There’s always something to howl about

A Scary Thought on the (Non-Existent?) Shadow Inventory

The shadow inventory has been a topic of interest with almost every agent I talk to lately.  Most believe it is large and few understand why it isn’t in the marketplace rather than held by the banks.  Russell Shaw recently wrote about the shadow inventory being gibberish.   It is an interesting article and one I recommend reading.

I rarely disagree with Mr. Shaw, and rather than do so now I’ll simply suggest that we are talking past one another.  As I read it, he is suggesting that this inventory doesn’t exist because it is, for the most part, out there already; just not listed as REO.  He makes it quite clear, however, that he is not talking about foreclosures still to come. (Apologies to Russell for over-simplifying.)  This is where we begin to part ways.  I submit that the shadow inventory must necessarily include not only actual REOs (or REOs not listed as REOs), but the entire picture.

More to the point, if we look at all the homes that have been foreclosed on, are in foreclosure and should be in foreclosure, we are left scratching our heads and find ourselves back to the same question: why aren’t the banks taking these homes in, putting them on the market, and selling them?   (I’m talking here especially about those homes where people have stopped making their payments and continue to live for 6, 12, even more months.)

Here’s a graph courtesy of the New York Times:

Sources: Federal Reserve Board and Mortgage Bankers Association, via Haver Analytics

That is an awful lot of mortgages in foreclosure; but add to that that lower line – of mortgages in default and not yet in foreclosure – and the numbers are staggering (again, think of people staying on a year after they’ve stopped making payments).  So no matter what we call it, the question remains: What are the banks doing? Why aren’t these mortgages foreclosed?  Why isn’t this inventory on the market?

I know all real estate is local and there are plenty of areas around this country where the last thing agents want to see is more inventory.  But here in San Diego this question of  Shadow Inventory is burning a hole in people’s brains.  We are down to less than two months inventory and the effective inventory (discounting homes that are not financeable due to cracked slabs, missing kitchens, etc.) is closer to one month.  The average buyer is writing over fifteen offers before buying a home or simply walking away in frustration.  We are clamoring for this inventory; why isn’t it out there?

Here’s a theory I’ve been sharing over the past two months with the agents I talk to: the banks have a financial incentive NOT to sell these homes for the same reason they have a financial incentive NOT to lend money.  Let me ask you: if you could borrow money right now from the Fed at roughly 0%, and through carry trades create a very low risk return of 3%, would you do it?  Of course you would; that would certainly be more prudent than putting the money out there in relatively risky mortgages?  More important to our discussion of Shadow Inventory:  you can borrow that money at 0% so long as your balance sheet and reserves are in order. When you have a non-performing asset (like a mortgage not being paid) you can carry that for quite a while.  But, if you sell that home in foreclosure you book the loss.  I don’t know about you, but if I were a bank I would happily carry a non-performing asset and continue to borrow money at 0%.

When the Fed begins to raise rates -expected to be late 2nd quarter or early 3rd – the banks will thank them for the ride and begin clearing their books of these non-performing assets in a hurry.  If we follow this theory to its inevitable conclusion, we are looking at a scenario wherein inventory is going up (and home prices are dropping) while at the same time rates are rising.  Falling home prices and rising interest rates. Not the summer I want… and I hope to hell I am as wrong as I have ever been.


26 Comments so far

  1. Jeff Brown February 4th, 2010 9:43 am

    Thinkin’ from where I stand you could be mostly right. The only potential error I see is the rising interest rates. Though I agree they’ll go up, I don’t think it’ll be by that much, or for that long.

    In any case, San Diego’s home market this summer could very well be a circus in which you wouldn’t wanna be a performer.

  2. Christophe Attard February 4th, 2010 10:05 am

    I agree with your article and recently came across bank which did not or poorly advertized its REOs on purpose. They inflated the values of the REOs, only to show to the shareholders that they had a good amount of assets (on paper). They also did not take the loss as they did not sell them…

  3. Al Lorenz February 4th, 2010 11:41 am

    Logic is a beautiful thing! That makes lots of sense. Thanks!

  4. Russell Shaw February 4th, 2010 11:51 am


    We agree! Really nice post!

  5. Al Lorenz February 4th, 2010 12:19 pm

    “I don’t know about you, but if I were a bank I would happily carry a non-performing asset and continue to borrow money at 0%.”

    There is something that bothers me about this. While I agree it is likely the case, it reflects the poorest of management practices that are all to common.

    It certainly makes sense if I’m trying to make this month’s or this quarter’s numbers look as good as possible. Or maybe it is the only way to survive the month.

    But, if I am aware of the risk of this approach and that when I do finally have to liquidate, everybody else will as well, I know the non-performing assets will fetch far less. That is a suicidal business strategy. But, it probably keeps the paychecks coming every month until doomsday. So much for the shareholders.

  6. Tom Johnson February 4th, 2010 12:52 pm

    Al: The shareholders for the most part are already wiped out. At this point they are all well wired hedge funds and other institutional investors who themselves are in line for a “too big to fail bailout”. They just hope that the artificial life support from the Treasury and the Fed lasts long enough to loot sufficient money from the carry trade to cover a total wipe out on the zombie bank positions. Judging by the Goldman Sachs bonus pool, the shareholders are doing just fine, thank you.

