Banks and home lenders are grappling with a slump in home sales that threatens to upend the housing recovery and, potentially, mortgage profits this year.

The sluggish demand for homes is particularly worrisome for lenders following the dramatic drying up of refinance activity last year.

Home sales are at their lowest level in three years with new applications last week falling 17% from a year earlier, according to the Mortgage Bankers Association. Meanwhile, refinancings have dropped off a cliff for many lenders, falling 60% to 70% from a year ago. While many mortgage lenders have expanded into new markets, hired more loan officers and added new products, the transition to a purchase market from easier refis is taking a toll.

"The pool of potential borrowers is lower and people just are not selling their homes the way they used to," says Matt Hackett, operations manager at Equity Now, a New York mortgage bank. "Lenders are all trying to drum up the purchase business and shops that were previously refinance shops are trying to transform themselves into purchase shops, but it's easier said than done."

A confluence of factors has put a crimp in homebuying, including the bitter weather that has engulfed most of the country this winter and the qualified mortgage rule that took effect Jan. 10 (though the latter's impact is hard to quantify, since government-backed mortgages are exempt for seven years).

"We're in a temporary adjustment period with higher rates and new rules," says Jed Kolko, chief economist at Trulia Inc., a real estate website. "The economy is far from recovered. Home prices and rents have risen much faster than incomes."

Much less talked about are the lingering effects of the foreclosure crisis. More than 10 million homeowners were foreclosed on in the past four years, according to the data firm RealtyTrac Inc. Using home sales as a gauge — about 5 million homes get sold in a given year — that means two years' worth of potential homebuyers have been shut out of the housing market, since they are ineligible for a new mortgage for several years after a foreclosure.

Borrowers who sell their home in a short sale, in which the lender accepts a discounted payoff, must wait at least two years before purchasing a home backed by Fannie Mae or Freddie Mac. Those who have gone through a foreclosure have to wait three to five years before they can get a loan backed by Fannie or Freddie.

Last year, the Federal Housing Administration cut the minimum wait time to just one year for borrowers who lost their homes to foreclosure or a short sale if they were unemployed or their income dropped due to circumstances beyond their control. Previously, borrowers had to wait three years after a short sale, deed-in-lieu or a foreclosure.

But the FHA has strict documentation requirements for its "Back to Work" program, and while FHA loans are aimed primarily at first-time home buyers and require only a 3.5% minimum down payment, many lenders are still leery of lending to subprime borrowers. Even if FHA says it will accept a mortgage, lenders worry they will have to indemnify the agency for losses if the loan goes bad.

The loss of so many potential borrowers presents a challenge that lenders have not faced in more than a decade. After the 2008 meltdown, refis made up for the dearth of purchase loan originations.

Then there's the QM rule, which exposes lenders to litigation unless they make loans with certain narrow underwriting criteria, including a debt-to-income ratio no higher than 43%.

Chris Boulter, president of Val-Chris Investments, a private "hard money" lender in Irvine, Calif., says some potential homeowners who can put 40% down still "can't get a loan."

"Any borrowers who have had a short sale or foreclosure in the last three years are out of the market unless they are talking to a non-QM lender, and those that do it are very selective," Boulter says. "We cherry-pick the ones we're going to do because the potential liability the lender is faced with is draconian."

Of the 600 home loans his company originated in the past two years, only about six would not meet the QM standard, Boulter says. Borrowers who have gone through a short sale or foreclosure must have a 30% down payment and likely will get an interest rate of 7.5% to 9.9% from a lender like Val-Chris, he says.

Even without QM restrictions, a purchase market is much harder to compete in than a refi market. First-time homebuyers need a lot more "handholding," and loan officers who used to sell the benefit of a refi are having a much more difficult time selling some borrowers on purchasing a home, Hackett says. Moreover, the purchase business is dictated by relationships with real estate agents and homebuilders.

Affordability also is likely to play an outsized role this year, thanks the run-up in home prices in 2013 and a recent pull-back by large institutional investors that had been snapping up distressed homes as rental properties.

The national median home price rose 10.1% in the fourth quarter to $196,900 from a year earlier, according to the National Association of Realtors. In addition, each one-point rise in interest rates adds roughly 10% to the cost of a home, says Kolko. Those two factors combined have made it harder for first-time homebuyers to afford a home and have turned off the institutional investors.

"The housing markets have been supported in large part by the investor community over the past two years," says Scott Buchta, head of fixed income strategy at Brean Capital in New York. "Should investor demand begin to level out and the slack not be picked up by traditional homebuyers, the housing market could be in for a sluggish patch in mid-2014."

The industry also has been plagued by a lack of inventory, which explains why sales are lower than usual, particularly for homes priced below $300,000. In California, the inventory of low-priced homes fell 13% in January from a year earlier, while the number of homes priced at $1 million or above rose 11%, according to the California Association of Realtors.

Another headwind is negative equity, which has improved dramatically in the past year but remains a drag on homeowners' ability to sell their homes and buy new ones. Roughly 10.8 million homeowners remain underwater, owing more on their homes than they are worth, but several million more are at break-even, without enough equity to make a down payment on another home. In October, 11.4% of loans were underwater, down from 19% at the start of last year, according to Black Knight Financial Services, formerly LPS.

Paul Miller, a managing director at FBR Capital Markets, remains optimistic that there will be thaw before the spring homebuying season.

The five largest banks continue to lose market share of roughly $15 billion in origination volume each quarter, he says, boding well for midtier lenders such as Flagstar Bancorp (FBC), HomeStreet (HMST), PennyMac Financial (PMSI), and Stonegate Mortgage (SGM).

"While we expect the overall level of originations to decline year-over-year, we estimate that purchase volumes will increase approximately 20% in 2014, building momentum heading into 2015," Miller wrote in a recent report.

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