Dennis Smith has been watching homebuilder numbers in Las Vegas for 23 years, and he hasn’t seen anything like this.

The city, considered the epicenter of the housing crisis, held the highest foreclosure rate for 22 consecutive months until October when a new law went into effect that could land servicers in jail for mishandling foreclosure documents — bringing the process to a near halt.

Along the strip, skeletons of new casino developments sit abandoned. In the residential areas, foreclosure signs pockmark neighborhoods like a virus that has overwhelmed its host. Property prices have been slashed more than 63% since the collapse, according to DataQuick. And 70% of the mortgages in the city are underwater.

Signs of economic life are sporadic at best. The few remaining builders are beginning to dust off old plans in attempts to adapt them to areas with extreme concentrations of vacancies, but Smith laughs when asked if there are any new developments under way.

“You’re joking right?” he asks from his office at Homebuilders Research Inc. “If you ask any of these underwater homeowners about new developments, they’ll run you up the flagpole.”

While the problems nationwide aren’t quite as severe — roughly 25% of all mortgages in the U.S. are underwater — the situation is dire and the outcome is at best uncertain. Many agree the worst is behind us,  that those who’ve made it this far from the most catastrophic event since the Great Depression will likely survive.

But as you’ll see, there is more pain to come in 2012 as the housing industry and its policymakers continue to work through the debris. Smith summed up the uncertainty and fear as well as anyone.

“When it comes down to it, old folks like me just never thought the banks would stop lending,” he said. “Something from above has to get it going again.”

PAIN THEN GAIN

Banking analysts have been forecasting national home prices would drop another 5% to a bottom in the spring of 2012, according to JPMorgan Chase analysts.

But in November, analysts at Bank of America Merrill Lynch disagreed. They now believe prices will drop another 8% through the first quarter of 2013 as the market continues to work through the overhang of foreclosed properties. The final result, they said, would mean a 38% decline in the Case-Shiller index from its peak in the first quarter of 2006.

“The worst of the housing correction has passed, in our opinion, although there is one last significant hurdle: clearing the excess inventory of distressed properties,” the analysts said.

It all depends on pace. The BofAML analysts predict nearly 8 million previously foreclosed homes will be resold by the end of 2015, adding to the 6 million foreclosures already sold since 2007.

But any outlook, especially in today’s volatile markets, is difficult. The BofAML analysts note that their largest difficulty was determining the turning points in prices. Most forecasting models simply built in an error correction, which too often simply reverted back to the long-term mean. They, instead, developed a transition equation that accounted for short-run deviations from the trend such as months supply and changes in the share of distressed sales.

BofAML, like Moody’s Investors Service, built three forecasts for home prices along recovery, baseline and second-recession trend lines. Comparing the two lends a lot of optimism to the side of BofAML, though the eventual peak-to-trough decline in home prices from Moody’s was slightly less steep at 35% on its baseline compared to the 38% at BofAML.

But the uptick once the bottom is reached is drastically stronger from BofAML.

If the U.S. economy sours further — which is possible if policymakers in Europe can’t head off a collapse — both Moody’s and BofAML forecast a very similar consequence. Both said home prices would drop roughly another 20% through 2012 for an eventual peak-to-trough on the Case-Shiller of 46%.

ADAPT TO SEE 2013

It’s October, and the weather is nice in Chicago. It’s last day of the Mortgage Bankers Association conference, and Joe Dombrowski, the product manager for lending solutions at Fiserv passes by in the hallway. The entire conference has been building around some sort of strange optimism. It’s something shy of desperate but not quite confident either.

Dombrowski said nothing is certain heading into 2012 except that lenders are beginning to adapt. Some, he said, are busy unveiling new products and lobbying efforts. Others — like Bank of America exiting the correspondent space and MetLife jettisoning its servicing department — are simply abandoning entire market sectors because of the uncertainty.

Still, like Wells Fargo’s mortgage chief Mike Heid alluded to in the December HousingWire Magazine cover story, Dombrowski says those who’ve made it this far have a reason to be optimistic: They’re still around.

“I thought there was less of a sullen resignation and more of a conquering the challenge vibe among attendees. These, of course, would be the survivors,” Dombrowski says.

