Recent housing indicators such as existing home sales, new home sales and housing starts, suggest a recovery is underway in the nation’s housing sector. But is the recovery sustainable? There are a number of obstacles in the recovery’s path which may suggest that forward momentum is tenuous at best.

Perhaps the greatest obstacle is a mounting foreclosure problem. Recent studies have indicated that the pipeline of foreclosed properties is likely to grow considerably during the next three years. Fitch recently issued a study and warned that of the $189 billion securitized option adjustable rate mortgage loans outstanding, 88 percent of them are due to recast during the next three years. Of these loans, 94 percent of the borrowers have utilized the minimum monthly payment option, allowing their loans to negatively amortize. Fitch predicts that between 35 percent and 45 percent of these loans after reset will end in foreclosure. Further, over 75 percent of these foreclosures will take place in only four states: California, Florida, Arizona, and Nevada.

Similarly, CoreLogic recently released a report that evaluated the 2.8 million active interest only home loans worth $908 billion. The company found that the interest only periods on these loans will be expiring over the next three years. In the next 12 months, $71 billion of these loans will reset, while $100 billion will reset in the year after and by mid-2011, another $400 billion will reset. It is likely that a meaningful number of foreclosure filings will occur due to these resets over the next three years.

Mounting foreclosures portend unfavorably for future housing supply as well as home values. A steady flow of new foreclosed properties promise to directly add to existing home inventories. The months’ supply is currently excessive at 9.4 and new foreclosures could keep a floor on the months’ supply number for some time. An oversupply of homes in any local market promises to exert downward pressure on home values. Further, foreclosed properties usually sell at 10 to 25 percent price discounts compared to non-foreclosed properties, exerting additional downward pressure on a local market’s home values.

The double whammy of rising home inventories and falling home values is likely to inhibit home buying. Under these circumstances, it is possible that home sales could retreat rather than advance sometime during the next two years. A possible double dip in the current housing cycle is possible and disconcerting to say the least.

Another obstacle is the recoiling of government subsidies in the housing markets. The home buying tax credit is expected to expire in November. The tax credit has been highly effective in enticing first time buyers into the marketplace. In addition, it is likely that in recent months, some households purchased homes in advance of the expiring tax credit. In either case, the expiration of the tax credit is expected to have a negative impact on future home sales.

The Federal Reserve has indirectly subsidized the housing sector by purchasing a great deal of mortgage debt which bids up bond prices, while bringing down bond rates. Thirty-year mortgage rates are currently hovering around 5 percent, providing low cost financing for home purchases. At some point, the Fed will begin winding down its bond purchase operations, likely sending mortgage rates northward. Higher mortgage rates could inhibit future home sales.

Finally, the fate of the housing recovery is highly dependent upon the fate of the economic recovery. At present, it appears that the economic recession ended in the second quarter of this year and a recovery is now underway. However, consumer spending remains weak, and consumers are deleveraging their balance sheets due to large losses in household wealth and the economy continues to shed jobs. Add to this, the fragile state of the credit markets and financial system and it is reasonable to assume that a complete economic recovery is not yet assured.

The current housing recovery has not been built solely with bricks. The housing sector remains fragile and its recovery is susceptible to retreat. Given this state of affairs, it may be prudent for the government to continue its subsidy programs in an effort to assure a complete long term recovery.