Sep022009

Shadow Inventory in Orange County

 

Some say the world will end in fire,
Some say in ice.
From what I’ve tasted of desire
I hold with those who favor fire.
But if it had to perish twice,
I think I know enough of hate
To say that for destruction ice
Is also great
And would suffice.

Robert Frost

In order to discuss Shadow Inventory, we must define it. Shadow Inventory is the total of Preforeclosure Inventory, REO and some other sources. Preforeclosure Inventory includes all mortgages currently 60 days or more behind on their payments that are likely to become foreclosures but not yet REO. To understand these distinctions, review the foreclosure timeline below.

ARM Reset to Final Sale

 

 

When a mortgage holder gets 60 days behind, they become part of the preforeclosure inventory. Once a property is in preforeclosure inventory, there are two possible outcomes: (1) cure or (2) foreclosure.

Curing the deficiency involves one of three possible methods: (1) selling the house — something that doesn’t happen often when the owner is underwater — (2) paying off the deficiency in cash, and (3) loan modification. The first method used to be the most common, but now with so few mortgage holders with any equity, very few people are curing by a sale.

Few people ever pay off a deficiency in cash because if they had cash, they probably would not be in default.

Despite rumors to the contrary, loan modification programs have been completely ineffective. Very few people actually get the modifications, and most of those people re-default and end up in foreclosure anyway. If these programs were effective, it would show up in high cure rates; 6.6% is not very high.

There should be only five or six months between missing the second payment and a property being auctioned as foreclosure. Properties are not supposed to be warehoused as preforeclosure inventory, but with the various foreclosure moratoria, there is now a significant backlog of homes held in limbo. Preforeclosure inventory is market pergatory.

Mortgage holders are defaulting in large numbers. The current default rate is 10.7%, but it is projected to hit 14% by the end of the year. If you do a little math, you can calculate the number of homeowners currently in default in Orange County.

Number of OC Homes Delinquent on Mortgage Payments

Orange County Housing Units 1,029,603
OC Home Ownership Rate 61.4%
Total Owned Housing Units 632,176
Percent With Mortgage 68.4%
OC Homes With Mortgage 432,409
Current OC Delinquency Rate 10.70%
OC Homes Currently Delinquent on Mortgage Payments 46,268

(Links to source material provided above.)

Look at how devastating a delinquency rate of 10.7% really is.

Astonishing!

If there is any headline from the mainstream media you should take note of, it is the extraordinarily high delinquency rate. It is central to the calculation of Shadow Inventory, and it is the tsunami many here have been waiting for.

The rest of the analysis is built around this calculation.

Cure Rate

When a mortgage holder gets behind on payments, they often “cure” the deficiency — well, at least they used to. The cure rate in early 2007 was 45%; It recently fell to 6.6%.The cure rate is the ratio of the number of loans cured divided by the number of delinquent loans in the system. It is a measure of the percentage of loans each month that leave Shadow Inventory. It is a direct measurement of one of the methods of exiting the system — the other being foreclosure. When a property goes delinquent, what isn’t cured is a foreclosure.

Cure rates are very low right now because there is so much shadow inventory in the system that has no chance of curing. This makes the denominator of the calculation larger than it should be (Loans Cured / Total Delinquent) because delinquent loans are not becoming REO on time. There are about 15,000 loans in Preforeclosure Inventory that should be REO but due to foreclosure moratoria and other policies, Shadow Inventory (Preforeclosure Inventory plus REO) has been growing. This is consistent with anecdotal reports I have heard.

Shadow Inventory Calculation

With a little more math, you can calculate the the number of these defaults that are going to become REO.

OC Homes Currently Delinquent 46,268
Cure Rate 6.6%
Mortgages Brought Current 3,054
Properties Heading to REO 43,214

Note the above calculation determines how many will become REO. To calculate our current Shadow Inventory, the future REO must be shifted six months to allow for processing time. Our current Shadow Inventory is sourced from the projected REOs of six months ago — a time when delinquency rates were lower and cure rates were higher. Six months from now, things will be much, much worse.

 

I am projecting the delinquency rate to peak at 16% in the second quarter of 2010 about the same time unemployment peaks. It will remain elevated for some time as the lingering effects of unemployment take their toll. Shadow inventory will peak in December of 2010. With the ARM resets coming, peaking in 2010 requires massive capitulation (defaulting before the reset). Orange County may not capitulate on schedule, but the statistics suggest capitulation is already occurring.

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Shadow inventory is not the peak of foreclosures, it is the peak of the supply of properties in the foreclosure pipeline. How and when these properties are moved through the foreclosure process is anyone’s guess. When the crisis is finally over, a whopping 40% of all properties with mortgages in Orange County will go through foreclosure. It is the 175,000 pound pig moving through the snake, or the equity tsunami building building strength; you pick the analogy. It is bad.

reo

 

This is the number I am least sure of in this analysis due to the assumptions in the calculation. It should take 10 months for a property to go from being 60 days delinquent to an REO sale in the marketplace (360 – 60 = 300 = 10 months). Lately it has been taking much longer. To calculate the REO total, I have added every 12th month together to avoid double counting. I am assuming it takes on average 12 months to go through the system. If it only takes 10 months, then the total REO number is larger than 175,000, and if it takes 18 months, it is about 33% smaller.

The next step is to calculate REO Inventory and Preforeclosure Inventory. Graphrix was kind enough to obtain data on REO inventory and sales since January of 2007. With that data and the calculations above, the table below was generated.

REO Inventory and Preforeclosure Inventory

REO inventory is not mysterious; it is the sum of all properties that have entered the system minus those that have been removed through final sale to its new owner. When you run the calculation, you discover that REOs have been building up in the system for quite some time (I started with zero in January of 2007 which isn’t accurate. In short, my number is understated.)

If you know Shadow Inventory, and if you know REO inventory, everything left over is Preforeclosure Inventory. Below are a table and charts parsing this data.

 

The chart above shows the increase in REOs and REO sales over the last two and one-half years. Lenders have been consistently behind in processing REO causing a buildup in the system.

reo2

 

In 2009, lenders became more serious about selling its REO, and REO inventory has been holding steady at about 6,000 units all year. For the last year, foreclosures have been selling at the rate of about 800 a month in Orange County. This sales rate keeps prices stable, but it is too low to satisfy demand. This rate could increase some without hurting prices too much, but it will take a significant increase in REO sales to work off the inventory on its way.

reo3

 

The stabilization of REO inventory should be a good sign for the market; however, stabilization occurred by falling behind on the foreclosure process and by creating an enormous Preforeclosure Inventory.

reo4

 

How do we clear the market?

There are so many houses that must go through foreclosure, it is hard to imagine how to dispose of all of them. I tried to create a projection where nearly 100% of a normal sales volume were REOs to see how quickly they can be pushed through the system. I recognize this is not realistic, but it is the best-case scenario for clearing out the inventory problem.

 

reo5

Even with this aggressive scenario, the foreclosures still haven’t fully worked through the system by the end of 2013. Realistically, this problem will be with us until 2017. Lingering effects will last much longer.

The good news is that kool aid should be fully purged from the system by then….