Do the benefits of shadow inventory outweigh the costs?

Shadow inventory is composed of delinquent mortgage holders who still occupy the houses they are not paying for. Many in shadow inventory have been living payment free for years, and many will continue living for free for several more. So why did banks do this? Ordinarily, banks would foreclose quickly to get their capital back to loan it profitably to someone else. What was their benefit in allowing so many to squat for so long?

In mid 2008, house prices were crashing hard, particularly in subprime dominated markets which were the first to implode when their toxic mortgages required higher payments. Lenders quickly realized prices were crashing because they were flooding the MLS with inventory, and the available buyer pool couldn’t absorb it at bubble-era prices. A certain amount of price correction was inevitable because prices were too high, but many markets began to overshoot to the downside under the weight of so many foreclosures.

For the banks, continuing to flood the MLS with foreclosures was reducing the value of the collateral backing their loans and increasing their losses. It was in their best interest to stop and maintain as much bubble-era pricing as they could. New England witnessed the extreme of delinquent mortgage squatting as the legions of delinquent loan owners were not foreclosed on. As a result, their prices are still artificially inflated, and many copycats defaulted on their mortgages to obtain the same free housing benefit.

The national economy also benefited from this arrangement. Since millions of loanowners no longer made house payments, their income was freed up to spend on other goods and services. The squatter stimulus is huge, and politicians won’t complain about anything which stimulates a weak economy. Both banks and politicians supported a policy that enabled millions of delinquent mortgage squatters.

These benefits don’t come without a cost. First, supporting artificially high house prices reduces real estate transaction volumes. realtors are blind to this obvious fact, and they consistently endorse any policy designed to support inflated prices, particularly relaxing lending standards which they see as an impediment to more transactions. realtors would generate more commissions if prices fell further and more people could afford housing. Further, inflated house prices force new buyers to pay more than they should. If these buyers paid less, they would have more disposable income to stimulate the economy. Low interest rates have offset this problem to some degree but not enough to prompt enough buying to clear out the overhang of distressed inventory.

The weakness in the economy we experience today is partly due to the lack of disposable income, but it’s also caused by a moribund homebuilding industry. A significant sector of our workforce is unemployed. A short, painful correction was inevitable, but this has dragged on for five years now because rather than clearing out the overhead supply, lenders have been metering it out slowly which directly competes with builder supply. Though improving now, homebuilding will continue to sputter until the competing REO are washed through the system.

Another cost of shadow inventory is less obvious but perhaps more pernicious. We are creating a generation of borrowers who have no compunction about over-borrowing when times are good because they know they will be given years of free housing if there is a collapse. This moral hazard is sowing the seeds of the next housing bubble and crash. Plus, the gross unfairness of the distribution of these rewards is infuriating, particularly to those who must pay for it with a variety of government bailouts. The costs of these problems are difficult to quantify but no less real.

Despite these costs, the banks, government officials, and realtors all want to see shadow inventory persist because it serves to sustain inflated bubble-era prices and it provides a needed economic stimulus.

Diverting the Foreclosure Flood

By Steve Berkowitz, CEO of Move, Inc., operator of Realtor.com — 7/26/2012 @ 7:34PM

Millions of Americans, myself included, applauded when the nation’s five largest lenders and attorneys-general from 49 states reached a landmark $25 billion settlement last March.

I, for one, did not applaud. In fact, I was appalled because this settlement primarily benefited the banks. Millions of Americans were duped into thinking this benefited them, but it didn’t. California has already decided to take the settlement money earmarked for loanowners and spend that money on something else.

Among many things, this landmark agreement settled charges of foreclosure processing abuses dating back to 2008.

While the settlement was good news for distressed borrowers, the processing of foreclosures slowed dramatically during the 18 months of negotiations. The slowdown created a shadow inventory of more than 1.5 million shuttered homes ─ nearly twice the number of foreclosures sold last year and representative of about 39% of the 3.6 million+ foreclosures completed nationally since the start of the housing crisis in September 2006.