    We have been positioning a rental and property management business because at some point all those folks living for free in the un-foreclosed shadow inventory will have to start paying to live somewhere and I doubt that a mortgage is in their near future. Home-ownership rates are falling and the end result of all this is a renter nation.

  7. Greg Swann February 4th, 2010 1:16 pm

    This is an (admittedly uniformed) argument I have been making for months: That a bank can carry a note at its imputed value until they foreclose, but then they have to report that property at its listed value. I think this is why homes listed as short sales endure so long, also. I didn’t read Russell’s post, but it is obvious to me, driving through the suburbs of Phoenix, that there are many, many more vacant homes than there are listed homes. Some of those could already have been sold. I’ve heard claims of investors buying homes to warehouse the inventory — which might make sense in a world without weather, vandalism, taxes, HOA fees and wear and tear. But my take — again uninformed — is that the real shitstorm has not hit yet.

  8. Don Reedy February 4th, 2010 12:56 pm

    Falling home prices and rising interest rates

    Sean, you’ve scratched an itch I have had for many, many months. Thanks to both you and Russell for the insight.

    Do you want to join with me to build an ark? (Metaphorically, that is).

  9. Sean Purcell February 4th, 2010 7:16 pm

    Jeff – my fear is that rates will go up (although I’m not so sure how much) and stay up. The Fed has pumped so much liquidity into the market place that our dollar is almost worthless. They HAVE to start removing this funny money.

    That’s the optimistic view. Here’s the pessimistic view: China farts and our rates sky-rocket.

    I’d like to be partial to your view; why do you think the rate bump will be small and short-lived?

  10. Sean Purcell February 4th, 2010 7:35 pm

    Thanks Christophe – there’s a lot of fraud going on out there.

    Al – not sure if I agree with you. Tom answered pretty well, but allow me to add this: the bank’s responsibility to its shareholders is to maximize profits (preferably with an eye toward long term success). After careful calculation, it might make financial sense to sell later, even at a lower price, and make profits now. Remember, they’re not making less money later… they’re just losing more. That’s a fine but important concept.

    Bottom line is this: the banks may not be exhibiting poor management; they may be acting very responsibly and in accordance with the incentives placed before them.

  11. Sean Purcell February 4th, 2010 7:41 pm

    Thanks Russell. Your post got me thinking about this inventory in a whole new way and I appreciate it.

  12. Jeff Brown February 4th, 2010 7:52 pm

    Even with the cartoonish money printing, we’re still, IMO, in a deflationary cycle. Wanna repeat what our grandparents went through? Raise taxes, government spending, and interest rates. The massive de-leveraging happening here and around the globe is, again, deflationary, not inflationary.

    And that’s why I fall on the side of a mild interest bump that won’t have legs. That opinion and a few bucks’ll get me coffee and an oatmeal/raisin cookie at Starbucks.

  13. Sean Purcell February 4th, 2010 8:05 pm

    Don – I’m with you… just not sure what shape our “ark” should take (can we load it with two gold bars of every kind?)

    Greg – I don’t get that either: why would investors buy and hold inventory in this market? Sounds like a pretty dangerous strategy to me. But to your conclusion “the shit storm has not hit yet” I can only sadly agree. I’ve been rolling a post around in my head lately, about the year ahead from a “big picture” view, but it’s awfully damn depressing.

  14. Louis Cammarosano February 4th, 2010 8:33 pm

    Sean There are a couple of option for home owners that have plenty of equity in their homes and are worried that the price of their castle is going to go down and inflation is going to hit.

    They can sell and rent or
    They can take advantage of the low rates and equity in their homes and borrow money at low rates and purchase gold or silver.

    If they are right about declining home values and rising inflation they will have protected their equity with the precious metal hedge, without having to move.
    They can then pay their home equity loan back with less valuable inflated dollars.

    Of course if they are wrong and their home values and precious metals go down and inflation doesn’t come but rather we have deflation, they are in a heap of trouble!

  15. jimi February 5th, 2010 7:24 am

    Two large variables that you need to consider — Trial Loan Modifications and Foreclosure Moratoriums.

    The Feds through their “HAMP” initiative heavily incented the banks to defer foreclosures and initiate loan modifications. More than 1.2 million trial loan mods were extended from April through December 09′. These were “no doc” mods which the banks were required to extend. The Feds assumed that the delinq borrowers would follow up with income verification required in order to convert to a “permanent” modification. However, only 66,465 did so. Oops!

    Meanwhile, Federal and State foreclosure moratoriums swelled so-called “held-back” inventory from the market creating a hugh back-log. Now that the moratorium is ending, this overwhelming inventory needs to work it’s way through State foreclosure processes … let’s see you make a bueracrat hurry!

    Lastly, in my market, short-sales are an increasing percentage of home sales. From a bank perspective, these loans are included in the pending foreclosure inventory until sold.