NATIONAL SERVICING STANDARDS

For 2012, Dombrowski expects much of the conversation to revolve around the upcoming servicing standards. Managing the supply of foreclosures already on the market is one thing. Estimates vary, but the consensus is that there are about 200,000 REO under management by private banks, the Department of Housing and Urban Development and the government-sponsored enterprises.

More ominous are millions of foreclosures about to happen, and the question remains: Have lenders and servicers adapted quickly enough to treat them all under still-forming guidelines?

“I keep hearing that regulators, auditors and others will pay special attention to how a servicer posts payments, assesses fees and keeps accurate track of information impacting a borrower,” Dombrowksi says. “The feeling is that the default process has been exhausted.”

Each of the 12 that signed consent orders concerning faulty foreclosure practices with the Office of the Comptroller of the Currency have installed single points of contact for borrowers on the verge of foreclosure, the regulator said in November. They’ve also installed new controls to ensure that dual-tracking — foreclosing on a borrower in the middle of a modification, does not happen.

At the midpoint of 2011, more than 2.7 million long-delinquent loans, in the foreclosure process or REO properties sat in the shadow inventory, more than double the amount measured in 2010, according to Amherst Securities Group. With the market averaging 90,000 loan liquidations per month, it would take nearly three years to clear it all.

Here’s how Daren Blomquist, the head analyst at RealtyTrac, which monitors foreclosure filings across the country, sees it playing out.

As of November, banks were on track to repossess roughly 800,000 homes through foreclosure in 2011, down 23% from the more than 1 million taken back the year before. The slowdown doesn’t mean things are getting better, they’re a symptom of nearly the entire default industry cutting corners and mishandling reams of paperwork. The OCC said the third-party consultants and their servicers will spend all of 2012 looking over nearly 4.5 million foreclosure files over the last two years to find out who was hurt by problems and to determine how to compensate them.

RealtyTrac originally estimated 1.2 million foreclosures for 2011. The remainder, about 400,000 filings, were pushed forward, along with those that should have begun.

“If this foreclosure cycle had run its course naturally, 2009 would have been the peak in foreclosure starts and 2010 would have been the peak in bank repossessions,” Blomquist. “Delays in foreclosure processing in 2009 and 2010 initially pushed the peak of bank repossessions out to 2011, but then the further delays in 2011 will mean that, in hindsight, 2010 might have been the technical peak in bank repossessions, but we will plateau with stubbornly high foreclosure numbers in 2011, 2012 and even 2013, instead of a steady decrease back to normal over those years.”

The peak and subsequent slowdown that should have begun in 2011 won’t happen now until maybe 2013, but back to what he said about the foreclosures that should have begun. How many of those are there?

For that, you can get the best and most nightmarish answer from Laurie Goodman, an analyst at the Amherst, and one of the most trusted sources in the space. She recently told Congress the problem is much larger than the 2.7 million homes on the verge of default or already there. She illustrated before a Senate subcommittee that another 10.4 million mortgages were set to hit foreclosure in the coming years. These include 3.6 million delinquent loans and 2 million re-performing mortgages she estimates would default again.

The rest, she said, would include borrowers in negative equity. Half of the 2.5 million mortgages with strong pay history characteristics but at loan-to-value ratios of 120% or more would default. Even 5% of these always-performing mortgages with at least some equity would slip into foreclosure as well, she said.

None of the panelists so clearly described the looming housing problem and the consequences of continued inaction like Goodman did that day.

“To solve the housing crisis you must create 4.1 million to 6.2 million units of housing demand over the next six years,” she said, starting in 2012.

THE DEMAND PROBLEM

Creating demand. That is a hard enough problem with unemployment still stubbornly high, though it did drop to 8.6% in December. Most of the millions who’ve tumbled out of foreclosure will have to wait years before they qualify for another mortgage. Other would-be homebuyers, who’ve somehow maintained good credit through the crisis, can’t qualify under new stringent standards.

For example, the Federal Housing Administration, one of the last games in town for insured mortgages, reported an average credit score above 700 for the first time in its history for fiscal 2011.

