations.

The letter (available to download here) raises industry concerns over the Financial Accounting Standards (FAS) 166 and 167, which were drafted by the Financial Accounting Standards Board (FASB) in June. The proposed changes take effect Jan. 1, 2010 and will require assets and liabilities of special purpose entities (SPEs) like mortgage-backed securities (MBS) to come onto the balance sheet of the issuer, servicer or special servicer. The standards will immediately apply to all existing MBS and commercial MBS, as well new MBS and CMBS issued after January 1.

“FAS 166 and FAS 167 will require hundreds of billions of dollars of assets to come onto the banks’ balance sheets on Jan. 1, 2010,” said John Courson, MBA’s president and CEO, in a statement. “These assets would immediately require an allocation of capital under the regulatory capital rules proposed. Coming at a time when regulatory capital is already a scarce resource, it may hinder the current economic recovery underway.”

The regulatory agencies that use the generally accepted accounting principles (GAAP) like FAS 166 and 167 as a baseline for assessing regulatory capital requirements will not grant relief for these assets and liabilities, the letter said. Forcing banks to account for these assets and liabilities essentially overnight on January 1 would present a significant financial burden if capital requirements are not loosened.

The CMSA and MBA recommended the regulators grant capital relief if a security meets certain structures. In cases where the transferor acts as primary beneficiary, capital relief should be granted if the transfer meets all other criteria for sale accounting under FAS 166.

Relief should also be granted in cases where the beneficial interest holders of the affected variable interest entity (VIE) have no recourse to the general credit of the primary beneficiary, and in cases where the VIE's assets can only be used to settle the VIE's obligations, the joint letter said.

The CMSA and MBA also called for capital relief in situations where no explicit arrangements or implicit variable interests exist that provide financial support to the VIE. Servicing advances should not be counted as such an arrangement or interest, as advances are required only if the servicer determines them to be collectible, the letter added.

Write to Diana Golobay.