  16. Where Have All The Houses Gone? February 5th, 2010 9:29 am

    […] Purcell wrote an article, over on Bloodhound Blog, about how the “shadow inventory”.  Check out the graph in his article.  Close to one […]

  17. Sean Purcell February 5th, 2010 9:47 am

    Jeff – I think we disagree only as to severity. No doubt you are correct: de-leveraging and rising taxes are deflationary. No doubt government spending and increased money supply are inflationary. I’m coming down on the side of inflation. (Hyper-inflation?)

    I guess I’m betting my coffee and cookie against your coffee and cookie that our obscene monetary policy over the past couple years will trump the unwinding of so much debt and the government’s general economic ineptitude. The real problem: our bet is kind of a “heads I lose, tails you lose” proposition for the nation as a whole…

  18. Jeff Brown February 5th, 2010 9:56 am

    Sean — Apply Bernanke’s approach at some point before the Great Depression began. Would he have headed it off? Who knows for sure, but I think it’d been more likely than not he’d either of avoided it altogether, or it would’ve been Depression Lite. AND there probably wouldn’t have been subsequent inflation to the degree you predict, as the economy would’ve soaked it up without much if any liquidity left over. Of course, that assumes the guy in charge of the printing press knows when the hell to shut it off. 🙂

    If Obama gets his way with higher taxes and keeps increasing the deficit, it’s my contention he’d be repeating history. Not a happy thought.

  19. Sean Purcell February 5th, 2010 10:15 am

    Louis – You’re right, a precious metals hedge is one way to cover the potential risk I’ve stated, but as you point out: if we end up with Jeff’s deflationary cycle that hedge means you are screwed… twice! I tell investors they should be borrowing every last dime they can right now. Rates are going up in my scenario, but even in a deflationary cycle they can’t go much lower. Plus, money is almost worthless and every indication is it will continue down that path so why not borrow money today that I can pay back with less valuable money tomorrow. That’s what I tell investors.

    Homeowners, on the other hand, should not be playing games with their home. I used to believe in the home as an investment, but I have joined a 12 Step program, made my amends and changed my wicked ways. Your personal home is not an investment and debt on that home is BAD. No matter what we think is going to happen, the best bet as a homeowner is to own your home outright and not be concerned with temporary gyrations in the marketplace. Then your only concern is the government taking your home through criminal abuse of eminent domain… but that’s another post altogether.

  20. Tom Johnson February 5th, 2010 11:45 am

    Sean: As we evolve into a renter nation, do not shortchange the government’s ability to tax evil “property owners”. Sound familiar? I agree that a paid for homestead is the best fortress from which to weather the storm especially in states that have strong constitutional homestead protections, Texas and Florida come to mind.

  21. Ryan Ward February 8th, 2010 5:06 am

    There is a lot written here but in the end it’s simple: Banks will not flood the market simply because an increase in supply means lower prices for them and for everyone else. They are simply controlling the supply that hits the market.

    I believe this is about the smartest thing they have done in years.

  22. Louis cammarosano February 10th, 2010 9:47 am

    Sean if you are correct that home prices might fall and interest rates rise, wouldn’t those two factors keep inflation in check?

  23. Jeff Brown February 10th, 2010 3:08 pm

    Louis — Let me take a crack at that question.

    Those exact two factors co-existed in the Carter fiasco beginning in the 4th quarter of 1979 and extending for several years. Very high inflation and interest rates, while values fell.

  24. Sean Purcell February 10th, 2010 4:52 pm

    Inflation – usually defined as an increase in the price of goods across a wide spectrum – is better defined (at least in our modern, paper currency era) as a monetary issue: too much money chasing too few products – a supply and demand imbalance on a national scale. A much more accurate understanding, however, is that inflation is a tax resulting from the devaluation of the currency. (See: seigniorage)

    Homes are a very specific (though not fungible) commodity and they react to the laws of supply and demand as well.

    So, it is quite possible to debase the dollar to a level of hyperinflation, while at the same time experiencing price drops in a specific market with a supply/demand equation very out of balance. In other words: housing would have a very literal supply/demand imbalance whereas the nation as a whole is experiencing inflation, not because of increased demand or decreased supply… but rather due to the devaluation the dollar.

  25. JIm Whatley February 12th, 2010 8:53 pm

    I’m no where near you guys on Real Estate experience. My thinking is prices have no where but to go down. here is my thinking.

    1.everyone’s taxes property, Income and capital gains. are going up less income.

    2. Insurance is going up.

    3. To much damaged inventory.

    4. Less potential buyers who can qualify.

    5. Whole hoods where built in 05/06 these people are deadmen walking. Most don’t even know they are in trouble.

    I think banks will start using receiverships and avoid selling for huge losses. They well slow sell them collecting rent and keeping them on the books. The Federal government is gearing up to do just this.

    Just a Redneck who likes dogs even bloodhounds.

  26. JIm Whatley February 13th, 2010 10:39 am

    I forgot one thing on my list

    5. Energy Cost: heating cooling water and fuel to get to and from work.