8.7 years to clear Orange County distressed inventory at stable liquidation rate

Lenders are withholding inventory across the Southwestern United States in hopes of creating a shortage of supply to reverse the downward spiral in home prices. Lenders constantly try to balance two competing forces. First, lenders need to get their money back. Dead money tied up in non-performing assets does not contribute positively to their bottom line. Further, this money also cannot be used to fund ongoing operations. This puts enormous pressure on lenders to liquidate and put their capital toward a productive use. On the other hand, if they liquidate too quickly, house prices go down which reduces the amount of capital they recover. Taken in the context of all their holdings, declining asset values wipes the equity from their balance sheets whether they choose to recognize this fact or not.

If lenders liquidate non-performing loans and REO too slowly, many will go broke from the collective weight of their expenses and other overhead. Back when banks paid depositors interest on their accounts, interest expense drained bank resources. The bank bureaucracy also drains cash reserves. If banks don’t obtain interest payments to cover expenses — and non-performing loans don’t providing interest payments — then banks eventually go broke. Lenders avoid this problem by booking phantom interest on non-performing notes, and borrowing the rest from the federal reserve. This smoke and mirrors approach to solvency cannot go on forever. This pressure to liquidate is alleviated somewhat by mark-to-fantasy accounting and loans from the federal reserve, but reality compels banks to liquidate despite the impact this liquidation is having on resale home prices.

REO liquidations caused a two-year decline in home prices since the expiration of homebuyer tax credits in 2010. So far in 2012, lenders have abruptly curtailed foreclosure activities across the Southwest, but this slowdown comes at a price. The supply of distressed properties does not magically disappear because lenders stop putting it on the market. Whenever lenders slow the rate at which they liquidate their holdings, they merely prolong the agony for the housing market. Today, I want to quantify that agony and show why any market bottom will not be followed by a sustained rally to bubble peaks any time soon.

I hope this post will provide peace of mind to many who fear the lack of current supply means the foreclosure deals are gone for good. They are not. Prices will not rise quickly and sustain a new bull market. The lender liquidation process will go on for years.

Calculating lender liquidation time

In order to calculate the total amount of time it will take to clear the distressed inventory, we need to do the following:

  • calculate the total number of existing REO,
  • calculate the total number of future REO already in the pipeline,
  • estimate the number of future REO which will enter the pipeline based on the number of delinquent loans,
  • estimate the number of future bad loans which will go delinquent while the liquidation grinds on, and
  • calculate the total number of REO liquidations each month.

The calculation is relatively simple once we have the data:

existing REO + REO in process + future REO (current and future delinquencies) / monthly liquidation rate = months of distressed supply.

Surprisingly enough, most of this data is easy to find, and anyone can verify its veracity.

How many REO do the banks already have?

As of March 2012, lenders are holding 3,924 REO. They have been maintaining a balance of nearly 4,500 REO for the last several years. This is clear evidence of how lenders manage their REO inventories.

How many bad loans are being processed in Orange County today?

According to Foreclosure Radar, there are 11,078 total outstanding notices in Orange County. 4367 of those are Notices of Default, and 6,709 are Notices of Trustee Sale. Those numbers are down from the end of March numbers of 5,642 and 7,360 reported above. These are loans in the foreclosure pipeline. You can verify the current numbers at RealtyTrac.

Many of these delinquent borrowers will sell through a short sale, but between one-quarter and one-third will end up as REO. Both short sales and REO are distressed sales, and both weigh down prices.

Lenders add to the filings each month to chip away at the much larger shadow inventory number.

How many bad loans are waiting in shadow inventory in Orange County today?

According to a recent report in the OC Register, 5.5% of Orange County mortgages are more than 90 days delinquent. This is the most serious delinquency category as most borrowers who go more than 90 days delinquent never recover. They are the typical delinquent mortgage squatters waiting for the bank to get around to booting them out.

A serious delinquency rate of 5.5% is about seven times the historic norm of about 0.75%

So how many loans is 5.5% of the Orange County total?

According to the US Census Bureau, there are 1,048,907 housing units in Orange County as of 2010. Of those, 33.7% are multi-family units. That leaves 66.3% as either attached or detached single-family homes. That amounts to nearly 700,000 houses in Orange County (10,48,907 * 66.3% = 695,425). It doesn’t matter if these are owner-occupied or rental units as either one could have a delinquent loan associated with it.

According to the American Home Survey, there are 462,761 housing units in Orange County with a mortgage on it. That means 66.5% have mortgages, and 33.5% are owned free-and-clear.

If there are 462,761 mortgage in Orange County, and if 5.5% of those are more than 90 days delinquent, then there are 25,451 delinquent mortgage squatters in Orange County. We can assume these have been served notices, so if all 11,078 are subtracted, then there are still 14,373 waiting in shadow inventory.

How many loans will go bad in Orange County before the inventory is cleared out?

Conservative estimates put the number of underwater loan owners at over 100,000 just in Orange County. When factoring in transaction costs, this number rises to over 125,000. Many of this cohort will want to sell and move before they get above water, and many of them are barely hanging on with loan modifications in houses they really can’t afford. Whether this group sells as a short sale or defaults and becomes REO, the sale will be distressed, and it will put continuing pressure on prices.