This makes for a compelling narrative, but it’s not accurate. Shadow inventory was building up long before any Robo-signer problems. Banks used Robo-signer as a cover to justify a policy they were already implementing. Plus, the real shadow inventory is likely much larger than reported.

If this wave of foreclosures is released into local markets without concern for their impact on home values, many of our local real estate markets could be threatened.

Yes, they would. However, lenders have been managing this problem for the last five years, and so far, with few exceptions, they have managed to sustain artificially high prices in most markets. And now, they have the support of 3.55% interest rates courtesy of the federal reserve. I think it very unlikely they will suddenly start to push REO through the system at a rapid pace and cause prices to crash.

Thus, the long-awaited recovery, so critical to restoring value and equity back to our real estate economy and American homeowners, could saddle several major markets with foreclosures for years.

That is what will happen. The long-term liquidation of these houses will keep prices right where they are for a very long time. I speculate it will take at least until 2015 before foreclosure processing isn’t a dead weight holding back normal 3% per year appreciation.

A survey Realtor.com recently conducted found that more than half of all Americans (55.7%) are concerned that backlogged foreclosures will lower home values in their markets.

That’s encouraging. I didn’t realize that many people knew about shadow inventory. This may explain why realtors, economists, and reporters are embarking on a concerted effort to convince the general public the bottom is in and it’s safe to buy a house.

Some lenders are moving to ease their inventories in some of the states with the highest levels of backlogged foreclosures. Sales of bank-owned foreclosures were down nationwide from a year ago, but were up significantly in judicial states. In the second quarter of 2012, foreclosure starts increased in 31 states year-over-year, of which 17 were judicial states, hinting that lenders are still working through the bottleneck of unsold REO inventory in many areas. In fact, four of the five states in May 2012 with the highest foreclosure inventory as a percentage of all mortgaged homes were judicial states: Florida (11.9%), New Jersey (6.6%), Illinois (5.3%), and New York (5%).

Our nation’s lenders and real estate leaders must work together to preserve the price stability gained over the past 18 months by controlling the flow of foreclosures back into for-sale inventory.

Oh, really? The banking cartel must be assisted by realtors to force buyers to overpay for real estate? I don’t think so. The author of this article is from realtor.com. No buyers should believe realtors are interested in their well being. To a realtor, buyers are chum to be fed to the market to earn a commission.

We know that sudden spikes in inventory shock prices and destabilize markets, while healthy markets can sustain relatively high saturation levels of inventory if introduced over time. Should large volumes of foreclosures hit these markets over a relatively short period, home values will suffer and the emerging housing recovery will regress in many key markets.

No. If a large volume of foreclosures were processed quickly, many people would get bargains, and when the supply is gone, prices would rebound, and those that purchased at the bottom would have equity to re-ignite a move-up market. If we meter these houses out slowly over time, buyers will overpay and have less disposable income, and the move-up market will languish for a decade or more.

… Monitoring local market conditions so lenders can moderate the release of foreclosures is also important. In recent years, technology has made tremendous strides in enhancing our ability to watch local real estate markets in real time. With listings data from 850+ MLSs, Realtor.com tracks inventories, time on market, and list prices on thousands of markets with accuracy. We’re prepared to work with leading lenders to help actively monitor local markets so they can regulate the release of foreclosures into the marketplace.

He is openly proposing to collude in manipulating the real estate market. I recently asked Is the banking cartel in violation of the Sherman Antitrust Act? I think we have our answer.

Since the onset of the Foreclosure Era in 2006, we’ve learned a great deal about foreclosures and how they can devastate home values by destabilizing markets with sudden waves of discount-priced properties. By working together, lenders and real estate leaders can maintain the stability of our local markets by keeping another wave of foreclosures from sending America’s real estate markets under water.

I hope they fail.