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.

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