According to Fannie Mae’s third-quarter financial filing, the weighted average credit score for mortgages it acquired from 2009 through 2011 was 761. The average loan-to-value ratio at origination was 68%.

Combined, the GSEs and the FHA have financed 95% of the market since the crisis struck through 2011.

On top of that, the National Association of Realtors, which has been lobbying Washington and Wall Street, practically begging them to ease standards, said the contract failure rate in October was 33%.

That’s up from 18% the month before and just 8% one year ago.

“That’s just terrible,” says J.T. Smith, chief investment officer of the Florida-based boutique investment bank Aristar Funding Corp. “I see credit as a continued problem for end-demand of home sales.”

Nearly 20% of borrowers who took out a mortgage in 2007 are either 90 or more days delinquent or have already been foreclosed, he adds.

“That tells us going forward our base of potential real estate buyers has diminished, these people are out of the market for years to come. Dodd-Frank will continue to hinder any type of private-label lending coming into the market because of ambiguity and overreaching regulations,” Smith says. “Government needs to stop procrastinating and get out of the way, so this market can start to clear.”

PULL THE BAND-AID

In August 2009, a group of Australian medical experts set out to determine whether it was actually less painful for a Band-Aid to be pulled quickly or slowly.

They took 65 brave volunteers, applied the Band-Aids and ripped them off at two varying speeds, then had the volunteers grade the pain level from 0 to 10. According to their findings published a few months later in the Medical Journal of Australia, the volunteers graded the slower removal as causing nearly twice as much pain as the faster method.

While Jeremy Furyk, a professor at James Cook University in Australia and one of the key authors in the study, didn’t forge an analogy between pain threshold for Band-Aids and economics, he did admit pain is linked to preconception over what harms us and how much.

“The pain experience is a complex and incompletely understood process that incorporates many aspects of patients’ social and cultural beliefs, as well as previous experiences,” the authors note. “Our observation that preconceptions were associated with pain scores should not therefore be surprising.”

That brings us 8,000 miles away to George Livermore, the group executive for data and analytics at the California office of CoreLogic. The company has been hard hit by the downturn and is scrambling to adapt.

In August, the company formed a committee and brought in advisers from Greenhill & Co. to consider strategies for possible sell-offs. Its losses in the third quarter widened to $107 million as fewer foreclosures and originations cut into revenue streams tied directly to these types of services for lenders. It sold off five business units, including its appraisal management business, several consumer credit units and its marketing services.

It also laid off 6% of its workforce that quarter and one month later began laying off another 5%. While CoreLogic is not alone in taking the pain, it is doing the most publicly to adapt to a storm Livermore says is beginning to subside. 

“Mortgage brokers, appraisers and lenders have shrunk the most,” he says. “We’re not seeing that anymore.”

Looking at his data, the hardest hit markets are beginning to recover, including California, Florida and New York. Unemployment in these markets is actually beginning to slope downward. Homebuilders and remodelers, he said are adapting too. Instead of scaling out huge swaths of land for new developments, they are focusing on rebuilding older homes. Livermore said in some areas, builders have been thinned so greatly that those who survived are actually finding more work than they can handle.

Smaller lenders not so straddled with bad loans from the past are beginning to take more market share. He predicts in 2012, we will begin to see sizeable market share gains from lenders ranked outside of the big five.

His optimism seems almost shrill at first. When pressed, he shrugs and says he’s seen this before. The savings & loan crisis that struck in the early 1980s wiped out many banks that funded long-term mortgages with short-term deposits. When short-term interest rates rose, these firms were paying more to their depositors than they were making on the mortgages. The housing market began to crumble, wiping out many of the companies tied to the industry. Livermore says those who made it through that crisis are moving through this one by trimming down and tying off as much operational risk as possible. The industry is self-contracting down to only to what is essential in order to adapt.

“This time there’s fewer real estate agents, brokers and lenders. Yes, you have subprime and the secondary market that went away, but there’s still a lot of businesses that have shown a lot of resiliency,” Livermore says.

How much pain those left in housing can take in 2012 will be based on the perceived notion of it, the wisdom learned from having the Band-Aid pulled before.