Tight mortgage credit and home prices that linger well below normal levels remain barriers to a full and robust housing recovery. As a result, the market has gone too far in anticipating an early end to the open-end third round of quantitative easing, according to Bank of America Merrill Lynch (BAC).

In fact, with these conditions in play, BofA-Merrill Lynch expects more Fed intervention, at least for a while.

Analysts Chris Flanagan and Matthew Carr of BofAML suggest the Federal Reserve QE3 purchases will continue well into 2014, specifically the third quarter of 2014. Additionally, the actual commencement of sales of agency mortgage backed-securitizations are likely to continue until 2016.

"The Fed is likely to be a patient 'investor' in MBS and remain mindful of the challenges that still face the US economy," the analysts noted.

Similarly, Federal Reserve Vice Chairman Janet Yellen noted that housing has not provided the tailwind to the current economic recovery that it has previously. 

Yellen especially noted, the challenge associated with tight mortgage credit conditions, making it difficult for potential homebuyers, despite record-low mortgage interest rates, creating housing affordability. 

Home prices remain below fair value and the benefits of price gains over the next two years are likely to accrue to the limited few with access to mortgage credit, including investors, the analysts noted. 

Thus, due to tight credit, broad-based economic participation in rising home prices is still somewhat limited, according to BofAML.

Purchase applications are approximately right at the average level observed since the beginning of 2010 and at the levels previously observed in 1997, according to the Mortgage Bankers Association Purchase index.

As a result, if housing is to provide the strong tailwind to the recovery, broader based purchase activity will need to increase, meaning QE3 will remain in tact. 

"Early removal of policy that keeps mortgage rates historically low is not a recipe for creating that outcome," Flanagan and Carr said.

The analysts additionally noted that they are more constructive on the longer term outlook for credit, deriving a good chunk of value from the recovery in real estate rather than for agency MBS, which ultimately will have to deal with the end of QE3.

Regardless of the timeline for QE3, real estate appears poised to sustain the recovery that residential real estate prices increase by more than 8% in 2012, according to CoreLogic data. 

"If employment remains weak to the point that protracted QE is required, real estate should benefit from the asset inflation associated with the Fed’s asset purchases," the analysts noted. "Conversely, if employment recovers robustly, forcing an early end to QE3, increased demand for both commercial and residential investment should follow."

The Fed’s attention to negative home equity suggests a more explicit targeting of residential real estate prices, BofAML noted.

Although the unemployment rate is higher than anticipated, the residential real estate price/negative equity is worse, implying the Fed needs to shift its attention to this front, according to the analysts. 

"Our simple takeaway from this analysis is that the Fed will likely not rest easy until residential real estate prices show more persistent and pronounced price gains than what we have seen so far. We still like positioning in the legacy alt-A and subprime non- agency MBS markets to benefit from this story," Flanagan and Carr said.