Estimating the number of short sales or REO from this group is very difficult. Studies estimate strategic default at 17% of overall defaults, but the definition used in that report is very narrow. In reality, any loan owner who struggles with burdensome payments and chooses not to continue paying the mortgage may go through a short sale or modify their loan only to default later. They aren’t picked up in the strategic default statistics, but their choice to quit paying the mortgage while underwater was certainly carefully considered and strategic. Plus, how many short sales are strategic defaults in disguise? Selling short while deeply underwater and buying again at the bottom sure smells like a strategic loan exit.

Another source of future bad loans are the loan modification programs HARP, HAMP, and private programs run by the banks. Twenty-five to fifty percent of the participants in loan modifications programs redefault within a year, and less than half will ultimately survive until they are no longer underwater. Millions of borrowers applied for these programs nationwide, and several hundred thousand were initiated. I can’t find good data on the number in Orange County, but it’s safe to assume its a number over 10,000. If over half of those redefault and become REO, that’s another 5,000 REO held in reserve.

I think it’s a conservative estimate to conclude at least 10% or 12,500 underwater borrowers will be added to the pool of REO over the next few years. Many others will become short sales. The total number of REO from strategic default from underwater loan owners could easily be much, much higher.

So how many REO will need to be sold?

If you add up the above, you get 41,875 REO to be cleared out over the next several years.

(3,924 + 11,078 + 14,373 + 12,500 = 41,875).

Is 41,875 a big number? That depends on how many REO sell each month. One of the biggest fallacies promoted on the web is that shadow inventory will only take a few years to clear because if you divide the total number by the total monthly sales, the result is only a few months (CoreLogic should be ashamed of such shoddy analysis). It doesn’t work that way. To accurately calculate the months of supply of shadow inventory, the denominator must be the total number of REO sold each month, not the total number of homes sold (At least Standard and Poors knows what they are doing). The latest plausible estimate for the nation is 45 months, or just under 4 years. As your about to see, even that duration is too quick.

How many REO sell each month?

Since REO inventories have held steady at about 4,500 units (see above), the 450 units lenders take in each month must be matched by outflows of an equal number. The small decline in REO inventories over recent months has come about partly from a small increase in sales, but mostly from a large decline in the number of REO banks are picking up at auction.

Lenders had been liquidating about 450 per month since the expiration of the homebuyer tax credit in 2010. That rate of liquidation is too high to sustain current pricing, so as banks maintain this rate, prices continue to drop. Therefore, lenders decided to reduce the rate to try to find an equilibrium where prices do not decline. Until demand picks up further, expect lenders to keep REO liquidations to less than 400 per month.

At current sales rates how long will it take to clear out all the current bad loans in the system?

It’s time to crunch some numbers.

At the currently stable rate of liquidation of 400 per month, it will take lenders 104 months or 8.7 years to clear the market. (3,924 + 11,078 + 14,373 + 12,500 = 41,875 / 400 = 104 / 12 = 8.7)

At the previous rate of liquidation of 450 per month — a rate proven to cause prices to decline — it will take lenders 93 months or 7.7 years to clear the market. (3,924 + 11,078 + 14,373 + 12,500 = 41,875 / 450 = 93 / 12 = 7.7)

Let’s say you don’t agree with my assumptions on future REO based on strategic defaults and failed loan modifications. If you only include existing REO, pipeline REO, and shadow inventory of 90-day delinquent loans, it will take lenders 73 months or 6.1 years to clear the market. (3,924 + 11,078 + 14,373 = 29,375 / 400 = 73 / 12 = 6.1)

Best case scenario if you include only existing REO, pipeline REO, and shadow inventory of 90-day delinquent loans and increase sales volumes by 20% to get back to historic norms (won’t happen without a move up market), it will take lenders 61 months or 5.1 years to clear the market. (3,924 + 11,078 + 14,373 = 29,375 / 480 = 61 / 12 = 5.1)

No matter how you sensitize the calculations it will take at least five full years to eliminate the existing distressed inventory with nearly nine years a more accurate number.

Realistically, it will take much longer than five years. Running at full steam it will probably take the full 8.7 years of my initial estimate. Over the last few months, lenders have drastically reduced their liquidations to about 300 per month to get prices to go back up. At that rate, they will be selling REO for another decade or more.

Remember, the rate of sales lenders are liquidating will barely hold prices steady. If they sell any more, prices will go down — they proved that over the last two years. If they sell any less, their liquidation will take more than a decade.

Do you see why I say it’s very unlikely prices will embark on a sustained rally? It’s all lenders can do to hold prices steady.

The long tail

Realistically, lenders will not process REO at the maximum rate beyond the next three to five years. As they get closer to the end, they will slow their REO processing to allow prices to slowly rise. They will still be putting out enough REO to keep appreciation in check, but they won’t put out so many as to push prices lower. This changing rate of liquidation is why price recovery graphs after asset price bubbles take on the shape they do.

Most loan owners mistakenly believe prices in Orange County have crashed from their normal values. In their minds, once conditions improve, prices will quickly recover to the peak then appreciate at 5% to 7% per year thereafter. That isn’t going to happen, partly because those expectations are totally unrealistic, but mostly because of the flattening weight of overhead supply.

Prices have only now fallen back to rental parity and begun to stabilize — and that only applies to the lower half of the market. The move up markets are dead, and they will continue to crumble.

With the long tail of lender liquidations, the Orange County housing market has been put on ice.

The Great Depression in the United States was so traumatizing because it went on so long. The Great Recession in the aftermath of The Great Housing Bubble may be just as bad on those who need real estate prices to go up in order to feel prosperous. Don’t believe the bottom-calling hype. This isn’t over yet.